MLP valuation at year end – still room to run!

2010 was another great year for the MLP sector. The MLP index, AMZ, finished 2010 with a total return (including dividends) of 36% compared to the S&P500 total return of 15.1%. And that was after a 76% return in 2009! Those kinds of returns will sure help you lead a more comfortable retirement which, after all, is my goal here.

But where does that leave us going into 2011? I have touched on MLP valuation a few times in previous posts (here here here here) and had come to the conclusion that MLPs were a bit frothy in price but not over valued. For the end of the year, I went back and did the same analysis but this time extending it to the top 5 MLPs by market cap and the AMZ index.

Metrics: I use two main valuation metrics for MLPs – current yield vs historical average yield and current spread to the 10 yr note vs historical average spread to the 10yr note. The yield is a similar metric to a P/E ratio but in this case it’s P/DCF (distributable cash flow) which is what MLP investors should care about. The spread to the 10yr note measures how MLPs have historically traded vs alternative income investments for which the 10yr note is a great proxy. I use historical data going back to the inception of the stocks and the AMZ index, most going back to at least the mid 90s. Lets get to the results.

Lets use the index, AMZ, to explain the chart. The AMZ index ended 2010 with a current yield of 6.20%. Also, the spread- the difference between the current yield and the yield on the 10yr US note – was 6.20% minus 3.31% = 2.89% at year end. Then we take those two numbers and compare them to the historical averages for those metrics. AMZ has historically traded at an average yield of 7.83% and a spread of 3.06%. The last two columns show at how much of a premium or discount AMZ is trading at – AMZ is trading at a premium to its historical yield and spread of 21% and 5.6% respectively. Ideally for establishing a new position an investor would like both metrics to be signaling a discount. For current owners of MLPs this by no means is a sell signal. AMZ has traded at bigger premiums to its averages in the past – for example 20% of the time AMZ has traded at a spread of 1.96% or below. So, I keep coming back to the same conclusion as my previous post, AMZ is frothy but not over priced.

As for the individual MLP stocks in the top 5, the chart clearly shows that the two best values are KMP and ETP. Both trade at less than a 9% premium to their avg yield and still trade at a discount to their avg spread. Also, both sport the highest current yields among the top 5 MLPs.

In my next post I’ll look in more detail at alternatives to MLPs for income investors and how they are currently trading with respect to MLPs. This will give us some more insight into the relative valuation of alternatives rather than just using the 10yr note as a proxy for other yield investments.

Disclosure: long KMP, ETP, and EPD