## Sunday, July 04, 2021

This is a continuity post from my previous post - How do I Conduct Fundamental Analysis for REITs? in which I have brought up the idea of using yield factor as a discount factor for the dividend yield to get the fundamental intrinsic value. I have shared this idea previously in 2019 - REITs Valuation post. Besides fundamental valuation, I would also employ the reversion to mean method to gauge the favorable price, which is similar to the post of 9 Attractive SREITs Based on Mean Reversion. I would use a fiction REIT - BAO HUAT REIT as an example to better illustrate my thought process.

Image by Gerd Altmann from Pixabay
I have created a simple spreadsheet with the example that I am going to use as below. You could first make a copy through this link and go through it together with this post.

There are two tabs, the "benchmarks" tab is for you to specific your benchmarks while the "valuation" tab is for you to key in REITs information and gets the valuation result. For both sheets, users are to key in the green cells. Feeling confuse? Don't worry, just read the following for my thought process.

1) Determine the Sector Yield & Market Cap Discount Rate

First, let's set the benchmark and minimum dividend yield for each sector. The benchmark dividend yield refers to the target dividend yield for an average REIT in terms of fundamentals (REIT with a yield factor of ONE). Minimum dividend yield refers to the lowest dividend yield one could accept for a particular sector.

Next, set the discount rate (in absolute %) for various market caps. This discount reflects the phenomenon that a REIT with a higher market cap is deemed safer whereby investors are willing to accept lower dividend yields compared to its peers. This would be applied after multiplying the yield factor with benchmark yield.

2) Determine the Fundamental Intrinsic Value

To determine the fundamental intrinsic value, multiply the yield factor with benchmark yield and then apply the market cap discount to the target dividend yield. As this is the target dividend yield without any top-up, I would then offset it with current income support or asset disposal. Below is the step:

Base Information

• Name - BAO HUAT REIT
• Top 3 Sectors - 50% Retail, 50% Industrial
• Market Cap -  S\$ 4 billions
• Existing Income support - 5% of distribution
• Existing Distribution from disposal - 5% of distribution
• Forecast FY DPU - 10 cents
• Yield Factor - 0.8
Calculation
• Market Cap Discount = 0.5%
• Benchmark Yield = (50% x 4.75% + 50% x 6%) = 6.25%
• Min. Yield = (50% x 4.25% + 50% x 6%) = 5.375%
• Target Dividend Yield = 0.8 x 6.25% = 5%. As it is lower than min. yield of 5.375%, therefore I will take 5.375% as target dividend yield, before applying the market cap discount.
• Target Dividend Yield after Market Cap Discount = 5.375% - 0.5% = 4.875%
• Target Dividend Yield after Market Cap Discount and Top-Up Offset  = 4.875 / (100% - 5% - 5%) = 5.417%
• Fundamental Intrinsic Value = Forecast DPU / Target Dividend Yield = 10 cents / 5.417% = S\$ 1.84 (rounded down)

3) Determine the Mean Reversion Price

The next step is to find out the average price based on the reversion to mean method. From the above, you could see there are 3 periods, so which should we take? Or should we just take a simple average? For me, I weigh it to focus more on the latest. Below is my set weightage:

Base Information

• NAV per Unit - S\$ 1.82
• Forecast FY DPU - 10 cents

Calculation

• Weighted Average P/NAV = 1.15 x 50% + 1.1 x 30% + 1.05 x 20% =  1.115
• Price based on P/NAV Mean Reversion = 1.115 x 1.82 = S\$ 2.02 (rounded down)
• Weighted Average Dividend Yield = 4.75 x 50% + 5 x 30% + 5.25 x 20% = 4.925%
• Price based on Dividend Yield Mean Reversion = 10 cents / 4.925 = S\$ 2.03 (rounded down)

4) Determine the Overvalue and Undervalue Price Range

Now that we have fundamental intrinsic value @ S\$ 1.84, P/NAV mean reversion price @ S\$ 2.02 and dividend yield mean reversion price @ S\$ 2.03. Next is to determine the prices for slightly overvalued/undervalued as well as overvalued/undervalued. Below are the benchmarks I am using:

For fundamental, I multiply the intrinsic value with the benchmark. For P/NAV, I take +1 SD as overvalued, +0.5 SD as slightly overvalued and vice versa. For dividend yield, I take -1 SD as overvalued, -0.5 SD as slightly overvalued and vice versa. The fair value would be the range in between slightly overvalued and slightly undervalued.

