W. P. Carey: An Asset/Income Approach Suggests Attractive Return

Sep. 26, 2021 12:57 AM ETW. P. Carey Inc. (WPC)17 Comments

Summary

  • This article suggests a valuation method based on book value and dividend to value well-established businesses as an asset plus income purchase.
  • The method relies on two of the most easily obtainable data with the least amount of ambiguity, and using a few reliable data points is often better than using many.
  • This valuation method suggests that W. P. Carey is attractively valued at its current price, offering a solid opportunity to buy a quality business under today’s overall expensive market.

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Investment thesis and background

My last article analyzed the long-term prospects of W. P. Carey (NYSE:WPC). A cost of capital analysis was used to show that the business sustainably earns a healthy return on capital invested, demonstrating its long-term profitability and stable moat. And the thesis was that it represents a quality REIT business that is slightly overvalued under current prices, and the price has indeed retreated by about 7% since my last writing.

This article describes an alternative valuation method based on book value ("BV") and dividend to value well-established businesses as an asset plus income purchase. The method is based on a multiple of BV plus 10 x dividend to estimate the investment value of a stock. The method relies on two of the most easily obtainable data with the least amount of ambiguity. In investing, I always prefer the use of a few data points that are reliable than many data points that are less reliable. The valuation method essentially approaches the valuation of stock as a 10-year bond (or an equity bond). The value of a bond should be the sum of its face value plus the coupon payments. And in this method, the BV is taken to be face value, and the dividend taken to be the coupons. The best stock investment should be like a bond.

This method applies to many types of stocks as to be elaborated later. But it is especially intuitive to REIT stocks. If you think like a long-term business owner (instead of a stock trader), then investing in REIT is nothing more than buying a piece of real estate property to collect rent. So the investment value consists of two parts: the value of the property itself and the future rent. This valuation method approximates the first part by the BV and the second part by 10 x dividend.

The rest of this article details the application of this method on W. P. Carey. And the results suggest that it is attractively valued at its current price. Given the quality of the business and today's overall expensive market, it is a good investment opportunity for a range of investing styles.

The businesses - overview and recap

Most of the detailed operation, profitability, and valuation information of the stock has been provided in my earlier article and won't be repeated here. This section provides a very brief recap of my last article to facilitate the new discussions.

WPC is a global REIT that invests in commercial properties. The business has a long history (45+ years) of working with different companies to monetize the value in their real estate. As seen from the next chart, WPC holds a large and diversified portfolio of high-quality real estate totaling 146 M square feet. The company boasts an occupation rate of more than 90% and an annualized base rent of $1.2 billion. Also note that more than 99% of the leases have an escalation built in. With the current inflationary prospects, this will serve as a good hedge should inflation persist longer and higher.

Through property investments and long-term tenant partnerships, WPC has been delivering stable income to investors. WPC investors have been handsomely rewarded in the past decade through a combination of earnings growth, valuation expansion. The stock delivered 240% of total return over the past decade, compares very favorably to that delivered from the SP500 index.

https://static.seekingalpha.com/uploads/2021/7/25/54495410-1627219369771018.png

Source: WPC Investor Presentation

The Asset + Income Valuation approach

The method calculates the investment value ("IV") of a stock based on the following formula:

IV = M x BV + 10 x dividend

where M is a multiplier for the BV. This valuation method essentially values a mature stock like a 10-year bond if you consider the BV as the face value of the bond and the dividend as the coupon payment. This method offers the advantage of valuation anchored in the most easily obtainable data with the least amount of uncertainty: BV and dividend. The multiplier, M, is a factor to adjust for the return on equity ("ROE") variation among different businesses. Most of the time, I will just use 1.

But in general, M is equal to (ROE/a benchmark ROE)^2. The idea is that if a given business is earning a ROE that is above a benchmark (some kind of average, e.g., the ROE of the S&P 500, the average ROE in its industry sector, or the cost of capital), then its BV should be valued more and M will be larger than 1 in this case. Vice versa, if a given business is earning a ROE that is below a benchmark, then its BV should be valued less and M will be smaller than 1 in this case.

In the case of WPC, because it's such a well-established and large-cap business, I will just use 5.5% as the benchmark ROE, essentially the average ROE of the business over the past decade (which also happens to be close to the average ROE of the broader market represented by S&P 500). So as an example, WPC's ROE in the current year is 6.3%. Therefore for WPC, M=(6.3%/5.5%)^2 = 1.31. This means that WPC's BV is worth about 31% more than the average, because WPC is able to earn about 15% higher profit on every $1 of its BV than the average.

With the above understanding, the following chart shows the results of this method applied to WPC. As can be seen, it captured the market price very nicely since 2015. Note that the business was not a REIT business until it converted in 2012. Therefore, the stock behavior during 2012 and 2015 was more a transition and it made sense that it did not following the IV closely. As seen from this chart, after the transition ended, when the market price fluctuates below the IV, it presents good entry opportunities followed by handsome total returns - though you do have to be able to stomach the short-term volatility.

Also seen, the current IV, based on the forward BV and dividend, is about $84. And at a price of $80, the stock represents a quality business for sale at an attractive price under today's overall expensive market.

