How to Value MLPs: Price to Distributable Cash Flow

In recent years investors have been drawn to master limited partnerships, or MLPs, due to the very generous distributions these companies pay. That said, investors do need to do a little more work to earn that extra income. That's because not only are MLPs a bit more complex come tax time due to the K-1 forms they send to investors, but valuing an MLP takes a bit more work as traditional stock valuation metrics don't work quite as well. While I can't help with the taxes, I can walk through an easy way to value an MLP by demonstrating how to figure out an MLP's price to distributable cash flow ratio.

Making sense of this metric
Most investors are probably familiar with a price to earnings ratio, or P/E ratio. That ratio works well for stocks, but doesn't help at all with MLPs. In fact, the P/E ratio can actually provide a pretty misleading value for MLPs. This is because MLPs typically have very high depreciation charges due to the asset heavy nature of their business. That depreciation eats into earnings, but not cash flow, which is why cash flow is king when it comes to MLPs.

Investors should also pay more attention to an MLP's distributable cash flow because that's what these companies use to fund their juicy distributions. With the price to distributable cash flow, or P/DCF, we're looking at what multiple investors are paying for a particular MLP's distribute cash flow stream. So, basically what we're doing is replacing the "E" of earnings with the "DCF" of distributable cash flow to value an MLP.

Looking for the right numbers
We're going to use the actual numbers from one of the largest MLPs in America, Enterprise Products Partners LP (EPD 1.65%), to run through an example. First, we'll look at the P/E ratio to show how it can impact results. Over the past 12 months the company's earnings were $2.8 billion, or $1.47 per unit. That gives the company a current P/E ratio of about 23 times earnings, which is well above the roughly 15 times ratio that the broader market tends to average over the long term. So, if we used the P/E ratio we'd conclude that this boring pipeline and processing business was insanely expensive. 

However, by looking at DCF we see a different story. But, before we get to that story let me show you where to look for this number as it can be trickier to find than earnings. Most MLPs report distributable cash flow right at the top of the earnings press release. For example, Enterprise's most recent earnings release had distributable cash flow right in the second paragraph as it noted that, "distributable cash flow increased to $4.1 billion for 2014", which I'll note is 43% higher than earnings. However, what the company doesn't readily provide is DCF per unit, but that's easy to figure out if its not right at the top of the press release. We just need to find the company's average outstanding units over the past year (which is usually on the balance sheet) and divide DCF from the past twelve months by the number of units. In Enterprise Product Partners case it had 1.9 billion units outstanding last year. A few strokes on a calculator tells us that DCF per unit was $2.15 over the past year.

One last note, make sure to use full-year numbers and not just the past quarter. It might take a bit more work to find those numbers, but remember MLPs do pay well for the little extra work that investors need to do.  

Once we have the DCF per unit for the past 12 months we'll need to perform one more simple calculation to find the P/DCF ratio we've been seeking. We divide the company's current unit price, which at the moment is about $34, by its DCF per unit of $2.15 and we get a P/DCF ratio of 16 times. That's much less expensive than its P/E ratio suggested as it tells us a completely different story.

Here's a visual look at the numbers:

Source: Company releases and author's calculations.

All of this is relative
Now that we have a better valuation multiple, we still have work to do. The best way to value an MLP is to compare its valuation relative to its peers. For this we'll use fellow behemoths Williams Partners (NYSE: WPZ) and Energy Transfer Partners (ETP). Here's how the trio compares to each other.

Source: Company releases and author's calculations 

First, note how out of whack the P/E ratio is for both Energy Transfer Partners and Williams Partners. A value investor would take one look at those and bolt for the door. However, by digging deeper into the actual cash flows of these companies we find that the valuation is actually much more compelling. This is why P/DCF is a much better way to begin to look at the value of an MLP.

Investor takeaway
Just like the P/E ratio, a P/DCF ratio is really just a jumping off point for further research. By running a few of these ratios from target MLPs we can pinpoint candidates for further research. While valuing an MLP takes a little extra work, the payoff from the generous distributions can make it well worth the extra effort.