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Kinder Morgan Stock Upgraded: What You Need to Know

Rich Smith, The Motley Fool

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Kinder Morgan (NYSE: KMI) stock is once again on sale. The oil pipeline operator received a vote of confidence this morning when Bank of America/Merrill Lynch announced it is upgrading the stock to buy.

Here's what you need to know.

Pipeline next to gravel road stretches into the distance, with mountains in the background

Image source: Getty Images.

Valuation matters

Merrill Lynch likes Kinder Morgan stock primarily for its "valuation," according to StreetInsider.com. And yet, that valuation may not look immediately attractive to most investors, seeing as based on trailing earnings, Kinder Morgan currently sells for a P/E ratio of 188 (data from S&P Global Market Intelligence).

And yet, in January, Kinder Morgan reported estimates-beating results. Although earnings declined year over year to end with a $0.47-per-share loss, Kinder Morgan attributed this loss primarily to effects of the just-passed 2017 tax reform, and argued its results were actually "solid" apart from those tax effects. Analysts agreed, noting that Kinder Morgan's adjusted earnings for Q4 2017 were actually up 17% year over year, and $0.03 ahead of estimates.

Merrill Lynch in particular thinks that after Kinder Morgan beat estimates once already, there's the potential for "attractive upside" in the shares, as "fundamentals" at the company are "improving." 

In today's note, the analyst not only upgraded Kinder Morgan to buy, but assigned the stock a $20 price target. If Merrill is right, this implies there's as much as 28% upside in the shares over the next 12 months.

Valuing Kinder Morgan stock

So is Merrill Lynch right?

Valued on its trailing P/E ratio of 188, it's hard to make much of a case for investing in Kinder Morgan stock -- even at analysts' projected 18% long-term growth rate. On the other hand, while GAAP earnings remain weak, last year, Kinder Morgan did generate free cash flow of more than $1.4 billion. With a price-to-free-cash-flow valuation of less than 25 and a dividend yield of 3.2%, Kinder Morgan does begin looking attractive when valued on free cash flow.

Viewed from yet another perspective, Kinder Morgan stock is currently selling for almost no premium whatsoever to its book value (Kinder Morgan has a price-to-book-value ratio of 1.03). Boasting an "unparalleled asset footprint" that includes the "largest natural gas network in North America" (Kinder's words), it's hard to imagine any competitor being able to build up a similar business at a cost similar to the cost to buy Kinder Morgan at book value -- yet that's all the market is valuing the stock today.

That's perhaps the strongest argument in favor of buying shares of Kinder Morgan.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares) and Kinder Morgan. The Motley Fool has a disclosure policy.