One of my tenets in dividend growth investing is to avoid buying companies that are overvalued. That’s why I write a couple of articles a month on valuation. One by one, we go through the available stocks and see whether they are fairly priced.
We want bargains. If we can’t find bargains, we want high quality stocks that are at worst fairly priced. We never want to overpay.
I value companies using a 4-step process that is fully described here. Once all of the steps are completed, I average the 4 results and grade them according to the following scale.
The colors are like those on a traffic signal. Green means go and red means stop.
Green suggests that the stock is on sale; yellow indicates a neutral or fair price; orange means caution; and red suggests that the stock is selling for a lot more than it is worth. As Warren Buffett has said, “Price is what you pay. Value is what you get.”[ad#Google Adsense 336×280-IA]This article’s subject is Omega Healthcare Investors (OHI).
OHI is a medium-sized real estate investment trust (REIT).
It owns healthcare facilities in the United States and United Kingdom.
I own OHI in my Dividend Growth Portfolio. OHI is now in its 18th month of flat or declining price.
Sometimes that is bad news for a company, but other times it is good news: It may mean that a quality company is available for a good price courtesy of Mr. Market.
Let’s see if Omega Healthcare Investors is selling for a good price.
First off, OHI is A-rated for dividend safety by Safety Net Pro. That means that Safety Net Pro does not see much danger to the dividend.
That’s a good sign. I usually don’t even look further at stocks unless they get an A or B from Safety Net Pro.
OHI gets an A, so let’s go ahead and investigate its valuation.
Step 1: FASTGraphs Default Valuation
In this first step we compare OHI’s current price to FASTGraphs’ basic estimate of its fair value.
FASTGraphs starts us off with a price-to-earnings (P/E) ratio of 15, which is the long-term historical average for the whole stock market. It is a good place to start.
OHI is a real estate investment trust (REIT), so instead of reported earnings, it is universally accepted that the better measure of a REIT’s profitability is a metric called funds from operations, or FFO. FASTGraphs lets us select FFO as the valuation metric.
The basic fair value estimate is shown by the orange line on the following graph. The “F” at each data point indicates that we are using FFO. Every point on the line is simply OHI’s FFO multiplied by 15. Theoretically, the orange line therefore traces the stock’s fair value.
The thin lines are 10% increments above and below the orange fair-value line. The black line is OHI’s actual price.
As you can see, OHI’s current price is considerably below the orange fair value price computed by FASTGraphs using this basic method.
We can quantify the difference. Just make a ratio between OHI’s actual price-to-FFO value and the theoretical fair value of 15. The actual value is shown in the upper right as 11.3.
So the ratio we want is 11.3 / 15 = 0.75, which rounds to 75%. In other words, by this method, OHI is undervalued by 25%. That is a significant discount to fair value.
The fair value for OHI using this first valuation step is $50, compared to the stock’s actual price of about $37.
That seems like a bargain so far, but let’s look at the other steps.
Step 2: FASTGraphs Normalized Valuation
Next, instead of using the market’s long-term P/FFO of 15 to define fair value, we use Omega Healthcare’s own long-term average.
Here is why we take this additional step: Many stocks typically trade at valuations above or below the valuation ratio of 15 that we used in the first step. A stock’s own long-term average ratio reflects the market’s long-term sentiment about the stock.
I call this second step the “normalized” valuation. We are adjusting our notion of fair value to how the market has been valuing our specific stock rather than what how it has been valuing stocks in general.
OHI’s 10-year average P/FFO ratio is shown in the dark blue box at the right of this graph: 12.4. The blue line on the graph traces OHI’s FFO per share times 12.4 to create a normalized notion of its fair value.
This narrows the valuation difference. OHI’s price line is still under the blue fair-value line, but not by as much in the first step.
Using OHI’s average valuation ratio of 12.4 in the same equation as we used in Step 1, we get 11.3 / 12.4 = 0.91. So this second step suggests that OHI is undervalued by about 9%.
I consider any price within 10% of fair value as a fair price, although obviously here we are at the low end of the fair-value range. The specific fair price here computes to $41.
Step 3: Morningstar Rating
Our next approach is to consult Morningstar. They use a discounted cash flow (DCF) model to estimate a company’s fair value.
Unfortunately, Morningstar does not cover OHI. It is too small a company. So we won’t have this data point in our valuation summary.
I did check S&P Capital IQ, but they do not cover the company either, except for generic data (meaning that there has been no analytical interpretation). Among the generic data, I found this chart that portrays OHI as somewhat undervalued compared to similar companies.
Note that the data in this chart indicates that OHI’s current P/FFO valuation of 10.3 is almost 9% below its 5-year average valuation of 11.2. That is essentially the same result that we obtained above under Step 2.
Step 4: Current Yield vs. Historical Yield
A review of a stock’s historical dividend yield gives us a fourth way to estimate fair value. A higher current yield compared to the stock’s historical average suggests better valuation, because dividend yield is higher when price is lower, all else equal.
This table is from Morningstar.
In the 2nd-to-last line of the table, marked with the red dot, we see that OHI’s yield of 6.2% is a little lower than its 5-year average yield of 6.5%. However, in this table, Morningstar uses OHI’s trailing yield rather than the forward indicated yield. We know that the latter is 6.5%, as shown on the FASTGraphs earlier and also on Morningstar’s own main page for the stock.
So by this measure, OHI’s current (projected) yield is the same as its 5-year average yield, both being 6.5%.
That means that the stock is fairly valued by this method.
Now we put the 4 steps together and average them out.
I consider any stock that is more than 10% below its fair value price to be undervalued, meaning that it is a good price.
In this case, OHI’s current price of about $37 is 14% below my calculation of its fair value price at $43. So I consider OHI to be undervalued at this time. With it’s A-rated yield of 6.5%, I think that now would be an advantageous time to purchase shares.
As always, do not use this article as a recommendation about Omega Healthcare Investors. Always do your own due diligence before buying anything.
— Dave Van Knapp[ad#wyatt-income]