A New High for this REIT

In this article, let's take a look at Omega Healthcare Investors Inc. (OHI, Financial), a $5.62 billion market cap company that invests in income-producing healthcare facilities, mainly long-term care facilities located in the United States.

10th consecutive increase

A few days ago, the board of directors approved a 1.9% increase in its quarterly dividend to 53 cents from its previous 52 cents. Based on that, shares rose and closed at $43.40 at the end of trading day. The current dividend yield is 4.58%, which we think is appropriate enough to protect purchasing power.

Growth of $10,000

If you had invested $10,000 five years ago, today you could have $29,394, which represents a 24% compound annual growth rate (CAGR).

Revenues and Margins

Looking at profitability, revenues increased by 26.49% and led earnings per share increased in the most recent quarter compared to the same quarter a year ago ($0.48 vs. $0.32). During the past fiscal year, the company increased its bottom line. It earned $6.56 versus $6.48 in the previous year. This year, Wall Street expects an improvement in earnings ($7.49 versus $6.56).

The gross profit margin is considered high at 70.58%, and it has decreased from the same period last year. Further, the net margin of more than 43% is ranked higher than 79% of the 964 companies in the Business Services industry.

Relative Valuation

In terms of valuation, the stock sells at a trailing P/E of 15.7x, trading at a discount compared to an average of 34.1x for the industry. To use another metric, its price-to-sales ratio of 2.6x is above the industry average of 1.72x.

Due to its strong earnings growth, this stock has surged by 39% over the past year, outperforming the S&P 500 Index.

Absolute Valuation

In stock valuation models, dividend discount models (DDM) define cash flow as the dividends to be received by the shareholders. Extending the period indefinitely, the fundamental value of the stock is the present value of an infinite stream of dividends, according to John Burr Williams.

Although this is theoretically correct, it requires forecasting dividends for many periods, so we can use some growth models like: Gordon (constant) growth model, the Two- or Three-stage growth model or the H-Model (which is a special case of a two-stage model). With the appropriate model, we can forecast dividends up to the end of the investment horizon where we no longer have confidence in the forecasts and then forecast a terminal value based on some other method, such as a multiple of book value or earnings.

To start with, the Gordon Growth Model (GGM) assumes that dividends increase at a constant rate indefinitely.

This formula condenses to: V0=(D0 (1+g))/(r-g)=D1/(r-g)

where:

V0 = fundamental value

D0 = last year dividends per share of Exxon's common stock

r = required rate of return on the common stock

g = dividend growth rate

Let´s estimate the inputs for modeling:

Required Rate of Return (r)

The capital asset pricing model (CAPM) estimates the required return on equity using the following formula: required return on stockj = risk-free rate + beta of j x equity risk premium

Assumptions:

Risk-Free Rate: Rate of return on LT Government Debt: RF = 2.67%. This is a very low rate because of today´s context. Since 1900, yields have ranged from a little less than 2% to 15%; with an average rate of 4.9%. So I think it is more appropriate to use this rate.

Beta: β =0.79

GGM equity risk premium = (1-year forecasted dividend yield on market index) +(consensus long-term earnings growth rate) – (long-term government bond yield) = 2.13% + 11.97% - 2.67% = 11.43%[1]

rOHI = RF + βOHI [GGM ERP]

= 4.9% + 0.79 [11.43%]

= 13.93%

Dividend growth rate (g)

The sustainable growth rate is the rate at which earnings and dividends can grow indefinitely assuming that the firm´s debt-to-equity ratio is unchanged, and it doesn´t issue new equity.

g = b x ROE

b = retention rate

ROE=(Net Income)/Equity= ((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)

The “PRAT” Model:

g= ((Net Income-Dividends)/(Net Income)).((Net Income)/Sales).(Sales/(Total Assets)).((Total Assets)/Equity)

Let´s collect the information we need to get the dividend growth rate:

Because for most companies, the GGM is unrealistic, let´s consider the H-Model which assumes a growth rate that starts high and then declines linearly over the high-growth stage, until it reverts to the long-run rate. A smoother transition to the mature phase growth rate that is more realistic.

Dividend growth rate (g) implied by Gordon growth model (long-run rate)

With the GGM formula and simple math:

g = (P0.r - D0)/(P0+D0)

= ($44.14 ×13.93% – $2.12) ÷ ($44.14 + $2.12) = 8.71%.

The growth rates are:

G(2), g(3) and g(4) are calculated using linear interpolation between g(1) and g(5).

Calculation of Intrinsic Value

Final comment

We have covered just one valuation method, and investors should not rely on one alone in order to determine a fair (over/under) value for a potential investment.

Trading at nearly the 52-week high seems to be announcing a fall in price. However, we think that it is the right time to add the stock to your long-term portfolio.

We must say that dividend payouts are one of the biggest attractions for REIT investors, so I feel confident in my bullish sentiment on this stock, despite the result of the absolute valuation model.

Hedge fund guru Jim Simons (Trades, Portfolio) added the stock in the third quarter of 2014.

Disclosure: Omar Venerio holds no position in any stocks mentioned.

[1] These values were obtained from Bloomberg´s CRP function.