How to Value MLPs

When evaluating the worth of a publicly traded corporation, metrics such as price to earnings ratio, price to earnings growth, and debt to equity are commonly employed. Master limited partnerships (or MLPs) are a different breed of investment and require different metrics to evaluate. Below are three useful metrics for sizing up MLPs.

Distribution coverage ratio (DCR)
MLPs pay distributions, sometimes yielding 10% or more. Just like with a corporation, chasing yield can be hazardous. One way to determine if an MLP's distribution is sustainable is the distribution coverage ratio. This is the ratio of distributions to distributable cash flow. If the ratio is 1.0, the MLP is paying out what it generates in cash flow. Above 1.0 means the company is retaining some cash rather than paying it all out. A good thing, by and large. A ratio below 1.0 is generally considered non-sustainable. One quarter with a low coverage ratio isn't a big deal, assuming it's just one quarter.

Price to distributable cash flow (P/DCF)
This is the MLP equivalent to a corporation's price to earnings ratio. The ratio is calculated by dividing the market capitalization of the company by its annual distributable cash flow. Similar to the price to earnings ratio, a price to distributable cash flow above 15-16 is considered high or expensive. If an MLP is rapidly or consistently growing its distribution, it may be worth paying the premium.

Debt to adjusted EBITDA (D/EBITDA)
Since MLPs are required to pay out most of their earnings to unit holders, they must constantly take on debt to fund operations and acquisitions. Like any company, well-managed debt can prove beneficial, and too much debt can cause trouble. For MLPs, a common metric is debt to adjusted earnings before income taxes, depreciation and amortization, or adjusted EBITDA. Most MLPs keep their debt to adjusted EBITDA below 4.0. A higher ratio suggests the MLP is taking on some significant risk.

Let's look at three MLPs using these metrics. The findings are summarized in the chart below. 

Data from company websites, SEC filings, and The Motley Fool

What does this chart tell us? First, Martin looks like the highest-risk investment of the three. Its debt to adjusted EBITDA is the highest, meaning it's the most leveraged. And, the distribution coverage ratio of 1.0 means it's paying out all of its distributable cash flow. The other two MLPs are holding some cash in reserve, possibly to self-finance acquisitions or capital projects. This high risk is also reflected in Martin's relatively high yield.

In fairness, Martin executives, in their latest investor presentation, indicated their intention of reducing their debt load to 4.25-4.5 times adjusted EBITDA. Martin is also seeking a variety of opportunities to expand the business, including expansion of existing facilities and acquisitions.

My question is: How much money can they spend? They are trying to reduce the company's debt load and are already paying out virtually all of its distributable cash flow; that limits their funding options. In response to a similar question during the latest earnings conference call, Martin management indicated more clarity on this issue will be forthcoming in the next three to six months.

Both Energy Transfer and Targa look equally strong with respect to debt and distribution coverage ratio. So why invest in Targa when you can get a bigger yield with Energy Transfer? Energy Transfer is also less expensive by price to distributable cash flow.

Not evident in the above chart is distribution growth. Targa has consistently grown its distribution by around $0.02 a quarter each quarter since 2010. The stock has more than doubled in that same time. In contrast, Energy Transfer Partners began increasing its distribution only in the fourth quarter of 2013. Over the past year, the stock is up almost 20%, but it was up and down 20% in the years before that. That is, Targa has a proven track record of growing returns; Energy Transfer, not so much.

Final Foolish thoughts
Of the three MLPs presented here, Martin looks like the one to avoid. Of Energy Transfer Partners and Targa, I'm partial to Energy Transfer Partners because investors can receive a higher initial yield backed by a solid distribution coverage ratio. Energy Transfer Partners has also begun increasing its distributions and has indicated there will be more increases to come. The price of the stock should also grow. Lastly, it's relatively inexpensive, with a price to distributable cash flow of 8.76. The risk is that Energy Transfer Partners' distribution increases will be meager, and relative to Targa's steady distribution growth, investors may end up with a lesser yield over time.