Kinder Shares Are Crazy Undervalued: Here's How To Earn A 32.3% Yield

| About: Kinder Morgan, (KMI)

Summary

Wall Street's punishment of Kinder Morgan shares has gone too far.

Kinder's undervaluation offers income investors a chance to earn substantial income yields; as much as 32.3%.

Find out how, as well as what risks you need to be aware of.

Click to enlarge

Source: Kinder Morgan, Inc.

As a dividend growth investor I'm skeptical of buying Kinder Morgan (NYSE:KMI) even at today's low share price, due to the low yield. However, many readers have pointed out that an investment in Kinder today could make for an exceptional long-term turnaround investment.

KMI Total Return Price Chart

KMI Total Return Price data by YCharts

Given that Kinder's total return over the past year has been so terrible I decided to take another look at Kinder's valuation to see if this was indeed a potentially good buying opportunity. I also began pondering whether or not income investors might want to give it another look, despite the low 2.7% yield. What I found shocked me and inspired this article.

Read on to find out just how undervalued shares of Kinder Morgan are today, but more importantly, how you can potentially earn shockingly high yields from them.

3 ways to look at Kinder's valuation

Source: Fastgraphs
Price/Operating Earnings Historic P/OE Price/Operating Cash Flow Historic P/OCF Average Historical Discount
26.4 31.7 8.7% 9.9 14.4%
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The most obvious valuation metric that dividend investors notice is the yield. At 2.7% Kinder is offering a 29% higher dividend payout than the S&P 500. However, it's still a far cry from its previous glory days before it slashed its dividend 80% at the end of 2015.

On the other hand, looking at Kinder's current price to operating income and operating cash flow, and comparing these metrics to their historical levels clearly show that Kinder is indeed trading at a discount. The problem is that neither the yield nor historical valuations give us an idea of what Kinder Morgan's fair value is.

For that we can turn to a discounted cash flow analysis. A quick warning about DCF analysis: never use this or any valuation method as the sole reason to make buy, sell or hold decisions. The reason why is that a DCF analysis relies on long-term growth assumptions and arbitrary discount rates to determine a fair current value of a company's future cash flows and intrinsic value (tangible book value).

Sources: Earnings releases, Fastgraphs, Gurufocus
TTM DCF/Share 10-Year DCF Growth Projections DCF Fair Value Estimate Reverse DCF Implied Growth Rate Margin of Safety
$2.11 6.0% $41.48 -7.3% 56%
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That being said, a DCF can offer a useful idea of whether or not a stock is truly undervalued, as well as the broad magnitude of that undervaluation, the implied growth rate that Wall Street is pricing into the shares and the margin of safety.

For this DCF analysis, I used the 20-year terminal growth rate of 4%, which is reasonable for a mega-cap energy company. In addition I used the S&P 500's historical total return of 9.1% CAGR since 1871 as the discount rate. The reason for that is that it gives the fair value estimate that, at least theoretically, will result in a total return equal to the market's historic norm over the next 30 years.

With a 56% margin of safety it's obvious that, even if these assumptions don't prove 100% accurate, Kinder Morgan is extremely undervalued. Thus long-term investors should do very well owning the shares at today's prices, especially once energy prices recover.

However, for the purposes of generating maximum income, what matters is knowing whether a stock is undervalued or overvalued, because then you can use covered option writing to turn those shares into a high-yield income generating machine.

Cash covered puts: your ticket to crazy high yields

Options are often thought of as highly risky tools used by speculators to do high-leveraged betting on share prices. While this is certainly possible, they can also offer income investors a low risk way to generate potentially astounding yields when the market mispriced shares; as it is now doing with Kinder Morgan.

Source: Yahoo Finance
Put Option Premium/Share Implied Purchase Price Implied Yield on Cost Option Yield Annualized Option Yield
September 2016 $18 $1.08 $16.92 2.96% 6.0% 32.27%
September 2016 $17 $0.69 $16.31 3.07% 4.06% 21.05%
September 2016 $16 $0.39 $15.61 3.20% 2.44% 12.27%
December 2016 $18 $1.71 $16.29 3.07% 9.50% 21.9%
December 2016 $17 $1.20 $15.80 3.16% 7.06% 16.05%
December 2016 $16 $0.93 $15.07 3.32% 5.17% 11.63%
January 2017 $17.5 $1.66 $15.84 3.16% 9.49% 18.22%
January 2017 $16 $1.06 $14.94 3.35% 6.63% 12.58%
January 2017 $15 $0.79 $14.21 3.52% 5.27% 9.95%
January 2018 $17.5 $2.80 $14.70 3.40% 16.0% 10.11%
January 2018 $15 $1.74 $13.26 3.77% 11.6% 7.38%
January 2018 $12.5 $1.10 $11.40 4.39% 8.80% 5.62%
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For example, cash covered put writing is a low risk method in which you basically sell an insurance policy to someone who owns shares of Kinder and is worried that the share price might fall. Let's use the example of September 2016 $18 puts (which is the highest yielding put option available), as an example to see how this works.

