While many investors focus on earnings and P/E ratios when they are evaluating stocks, these metrics are not particularly important when it comes to valuing master limited partnerships (MLPs). Instead, distributable cash flow (DCF) and coverage ratios are much more important.
DCF is the cash flow available to the partnership to pay distributions to LP unitholders and the general partner (GP). While calculations can vary slightly between companies, it is basically adjusted EBITDA (earnings before interest, taxes, depreciation & amortization) with interest expenses, taxes, and maintenance capital added back in. Maintenance capital is added back in because that is the part of a company's CapEx (capital expenditure) budget that is needed to sustain current operations and cash flow, while growth capital (the other component of CapEx) is used to expand operations and increase cash flow.
Since DCF strips out all non-cash items, it is a truer measure of how much cash an MLP is generating and whether it can continue to pay out or increase its dividend. Thus, DCF-based metrics are better measures to use in the valuation of MLPs compared to earnings-based measures, which include a lot of non-cash items like depreciation.
The coverage ratio, meanwhile, is basically an MLP's distributable cash flow available to common unitholders divided by the distribution paid out to common unitholders. It is important because it illustrates the cushion an MLP has to pay its dividends.
Typically, MLPs that are more energy (natural gas processors) or weather sensitive (propane marketers) carry higher coverage ratios than companies with higher fee-based businesses. Companies with higher coverage ratios have more flexibility to grow their businesses without taking on more debt and/or raise their current dividends.
In a new 70-page report, BullMarket.com examines the various valuation metrics used to evaluate MLPs (and LLCs), gives it top picks in 11 MLP subsectors, and answers some common questions, such as whether MLPs could face the same fate as former Canadian Energy trusts such as Pengrowth Energy Trust (PGH).
Among the stocks featured in its report are Magellan Midstream Partners (MMP), Martin Midstream (MMLP), Atlas Pipeline (APL), PAA Natural Gas Storage (PNG), BoardWalk Partners (BWP), Crosstex (XTEX), Exterran Partners (EXLP), and many others.
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