Source: author based on data from Yahoo Finance

Warning and clarification

Here a strong warning is in order. I am NOT suggesting you go out and start buying every/any stock that is selling below its IV. As investors, we face many risks. Two of the major risks are A) quality risk or value trap, i.e., paying a bargain price for something of horrible quality, and B) valuation risk, i.e., paying too much for something of superb quality.

For me, the IV valuation is mainly to avoid the type B risk AFTER the type A risk has been eliminated already. A miserable company cannot become a good investment in the long run no matter how cheap you bought it. But a good company can become a bad investment if bought at a high price. The optimal zone lies in the middle as shown, which represents an optimal trade-off between quality and valuation and hence reduces risks. I certainly did not invent this approach, and plenty of people (Buffett being the most famous one) have thought about and written about it before. If you are interested, Joel Greenblatt's little book, entitled "The Little Book That Still Beats the Market", probably is the best starting point on this general philosophy.

I also did not invent the M x BV + 10 x Dividend formula. Others have thought about it before. For example, Thomas Au's book entitled "A Modern Approach to Graham and Dodd Investing" gave an excellent treatment on this topic. The main advantages of this approach are:

1. It relies on the two most easily obtainable data with the least amount of ambiguity. Many times, a few members with good certainty are much better than a bunch of numbers subject to ambiguous interpretation.

2. It is more of end-result driven approach. If a business is doing a good job making money and allocating capitals, then it should be reflected in either an increase book value, or a growing dividend, or both. Otherwise, something must be missing.

Source: author

Further rationale of the method applied to WPC

With the above backdrop, now let's look at WPC more closely and see why/how the method applies.

When we are investing in well-established and mature businesses (especially dividend growth stocks), it makes sense to focus more on the current asset value and income, rather than stipulate on future growth. And what can be more current than what the business is already worth (the BV) and distributing (the dividend)? Admittedly, there is still ambiguity in the BV. But it is really the best we have for the current worth of a business.

As for the dividend, it is really the most reliable and clear signal of a company's performance. Earnings fluctuate from year to year, often due to factors out of anyone's controlled: interest rate change, overall economy, or just bad luck. Moreover, earnings are also more open and prone to accounting manipulation and interpretation. Dividend overcomes all the above issues. The dividend is not subject to any subjective interpretation. And it reflects management's view more clearly and directly - at least for a business like WPC who has a long track record of being a good steward of their dividend. If it increases, it means management must have good confidence in their business at least in the near future. If it decreases, then that means the opposite. Simple and clear.

Source: author based on Seeking Alpha data.

Closer look at WPC: profitability and growth

The next chart shows WPC's BV over the past decade. As seen from the chart, WPC has been maintaining a stable and well-balanced balance sheet. Thanks to its stable and strong cash generation ability, WPC has been able to grow earnings and dividends with a strong and stable balance sheet. The second chart in this section shows the ROE of WPC in the past decade. As seen, its ROE has been on average around 5.5% as aforementioned.

Source: author based on Seeking Alpha data.

Source: author based on Seeking Alpha data.

Valuation and potential return

If the above argument and rational have made sense to you by now, it is relatively straightforward to project a "normal" return scenario in the next 3~5 years, as summarized in the chart below.

Source: author based on Seeking Alpha data.

This projection is made under the following very conservative assumptions:

  • BV grows at ~1% per year to $38.75 per share in 3~5 years.
  • ROE remains at the historical average of 5.5%, and consequently, EPS is projected to grow to $2.15 per share.
  • The dividend would grow to $5.5 per share, at approximately 2.5% CAGR. In comparison, WPC has been growing its dividend at a 5.6% CAGR in the past.

Based on these assumptions, the projected IV in 3~5 years would be about $93.8. And at the current price level, the total ROI (with dividend added) is projected to be 45%, or 7.7% annualized. It is a very solid return, especially when adjusted for the investment risks, quality of the business, and secular support.

Conclusion and final thoughts

This article suggests a valuation method based on book value and dividend to value well-established businesses as an asset plus income purchase. The method relies on two of the most easily obtainable data with the least amount of ambiguity, and using a few reliable data points is often better than using many but less reliable data. This method applies to many types of stocks as to be elaborated later. But it is especially intuitive to REIT stocks.

This valuation method, when applied to WPC, suggests that it is attractively valued at its current price, a rare case for a high-quality business under today's overall expensive market. Furthermore, this valuation method also shows the projected total return in the next 3 to 5 years to be ~45%, or 7.7% annualized. It is a very solid return, especially considering the quality of the business and the fact that a good part of the return is in the form of current dividends.

This article was written by

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** Disclosure** I am associated with Envision Research

I am an economist by training, with a focus on financial economics. After I completed my PhD, I have been professionally working as a quantitative modeler, with a focus on the mortgage market, commercial market, and the banking industry for more than a decade. And at the same time, I have been managing several investment accounts for my family for the past 15 years, going through two market crashes and an incredible long bull market in between. 

My writing interests are mostly asset allocation and ETFs, particularly those related to the overall market, bonds, banking and financial sectors, and housing markets. I have been a long time SA reader, and am excited to become a more active participator in this wonderful community! 


Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

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