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Investment thesis and background
Buffett famously advised that the best equity investment should be bond-like. Following this advice, this article suggests a valuation method based on book value (“BV”) and dividend to value well-established REIT businesses as an asset plus income purchase. The method is based on a multiple of BV plus 10x dividends 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 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 10x dividend.
The rest of this article details the application of this method on STORE Capital (NYSE:STOR). These results provide insight into Buffett’s past purchases of STOR shares. And moreover, the results also suggest that it is slightly undervalued at its current price by a few percent. Given the quality of the business and today’s overall expensive market, it is a good investment opportunity for a range of investing styles.
STOR and Buffett
If you’re a devout Buffett cultist like this author, you must have known that he holds a sizable position of STOR. His STOR position is about $0.8B as of this writing - not the biggest deal in his humongous portfolio. But considering that A) STOR is the only REIT holding in his portfolio, and B) his holdings are about 10% of total outstanding shares, you can see that the grandmaster position is a strong endorsement on STOR.
Following his advice that the best equity investment should be bond-like, this article analyzes STOR using an asset + dividend approach – just like a bond. More specifically, 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 and I will use 1 in this case too.
But in general, M is equal to (ROE/a benchmark ROE)^2. The idea is that if a given business is earning an ROE that is above a benchmark (some kind of average, e.g., the ROE of the S&P 500 or the average ROE in its industry sector), 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 an 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 STOR, I will just use M=1 as its ROE is close to the average ROE of the broader market represented by S&P 500 as to be detailed later.
With the above understanding, the following chart shows the results of this method applied to STOR. As can be seen, it captured the market price very nicely. As seen from this chart, 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.
As you can also be seen, Buffett made his major purchases 2016-2017 when the prices were below IV by a good margin. So essentially, it is like he bought a high-quality AND high-yield bond AND at a price significantly discounted to face value all at the same time. And we will see the detailed numbers a bit later. It is hard not to make a good profit on such deals.
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 an end result-driven approach. If a business is doing a good job making money and allocating capital, then it should be reflected in either an increased book value, or a growing dividend, or both. Otherwise, something must be missing.
Source: Author
Further rationale of the method applied to STOR
With the above backdrop, now let’s look at STOR 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 STOR 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. Simply and clear.
Source: Author based on Seeking Alpha data.
Closer look at STOR: Profitability and growth
The next chart shows STOR’s BV over the past decade. As seen from the chart, STOR has been maintaining a stable and well balanced balance sheet. Thanks to its stable and strong cash generation ability, STOR 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 STOR in the past decade. As seen, its ROE has been also quite stable and consistent, with an average around 15% as aforementioned. And this is the reason why I just used M=1 here, because its average ROE is quite close the average ROE of the overall economy. Notably, the ROE has improved quite a bit over the past decade. It started around 10% at the beginning of the decade and has improved to about 20% now.
Source: Author based on Seeking Alpha data.
Source: Author based on Seeking Alpha data.
Valuation and potential return
If the above argument and rationale have made sense to you by now, it is relatively straightforward to see the reasons for Buffett’s purchases. As shown in the following table, when he made his purchases, he essentially paid for a high-quality equity bond with a discount ranging from 26% to 39%. And furthermore, the investment at the same time is very likely to further grow its coupon payments in the future too.
Now, with the price corrections in the recent week, the price has dipped near/below the IV again and potentially creates an entry opportunity. As shown in the following table, the current price is about 4% below the IV (and note the here the IV is based on the FW financials of STOR).
Source: Author based on Seeking Alpha data.
Conclusion and final thoughts
This article suggests a valuation method based on book value and dividend to value well-established REIT businesses as an asset plus income purchase – essentially like a bond. This method is especially intuitive to REIT stocks. As a long-term business owner, 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 10x dividend.
When applied to STOR, the results provide insight into Buffett’s past purchases of STOR stocks. He essentially paid for a high-quality equity bond with a high yield, at substantial discounts ranging from 26% to 39%, and with good odds of coupon payments growth in the future. And moreover, the results also suggest that it is slightly undervalued at its current price by a few percent. Given the quality of the business and today’s overall expensive market, it is a good investment opportunity for a range of investing styles.
