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Equity valuation is a tricky game. With countless strategies and methodologies, many of which have conflicting results, it is important to know which tools are reliable. In this article, we will be examining price/FFO and show both logically and historically how powerful this metric really is. It is a cornerstone of value investing and should always be weighed when considering an opportunity.

Statistical evidence of the strength of price/FFO

To test the relevance of the metric, we can use a simple yet diversified REIT portfolio based on a single rule: Invest an equal amount of money in the lowest price/FFO stock of each of the 8 REIT sectors. For ease of accounting, let us use $8000 or $1000 in each stock. The 8 stocks, again, the lowest price/FFO of each sector were as follows:

Company (ticker)

Price/FFO

Sector's Average Price/FFO

Market Price 9/23/11 $

Sun Communities (NYSE:SUI)

11.5

18.3

$35.71

Pennsylvania REIT (NYSE:PEI)

5.2

13.7

$8.26

First Industrial Realty (NYSE:FR)

9.8

12.4

$8.25

MPG Office Trust (NYSE:MPG)

4.4

11.0

$2.31

Sabra Health Care (NASDAQ:SBRA)

7.8

13.5

$10.28

Cube Smart (NYSE:CUBE)

13.8

16.0

$8,67

Ashford Hospitality (NYSE:AHT)

3.1

10.4

$6.15

Winthrop Realty Trust (NYSE:FUR)

6.0

12.9

$8.79

The $8000 invested in these stocks on 9/23/11 would have grown to $12,677.60 for total returns of 58.47%. In contrast, the MSCI REIT index, RMS, returned only 30.10% over that same 1 year period.

click to enlarge image

As we know, correlation does not prove causation, but the significant difference provides some merit to the metric. Perhaps more impressive was that the lowest return on any of these 8 stocks was 30.02%, right in line with the RMS.

Ticker

Market Price 9/25/12 $

Dividends Paid $

Total 1 Year Returns %

SUI

$43.91

$2.52

30.02%

PEI

$15.90

$0.62

100%

FR

$13.05

$0.00

58.18%

MPG

$3.26

$0.00

41.13%

SBRA

$20.37

$1.31

110.89%

CUBE

$12.89

$0.31

52.25%

AHT

$8.15

$0.42

39.95%

FUR

$0.65

$0.65

35.95%

TOTAL

58.47%

Now that we have established the historical benefits of the usage of price/FFO, let us examine the logic behind it.

Imagine two hotdog vendors across the street charging different prices for the exact same product. Over time, customers will learn to go the cheaper vendor, and then the other will be forced to lower his prices. It may take a bit for customers to return, but eventually an equilibrium will be reached. Much like the pull toward equilibrant hotdog prices, in the stock market there is a pull toward an equilibrant FFO multiple. Stocks priced well above will be inclined to drop relative to the market, and those priced below it will have a tendency to rise relative to the market.

What is it that makes FFO so important? Well, the entirety of FFO is returned to shareholders, either directly through dividends, or indirectly through its use by the company. If the company uses it for acquisitions, paying down debt, or other accretive actions, future FFO will be increased and the money will be transferred to shareholders through increased dividends or the stock price rising due to growth of the company. Of course this is the idealized version. In reality there is some waste, but the concept remains that FFO directly contributes to shareholder returns.

If we were to assume it is entirely returned to shareholders, we can calculate the expected returns based on 100 divided by Price/FFO. Thus, a stock with a price/FFO of 20 would return 5% annually, and one with a price to FFO of 10, would return 10% annually. Again, this is an oversimplification, but FFO clearly contributes to returns.

In summary, usage of valuation metrics such as price/FFO can greatly enhance portfolio development. Value stocks have a tendency to outperform the market, yet they are often overlooked. Just make certain that the undervaluation is due to the market's pricing rather than internal troubles.

Disclaimer: 2nd Market Capital and its affiliated accounts are long SUI, SBRA, and AHT. This article is for informational purposes only. It is not a recommendation to buy or sell any security and is stricly the opinion of the writer.

Source: The Price/FFO Metric: A Driving Force Of Outperformance