One of the most common valuation metrics used by investors is the trusty old price-to-earnings ratio, or P/E ratio for short. However, there are some cases where that usually trustworthy metric just can't be trusted. One place in particular where it's pretty much worthless is in valuing energy stocks. That's because the highly capital-intense industry is known for depreciating away earnings, which has a big impact on the "E" in the P/E ratio.
Take natural gas pipeline kingpin Kinder Morgan Inc (NYSE:KMI). The boring pipeline and terminal operator has a P/E ratio that would have value investors running for the hills. We can see its skyrocketing ratio in the following chart.
At 42 times earnings, Kinder Morgan is trading at a multiple that's more than double what the broader market is trading for these days. While Kinder Morgan might deserve some sort of premium as it is the largest energy midstream company in North America, twice the market multiple seems unjustifiable. However, as I'll soon show, the P/E ratio is the wrong number to look at as the company's earnings are being artificially held down, making the company look expensive.
The earnings' warning
One thing investors will find is that an energy related company's reported earnings can be a deceiving number. Last year, for example, Kinder Morgan reported net income of $1.03 billion, or $0.89 per share. If we divide the company's $0.89 per share in earnings by its current stock price, we come to a whopping 42 times earnings.
Those numbers would likely set off a lot of alarm bells for investors. Not just because the P/E ratio is high, but also because Kinder Morgan paid $1.74 per share in dividends last year, suggesting its dividend is in danger.
Counting the cash flow
However, there were two factors that reduced Kinder Morgan's taxable earnings and make that number set off alarm bells. First, the company takes heavy depreciation, depletion and amortization expenses, or DD&A, each year because of the capital intensity of building and maintaining all of its pipelines and terminals as well as its oil operations. Last year, those expenses totaled just over $2 billion, which compressed overall earnings. On top of that, the company wrote down the value of some of its oil and gas properties, lopping another $272 million from pre-tax earnings.
The company's cash flow, however, tells a much different story. To determine that cash flow number, non-cash write-downs and DD&A is added back in, while only sustaining capex is removed from cash flow, with the rest of the capex being termed growth capex. In Kinder Morgan's case, this added a net $2.2 billion back to cash flow before adjustments for taxes. Once all of these adjustments are accounted for, the company was left with distributable cash flow, or DCF, of $2.62 billion last year, or $2.00 per share.
That leaves us with a much less expensive price-to-DCF of 20 times, which is much more in line with where the market is right now. It's also clear that the company fully covered its dividend with plenty of room to spare.
At first glance, Kinder Morgan's stock looks really expensive. However, that has to do with the capital intensity needed to maintain its business, which tends to pull down earnings. Once we take a look at the company's actual cash flows, we find a company that, while not dirt-cheap, is nowhere near as expensive as we were first led to believe.
Matt DiLallo has the following options: short January 2016 $32.5 puts on Kinder Morgan and long January 2016 $32.5 calls on Kinder Morgan. The Motley Fool recommends Kinder Morgan. The Motley Fool owns shares of Kinder Morgan. 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.