For a Christmas or birthday, did you ever get a gift that had another gift inside it? You know, like a book that you really wanted but then also another $10 bill tucked away inside? That's what I think we have in the shares of Extendicare (NASDAQOTH:EXETF)(TSX:EXE). The stock is priced almost like that gift: You're getting one business, but inside that business is another worth at least $10 per share more.

So that's why my Special Situations portfolio is stepping up to buy more, even though the portfolio already has 30% allocated to the position.

Why I'm back for more -- in numbers
This will be my third purchase of Extendicare. In the first two write-ups here and here, I didn't mention the valuation on the stock and why I thought it made such a compelling opportunity. I had quite a few requests on my discussion board asking for my valuation, since the stock generated a good bit of interest.

So let me run you through the numbers that I've been working with in the tables below. I'm using Extendicare's most recent closing price of $6.35 and using its annualized payout of $0.432. The American unit has 14,311 owned beds, according to the latest filing in November.

Let's work backwards a bit, starting from a estimate price of the Canadian unit and then what that implies about the American unit. We'll get to an American price per bed and compare that to one of my recent picks.

Canadian Parent Stock Price

Canadian Yield

Implied Price of American Unit per Share

American Unit Total (Millions)

American Debt (Millions)

Price/American Bed

Price/Sabra Bed

$6.35

6.8%

$0

$0

$521

$36,406

$122,684

$6.00

7.2%

$0.35

$31

$521

$38,541

$122,684

$5.50

7.9%

$0.85

$74

$521

$41,591

$122,684

$5.00

8.6%

$1.35

$118

$521

$44,641

$122,684

$4.50

9.6%

$1.85

$162

$521

$47,691

$122,684

OK, so let's interpret this somewhat complex table. If the Canadian unit comprises the full value of the combined company today, then you're getting a 6.8% yield and getting the equity in the American unit for $0. But since the American unit has debt of $521 million, the enterprise value per bed comes to $36,406. If you think a 6.8% yield is too low for the Canadian parent, then you can adjust to what you think the yield on the stand-alone Canadian company should be. Any way you slice it, these beds are much cheaper than what they're currently fetching at the publicly traded Sabra.

Now, here's the interesting part. The market is pricing the American beds at less than half -- maybe as little as a third! -- of what it's giving Sabra Healthcare REIT (NASDAQ:SBRA), a stock that I sold from the portfolio last week after notching 21% annualized gains for just over three years.

So what happens if those beds achieve a valuation in the range of Sabra's beds or even lower at $100,000? Here are a couple of scenarios and what the American unit is worth in each.

 

Price at $100,000 per Bed

Price at $122,684 per Bed

Total Enterprise Value

$1,431 million

$1,756 million

Less Debt

$521 million

$521 million

Equity Value

$910 million

$1,235 million

Equity per Share

$10.42

$14.14

So let's add these on to what we might be paying for the Canadian unit and see what we get in our low scenario.

Canadian Unit
per Share

American Unit
per Share

Total

Upside

$6.35

$10.42

$16.77

164%

$6.00

$10.42

$16.42

159%

$5.50

$10.42

$15.92

151%

$5.00

$10.42

$15.42

143%

$4.50

$10.42

$14.92

135%

And then in our high scenario.

Canadian Unit
per Share

American Unit
per Share

Total

Upside

$6.35

$14.14

$20.49

223%

$6.00

$14.14

$20.14

217%

$5.50

$14.14

$19.64

209%

$5.00

$14.14

$19.14

201%

$4.50

$14.14

$18.64

194%

There are a few other details that push my estimate of total value higher, such as splitting the American company into a property company and an operating company, but I'm leaving that out for brevity and clarity.

The valuation here is very compelling. In fact, it's the clearest value that I've seen since I've been running my Special Situations portfolio. You're getting a high dividend yield while you wait for the company to unlock value with the spinoff or sale of its American unit. But let me put it in other terms: You are getting a business for free or nearly free. My estimates suggest you're paying from 0%-13% of the real value of the American unit. And that could lead to gains of least 100% and maybe even 200%. It's like that book with a $10 bill slipped inside it, but it might even be a $10 and a $5.

Management simply needs to unlock the value of this business by divesting it, as they've said they have been doing.

Foolish bottom line
Could something go wrong? Absolutely. Lawsuits could whittle down the value of the American unit. More onerous payment terms from health insurers such as Medicare and Medicaid could hurt revenue. More political turmoil could hurt.

But the price for the American unit is so cheap and therefore the odds are so clearly stacked in our favor here, that it's hard to foresee this becoming a permanent loss of capital. That's why I have the confidence to add to a position that already comprises 30% of my Special Situations portfolio. So I'm adding another $2,000 to Extendicare, pushing the stock to more than one-third of my total portfolio.

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Jim Royal owns Extendicare, as does The Motley Fool. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.