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Play The Percentages With BP plc

BPThe forward price-to-earnings (P/E) ratio — share price divided by the consensus of analysts’ forecasts for earnings per share (EPS) — is probably the single most popular valuation measure used by investors.

However, it can pay to look beyond the consensus to the spread between the most bullish and bearish EPS forecasts. The table below shows the effect of different spreads on a company with a consensus P/E of 14 (the long-term FTSE 100 average).

EPS spread Bull
extreme P/E
Consensus
P/E
Bear extreme
P/E
Narrow 10% (+ and – 5%) 13.3 14.0 14.7
Average 40% (+ and – 20%) 11.7 14.0 17.5
Wide 100% (+ and – 50%) 9.3 14.0 28.0

In the case of the narrow spread, you probably wouldn’t be too unhappy if the bear analyst’s EPS forecast panned out, and you found you’d bought on a P/E of 14.7, rather than the consensus 14. But how about if the bear analyst was on the button in the case of the wide spread? Not so happy, I’d imagine!

BP

Today, I’m analysing oil supermajor BP (LSE: BP) (NYSE: BP.US), the data for which is summarised in the table below.

Share price 501p Forecast
EPS
+/-
consensus
P/E*
Consensus 80.3 cents n/a 10.5
Bull extreme 93.0 cents +16% 9.1
Bear extreme 66.0 cents -18% 12.8

* EPS at current $ to £ exchange rate of 1.685

As you can see, the most bullish EPS forecast is 16% higher than the consensus, while the most bearish is 18% lower. This 34% spread is narrower than the 40% spread of the average blue-chip company.

I’m not surprised the spread of EPS forecasts for BP has narrowed recently. Much of the heavy lifting of the restructuring of the company in the wake of the 2010 Gulf of Mexico oil spill has been done. With less uncertainty, earnings visibility has improved, and the breadth of plausible earnings scenarios has become less extreme.

Still, with some work on the shape of the company still to be done, and in an industry where prices can be pretty volatile, I’m a little surprised the spread of EPS forecasts is narrower than that of the average blue-chip company.

BP’s shares have gone nowhere since recovering to a post-oil-spill high of a bit over 500p in January 2011. But earnings, too, have made no headway, and the market remains fairly unexcited by the stock.

The most bullish EPS forecast puts BP on a ‘value’ single-digit P/E of 9.1, while the consensus is not far into double digits at 10.5. Even at the bear extreme of 12.8, the P/E is below the FTSE 100 long-term average of 14.

As such, I reckon the risk-reward balance is tipped towards reward for far-sighted investors.

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G A Chester does not own any shares mentioned in this article.