BHP - what's it worth?

Reading through the plethora of picks for 2007’s top performers, or favoured stocks by brokers in the paper each week, one company seems to be this season’s must have and that’s BHP

Looking up BHP I’ve found that of 15 brokers submitting their estimates to Thomson Financial, 6 have it as a ‘strong buy’, 7 as a ‘moderate buy’ and 2 say ‘hold’. The median EPS forecast for 2007 is 286.3 rising to 294.2 for 2008. So it looks like that BHP, trading at $25.33, is on a forward PE of just 8.8x. By comparison, RIO is on a forward PE for ’07 of 9.3x consensus estimates.

Yet BHP has underperformed the All Ords in the last 12 months – yes, in one hell of a commodities boom, the chief commodity company on the bourse hasn’t delivered a market return. And it’s not just underperformance, BHP shares basically haven’t moved since Jan-06 while the market has put on perhaps 18-20% (BHP in blue, All Ords in red in graph below from Yahoo Finance)

There could be a few reasons for this. Maybe it’s just cheap, taking a breather after performing well the prior year, or is this just indicative of a market at the top of the cycle where PE ratios are low because the market doesn’t think earnings are sustainable. I am probably leaning toward the latter.

One of my favourite tactics when assessing if a company is cheap or not is to reverse engineer the share price, that is, what sort of growth rate is factored into the current price? I was at a presentation from Investors Mutual where they talked about how they use a variant of this strategy and identified that stocks like CSL and Brambles were effectively priced for 0% sales growth over the next 10 years. I’ve also used it successfully for stocks such as Super Cheap Auto recently and, believe it or not, Telstra.

I’ve used figures from a major institutional broker as the backbone of my own ‘back of the envelope’ calculations for BHP (note that the broker’s DCF valuation for BHP is $20.92 and they have a ‘neutral’ rating). Anyway, using the broker’s figures out to 2011 as a base then applying a simple growth factor beyond, and calculating a terminal value, it tells us that to justify a price of $25.33, BHP only needs to grow free cash by 2.5% p.a. from 2007 to 2016 (assuming an AUD/USD rate of 0.7850). Increasing the annual growth of free cash flow over the period to 3.5% increases the current value to $26.85 or +6%.

These aren’t demanding growth targets but commodities are by nature a volatile market; witness the large swings in prices of copper, for example, on a regular basis. I’ll be keeping an eye on the former Big Australian to see how things pan out. Maybe the shares will outperform in 2007, keeping the tipsters in bread and soup for another year.