Putting Blackstone Group LP's Yield Valuation Argument To Bed

| About: The Blackstone (BX)


I was the first to propose valuing Blackstone Group LP based on its stable and growing fee-related earnings distribution.

Blackstone CEO Steve Schwarzman adopted this valuation approach on the 2Q16 call.

Since then, various writers and commenters have argued that BX does not deserve a yield similar to the S&P's 2%.

I use two fundamental concepts of finance -- Gordon Growth and CAPM -- to demonstrate that Blackstone Group LP should command the same fee-related distribution yield as the S&P.

None of this argument gives any credit whatsoever to Blackstone's lucrative performance fees, which have matched fee-related earnings dollar-for-dollar from 2010-2015.

Several articles on Blackstone Group LP (NYSE: BX) - my own included - have focused on Blackstone CEO's use of a 2%-3% fee-related distribution yield to value Blackstone at $33-$50 per unit. As I pointed out in my last article, I was the first to propose this valuation methodology earlier this year, when I changed my view on Blackstone from bearish to bullish.

Naysayers in various articles and comment sections have opined that if the S&P 500 yields 2%, then Blackstone Group LP should yield something greater than 2%. From what I've read, the argument goes that the S&P 500 is more diversified, and therefore less risky, and so should command a lower yield.

I take issue with this argument, and will break down my counter-argument in this article

The yield a stock commands is (theoretically) based on two variables: required ROE ("r") and expected long-term growth rate in dividends ("g")

For those not familiar with the Gordon growth model, it's a fundamental concept in finance. All stocks are valued based on expected future dividends…all stocks, even stocks that do not pay a dividend now and will not pay a dividend in the foreseeable future.

The Gordon Growth model focuses on valuation of a stock via its current dividend payment per share, the required return on equity (ROE) an investor is willing to accept to own the shares ("r"), and the expected future growth rate in the dividend ("g").

In the formula above, D1 equals the dividend a year from now, "r" equals the required return on equity (ROE), and "g" equals the expected long-term growth rate in the dividend. "V" equals the value of the stock.

The naysayers are pointing out that required ROE ("r") for Blackstone Group LP is higher than the S&P; and I agree

Depending on which site you use, Blackstone Group LP has a beta somewhere 1.50-1.75. That means that BX is 50%-75% more volatile than the S&P 500, and is positively correlated with the broader stock market. Using a standard market risk premium of 5% and the good ole' CAPM formula, we can conclude that Blackstone Group LP's required ROE should be 3.75% higher than the S&P 500.

Doing the math to find "r":

BX "r": 2% + 1.75*(5%)= 10.75%

S&P "r": 2% + 1.00*(5%) = 7.00%

The naysayers are ignoring that Blackstone Group LP has a long-term expected growth rate ("g") higher than the broader S&P 500

The above "r" argument is fine and I happen to agree. What the naysayers are choosing to ignore, or are missing, is the "g," which, inconveniently, is just as important. So what is Blackstone Group LP's long-term expected growth rate, and what is the S&P's long-term expected growth rate (in the dividend)?

At this point, recall that this valuation opinion is only based on the portion of the distribution that is funded by fee-related earnings. Basically, this means that I (and Mr. Schwarzman) am attempting to calculate the distribution of the company excluding volatile and unpredictable (but lucrative) performance fee revenue, the culprit behind the recent decline in Blackstone Group LP's unit price.

I have a few thoughts here…part opinion, part data:

  1. According to irrationalexuberance.com, earnings and dividends on the S&P 500 have grown at a compound annual growth rate ("CAGR") of 4% and 7%, respectively, from the end of 2007 through the end of 2015 (basically, peak-to-peak). That's pretty good. Let's use the high end, and assume that the S&P has a long-term growth rate going forward into the future - or "g" - of 7%.
  2. According to Blackstone Group LP's SEC filings, Blackstone's fee-related earnings have grown from $386,697,000 in 2007 to $935,611,000 in 2015. That's a 12% CAGR. Factor in 2% a year dilution from increased share count, and you have a "g" of roughly 10%. Let's use that for Blackstone's long-term expected growth rate, or "g." Now you may argue this point, and validly claim that Blackstone's rate of growth will decline, but I would counter that: 1) the transition to alternative investments is only beginning, and; 2) if Blackstone Group LP's long-term expected growth rate is going to come in below the CAGR from the 2007-2015 period of 10% then the S&P 500's "g" is even more likely to come in below the 2007-2015 CAGR of 7% (which far outpaced the earnings CAGR due to financial engineering, etc. etc.).

Putting both "r" and "g" together, gets you back to a yield similar to the S&P 500

So now that we have both "r" and "g" for both BX and the S&P - the two critical input variables - let's put the formula together to see what we get.

BX: V = D1 / (10.75%-10%) = D1 / 0.75%

S&P: V = D1 / (7%-7%) = D1 / 0.00%

Obviously, this math cannot be applied exactly to either Blackstone's distribution or the S&P's dividend, but it illustrates my point: Blackstone's fee-related distribution valuation yield should only be 0.75% higher than the S&P 500 using CAPM, the Gordon Growth model, and completely ignoring BX's significant performance fees.

"So why are you using a 2% yield and not a 2.75% yield?" you say?

Simple. Blackstone Group LP's beta is boosted by Performance fee revenues and earnings. They're volatile…really volatile. And they boost the volatility of the stock. What would the beta of BX be without any performance fees? 1.6? 1.5? 1.0? I think probably closer to 1.3-1.4, but let's use 1.5. Substituting 1.5 in for 1.75 in the Blackstone CAPM formula above, and you get a required ROE ("r") of 9.5%. Use that 9.5% "r" in the Gordon Growth formula above, and all of a sudden Blackstone Group LP's valuation yield is less than the S&P's.

None of this gives any valuation credit whatsoever to sizable and lucrative performance fees that Blackstone will earn at some point going forward

And that should end this argument altogether. No part of this approach to valuing Blackstone Group LP gives any credit to Blackstone for earning - and distributing - lucrative performance fees. Aren't those real dollars that Blackstone is earnings and distributing to shareholders? You wouldn't think so, considering how BX units have been treated.

But now let's consider that performance fees have contributed another whole dollar for every dollar of fee-related earnings from 2010-2015, a six year period. Thus, you would think performance fees deserve some sort of valuation assignment.

In my view, the potential for Blackstone Group LP to match every dollar of fee-related earnings with a dollar of admittedly unpredictable and volatile performance fee earnings means that Blackstone Group LP should trade at a similar yield to the S&P 500 based on fee-related earnings only. And, if I'm honest with myself, that's not giving Blackstone Group LP a whole hell of a lot of credit.

Disclosure: I am/we are long BX.

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.