By selling one of these contracts you are taking on the potential obligation to buy 100 shares of Kinder Morgan at $18 if the share price is below that level by the end of September 16, 2016. The buyer of the option gets the assurance that he will get at least $1800 for his shares, and in return for this guarantee pays you $108 in option premium.

Because you have to set aside $1800 to buy these shares in case they are put to you, your return (not counting broker fees or taxes) on this 2.5-month contract is $108/$1800 or 6.0%. That's equal to about 2.4% per month or 32.3% on an annualized basis.

If Kinder Morgan ends up under $18 per share by September 16 then you wind up buying the shares at an effective price of $18-$1.08 or $16.92 per share. That gives you a 2.96% yield on cost.

The reason this is a useful, low-risk income generating strategy is because:

  1. You already like Kinder Morgan and are willing to buy the shares at today's higher price.

  2. You set aside the money to buy the shares and thus aren't using leverage, which would expose you to the risk of a potential margin call.

  3. Kinder is already heavily undervalued and if the share price is above $18 per share by September 16, then the contract expires worthless and you keep the option premium.

Once September rolls around you are either sitting on a 6% return on the $1800 you tied up for 2.5 months, or you own 100 shares of Kinder Morgan at 7.5% discount to today's price.

Risks to this strategy

While covered put writing is a low-risk way of generating income from highly undervalued shares, the fact is that nothing on Wall Street is 100% risk-free. In this case there are two risks you need to consider.

First, should Kinder Morgan drop below the implied purchase price then you will be put shares and be facing an unrealized loss. For example, if you write a September 2016 $18 put and oil prices were to collapse, driving Kinder down to its 52-week low of $11.2, then you might wind up kicking yourself because your paper loss at that point would be 34%.

The second risk is opportunity cost. Should Kinder soar then you might end up regretting not buying shares. After all, if you are indeed a long-term investor and agree with the DCF fair value estimate that Kinder shares are currently worth $41.48, then a 6% gross profit would seem like a small consolation for missing out on a potential 127% capital gain if shares were to somehow rocket to that level by September.

Of course these are two extreme examples but they illustrate the tradeoffs that come with covered put writing. You can wind up with an unrealized loss, and don't actually own shares in the company you think is undervalued and can thus end up missing out on a major rally.

Then of course there're the commissions and taxes. While my calculations excluded these for the sake of simplicity in real life you ALWAYS need to consider these costs. For instance, broker fees can run the gamut from Interactive Brokers (NASDAQ:IBKR) $0.7 per contract to as high as TD Ameritrade's (NASDAQ:AMTD) $9.99+$.75 per contract.

Studies show that keeping trading costs to a minimum is one of, if not the most important, the keys to a successful long-term investing. Which is why option writing is best suited for investors with enough capital to spread option fees over as many contracts as possible.

Once more using our September 2016 $18 Put's $108 per contract premium as an example, an investor on TD Ameritrade that wrote a single contract would be losing $10.74 of his/her premium, resulting in a 9.94% commission. On the other hand, if you are with eOptions and can afford to buy $18,000 of Kinder Morgan then you can write 10 contracts and end up paying just $4.5 of your $1,080 premium in fees, or 0.42%.

Finally, you can't forget that Uncle Sam will demand a cut of your profits. Option premiums are taxed as either long-term or short-term capital gains, depending on whether their duration is more or less than a year.

In our example the $108/contract premium would be taxed as a short-term gain, meaning the IRS would treat it as regular income; potentially incurring a tax rate of as high as 39.6%. This is why covered put writing is best done in a tax deferred account, such as a Roth IRA.

Bottom line: Kinder is indeed historically undervalued and cash covered puts can turn it into a low-risk, high-yield cash machine

For those investors who like Kinder's fundamentals and would be willing to buy shares today, I would recommend you consider the awesome high-yield potential cash covered puts can offer. While this strategy isn't entirely risk-free, the risk-adjusted income yield potential is outstanding and a great way to create an artificially higher dividend from Kinder Morgan.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.