Revenue Multiple Cycle Theory
Real Estate Investment Trusts can be viewed like a bond with a growing coupon. During good times, investors anticipate increasing coupon payments, or earnings, and they start buying. This cumulative buying puts upward pressure on stock prices. Based on investor psychology, this optimism leads to investors willing to bid an increasing multiple for that earnings coupon. Since that coupon is a derivative of revenue, this greed can be witnessed in an increasing multiple on revenue.
In bad times, investors fear over smaller earnings coupon payments, and their selling puts downward pressure on stock prices. This negativity often leads to a discount on that coupon. Investor pessimism is witnessed in a decreasing multiple on revenue.
Although not a complete valuation tool, for investments with long and predictable histories of revenue and earnings, like Realty Income (NYSE:O), the revenue multiple is a fear and greed gauge. It can be used as a tool to determine where in the cycle investment temperament is and around what range it may reverse.
Case Study: Realty Income
Tracing its history back to 1969, Realty Income has been managing commercial real estate for decades.
Through the successful asset, liability and tenant mix, Realty Income has produced steadily growing dividends for its owners. A 29.9% dividend on original purchase price exemplifies the benefit of owning a great company for the long term.
Price to Sales History
Examining Realty Income's historical price to revenue multiple, one will notice a typical range of 5.5 to 11.5. Because different borrowing rates, profit margins, and growth rates, investors may identify fear with Realty Income near the 5.5x revenue range, yet find greed levels with another company like Chipotle near the 5.5 revenue multiple. Each company is unique.
Observing this multiple alone does little good. Only when past fear and greed levels coincide with changing price direction, combined with proper valuation analysis, can this tool can be useful.
Margin of Safety Identification
To understand the importance of judging investor psychology, examine the price return, not including dividends, for those buying near the repetitively low price to sales ratio of 5.5 in 1995, 2000, and 2009.
It can be seen that buying Realty Income's coupons at these low multiples of revenue extremes were when substantial gains were made.
On the opposite side, the high price, low coupon greed areas have occurred near the 11x revenue in 1997, and 2004. Examine the performance of buying when Realty Income was at these levels.
It is often at these high multiple extremes when fortunes were lost.
Identifying this low price high coupon, high price low coupon range, value and overvalue areas based on investor psychology are established.
By no means is the revenue multiple an exact science. Anything from interest rate changes, dividend policy, and general business conditions can change investor psychology. Because of these reason, among others, the multiple can overshoot and undershoot historical ranges.
This methodology should not be a simple buy or sell rule.
Current Situation & Opportunity
Evidenced through years of successful reinvesting earnings and increasing dividends, Realty Income is one of America's greatest REITs. After a price increase of 319% and a multiple increase of 211%, from 5.3 in 2009 to 16.3 today, Realty Income is near a record high multiple of revenue.
According to the revenue multiple theory, however, this high multiple is currently indicating investors are being greedy. Unless revenue or margins increase quickly, might this high multiple on revenue present a good opportunity for investors to hedge their gains?
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.