BP p.l.c.'s (LON:BP.) Fundamentals Look Pretty Strong: Could The Market Be Wrong About The Stock?

With its stock down 11% over the past three months, it is easy to disregard BP (LON:BP.). But if you pay close attention, you might find that its key financial indicators look quite decent, which could mean that the stock could potentially rise in the long-term given how markets usually reward more resilient long-term fundamentals. Particularly, we will be paying attention to BP's ROE today.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

See our latest analysis for BP

How Do You Calculate Return On Equity?

ROE can be calculated by using the formula:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for BP is:

31% = US$27b ÷ US$87b (Based on the trailing twelve months to March 2023).

The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.31 in profit.

What Has ROE Got To Do With Earnings Growth?

So far, we've learned that ROE is a measure of a company's profitability. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. Assuming everything else remains unchanged, the higher the ROE and profit retention, the higher the growth rate of a company compared to companies that don't necessarily bear these characteristics.

BP's Earnings Growth And 31% ROE

Firstly, we acknowledge that BP has a significantly high ROE. Additionally, the company's ROE is higher compared to the industry average of 16% which is quite remarkable. Needless to say, we are quite surprised to see that BP's net income shrunk at a rate of 16% over the past five years. Based on this, we feel that there might be other reasons which haven't been discussed so far in this article that could be hampering the company's growth. These include low earnings retention or poor allocation of capital.

So, as a next step, we compared BP's performance against the industry and were disappointed to discover that while the company has been shrinking its earnings, the industry has been growing its earnings at a rate of 21% in the same period.

The basis for attaching value to a company is, to a great extent, tied to its earnings growth. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. If you're wondering about BP's's valuation, check out this gauge of its price-to-earnings ratio, as compared to its industry.

Is BP Making Efficient Use Of Its Profits?

When we piece together BP's low LTM (or last twelve month) payout ratio of 18% (where it is retaining 82% of its profits), calculated for the last three-year period, we are puzzled by the lack of growth. This typically shouldn't be the case when a company is retaining most of its earnings. So there could be some other explanations in that regard. For example, the company's business may be deteriorating.

In addition, BP has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Our latest analyst data shows that the future payout ratio of the company is expected to rise to 31% over the next three years. Accordingly, the expected increase in the payout ratio explains the expected decline in the company's ROE to 16%, over the same period.

Conclusion

On the whole, we do feel that BP has some positive attributes. Although, we are disappointed to see a lack of growth in earnings even in spite of a high ROE and and a high reinvestment rate. We believe that there might be some outside factors that could be having a negative impact on the business. Further, on studying current analyst estimates, we found that the company's earnings growth is expected to be pretty much the same. Are these analysts expectations based on the broad expectations for the industry, or on the company's fundamentals? Click here to be taken to our analyst's forecasts page for the company.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.