By Joseph Hogue
It seems like it should be a fairly straightforward concept. You invest your money in a company for a share of future earnings. Most of the companies in which I invest have been around for longer than I have, so those earnings should be fairly stable, if not following a gradual path higher.
Of course, investing can be anything but simple as the market charts its course through the new normal and you are trying to avoid the next historic crash in prices.
So when someone starts talking about 'simple' math that makes an investment a no-brainer, I start to wonder how simple it can really be. Especially when that someone is the CEO of the company.
That was the case recently during an earnings release by one of the world's largest asset managers. Not only is the lecturing mathematician the CEO, he's also the co-founder of the company.
I admire this CEO greatly and he's a guru in the world of private equity, but when I looked further into the details I found a few holes in his 'simple' math.
While I don't agree with the CEO's math, I did find evidence that the stock could be one of the most undervalued plays of the year.
Not only is this "best of breed" trading well under its fair value, but shares give investors exposure to asset classes to which they might not otherwise have access.
Simple Math Gets Complicated For This Asset Manager
Stephen Schwarzman, CEO and co-founder of The Blackstone Group (NYSE:BX), argued his case for shares during the firm's second-quarter release last month. The $311 billion private equity and asset management firm had just beaten earnings for the first time in five quarters and Schwarzman was ready to present the case for shareholder returns.
Schwarzman reasoned that the shares should be worth nearly double the current price just on expected fee-related earnings and the yield for the market. He used expected fee-related earnings for next year of $1 per share and the 2% dividend yield multiple of the S&P 500 to arrive at a fair value of $50 per share.
The math seems simple enough. The firm pays a hefty dividend that includes not only most of its fee-related income, but other income as well. Fee-related earnings have been growing steadily and assets under management have grown for 19 consecutive quarters. Fee-related earnings were higher by 27% in the second quarter on an 11% increase in fee-earning AUM over the year.
The math isn't quite as simple as it seems, though. First you have to assume the company meets its expectations for fee-related earnings. The consistent growth in fees and AUM over the last five years puts the odds in its favor, but there is always a risk.
I'm more skeptical of valuing Blackstone on the same earnings yield as the broader S&P 500. The asset manager is obviously less diversified than the larger market, and its earnings are not as stable. The stock's own earnings yield currently is closer to 2.8%, which would still imply a value of $35.70 if the company meets its $1 per share target for fee-related income.
But while I don't agree with Schwarzman's math, that doesn't mean that shares are not a strong buy.
The CEO's estimate doesn't include less-predictable revenues from performance fees or carried interest, which were $625 million in the second quarter alone and 51% of total revenue. While the shares may not be worth the same yield as the broader market, these other fees add significantly to the value.
Those performance fees and other income could be ready to jump in the years to come. The 2013 acquisition of Strategic Partners from Credit Suisse (NYSE:CS) has helped the firm raise larger amounts for its investment funds. In fact, it is nearing the close of a $7 billion fund that is about three times larger than others it has created, and will soon start investing in private equity deals and other assets.
Shares currently trade for 36 times trailing earnings of $0.77, which were lower than expected on some one-time charges in the third quarter. Forward earnings of $2.80 per share would put the valuation at just 9.9 times forward earnings.
The unpredictable nature of non-fee revenue makes earnings forecasts tricky, and the firm has missed expectations in five of the last 12 quarters. Still, even a conservative estimate of $2.50 per share and an earnings multiple of 15 times could mean a $37.50 share price target for a 35% gain on top of the 6% dividend yield.
The value in the shares is just part of the story for Blackstone. As a private equity and alternative asset manager, the stock holds diversification value for individual investors as well. Anyone with less than $1 million net worth or under $200,000 in annual income is locked out of the traditional alt asset space of private equity.
Earnings may be volatile, but private equity offers the opportunity for higher returns on pre-IPO and buyout investing, and the only way for many investors to get exposure is through shares of an asset manager like Blackstone. While I'm not quite as optimistic as the CEO and I don't agree with his math, shares of Blackstone hold significant upside potential and a great diversifier for investors' portfolios.
Risks To Consider: Shares of asset managers are susceptible to changes in the business cycle and could come under pressure if a recession occurs.
Action To Take: Go long on shares of Blackstone Group for an upside on strong fee-related income and as a portfolio diversifier in alternative assets.
This article was originally published on StreetAuthority.com.
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. I have no business relationship with any company whose stock is mentioned in this article.