Energy Transfer's (ET 2.32%) performance this year has been an enigma. On the one hand, the energy company has delivered record results. Despite its high-octane earnings growth, the master limited partnership's unit price has declined by about 5% in 2019 and roughly 25% in the past year. Because of that, the midstream company trades at a bottom-of-the-barrel valuation. That suggests it has some big-time upside, especially when adding in its nearly 10%-yielding distribution.

Drilling down into the numbers

Thanks to its strong showing during the first half of the year, Energy Transfer is on track to produce between $10.8 billion and $11 billion in adjusted EBITDA this year. That's about 15% above last year's level and about $200 million more than it initially anticipated.

A man drawing a chart of rising dollar signs on a green chalkboard.

Image source: Getty Images.

However, at the same time that earnings have outperformed, the company's market value has declined. As a result, its enterprise value (EV) is now down to about $90 billion. With the midstream giant on track to produce $10.9 billion in EBITDA at the midpoint of its forecast, it trades at an EV/EBITDA multiple of 8.3 times. For comparison's sake, its peers trade at an average EV/EBITDA multiple of roughly 11 times. Those numbers suggest that Energy Transfer has more than 30% upside.

That discount doesn't make much sense, given that the company is growing its earnings at a healthy pace. Furthermore, it has a solid financial profile since it has an investment-grade balance sheet and is generating enough cash to cover its ultra-high-yielding payout by two times.

Why the bottom-of-the-barrel valuation?

One of the knocks against Energy Transfer, however, is its balance sheet. While the company does have an investment-grade credit rating, its leverage ratio was above its 4.0 to 4.5 times target range at the end of the second quarter. That elevated level is because it's investing heavily in projects to expand its midstream empire. As those growth projects come on line and start producing earnings, leverage should decline toward the midpoint of its target range in the next year. While that's above the anticipated peer group average of 3.4 times, it's a solid level for a midstream company.

Another factor that has weighed on Energy Transfer's valuation this year is its decision to acquire SemGroup (SEMG) for $5 billion. It's paying an eye-popping 65% premium for the fellow midstream company. It's also using some of its dirt cheap units to help fund the deal. However, despite that big-time premium, Energy Transfer is getting SemGroup for a good value since it's only paying about 9.0 times its EBITDA. By comparison, Pembina Pipeline recently agreed to pay an EV/EBITDA multiple of 12.4 times to acquire Kinder Morgan Canada and a related pipeline from Kinder Morgan.

Because of the attractive value, Energy Transfer's acquisition of SemGroup will be immediately accretive to its cash flow per share. The deal will facilitate a new pipeline expansion project, while also positioning the company for additional growth. As a result, the acquisition should pay big dividends down the road, which is why it shouldn't weigh on Energy Transfer's valuation.

Patience could pay off spectacularly

Energy Transfer trades at a massive discount to its large-cap midstream peers. That big difference in price doesn't make any sense considering that the company is growing its earnings at a fast pace and has a healthy financial profile. Consequently, it appears as if it could have at least 30% upside as its valuation slowly makes its way back up to the peer group average. While investors will need to be patient for that to happen, they're getting paid well to wait, given Energy Transfer's nearly 10% annual income stream. Add that yield to the company's valuation upside, and it could produce some high-octane total returns in the coming years.