Fundamental (rounded down for all)

• Fundamental Intrinsic Value = S\$ 1.84
• Overvalued Price = 1.84 x 1.1 = S\$ 2.02
• Slightly Overvalued Price = 1.84 x 1.05 = S\$ 1.93
• Slightly Undervalued Price = 1.84 x 0.95 = S\$ 1.74
• Undervalued Price = 1.84 x 0.9 = S\$ 1.65

• NAV per Unit - S\$ 1.82
• Price based on P/NAV Mean ReversionS\$ 2.02
• Overvalued Price (+1 SD) = (1.18 x 50% + 1.14 x 30% + 1.07 x 20%) x 1.82 = S\$ 2.08
• Undervalued Price (-1 SD) = (1.12 x 50% + 1.06 x 30% + 1.03 x 20%) x 1.82 = S\$ 1.97
• Slightly Overvalued Price (+ 0.5 SD) = (+1 SD Price + Mean Reversion Price) / 2  = S\$ 2.05
• Slightly Undervalued Price (-0.5 SD) =(- SD Price + Mean Reversion Price) / 2 = S\$ 2

Dividend Yield (rounded down for all)

• Forecast FY DPU - 10 cents
• Price based on Dividend Yield Mean ReversionS\$ 2.03
• Overvalued Price (-1 SD) = 10 cents / (4.5 x 50% + 4.7 x 30% + 5.15x 20%) = S\$ 2.13
• Undervalued Price (+1 SD) = 10 cents / (5 x 50% + 5.3 x 30% + 5.35 x 20%) = S\$ 1.93
• Slightly Overvalued Price (-0.5 SD) = (-1 SD Price + Mean Reversion Price) / 2 = S\$ 2.08
• Slightly Undervalued Price (+0.5 SD) = (+1 SD Price + Mean Reversion Price) / 2 = S\$ 1.98

If your overvalue/undervalue benchmark is not an integer SD (whole number like ±1 SD or ±2 SD), then you would need to calculate the weighted average SD and multiply it with your benchmark instead of using the +1SD value from the table like the above example.

Summary

Let's put it into a table to have a clearer view.

Fundamental Intrinsic Value Relative Valuation - P/NAV  Relative Valuation - Dividend Yield
OvervaluedS\$ 2.02S\$ 2.08S\$ 2.13
Slightly OvervaluedS\$ 1.93S\$ 2.05S\$ 2.08
Fair ValueS\$ 1.75 to S\$ 1.92S\$ 2.01 to S\$ 2.04S\$ 1.99 to S\$ 2.07
Slightly UndervaluedS\$ 1.74S\$ 2.00S\$ 1.98
UndervaluedS\$ 1.65S\$ 1.97S\$ 1.93

5) Determine the Buy/Hold/Sell Price Range

With the above table, we could now determine what would be the buy, hold and sell price. This part is very subjective and varies between investors. Below are my rules:

The lowest price of "slightly overvalued", which is S\$ 1.93 for this case. Why not S\$ 1.92 if you ask? This is because the figure S\$ 1.93 is already rounded down in the calculation.

My Min. Sell Price Rule

The lowest price of the following:

i) Fundamental slightly overvalued AND relative overvalued

ii) Fundamental overvalued AND relative slightly overvalued

Let's do a calculation for both scenarios:

i) Fundamental slightly overvalued AND relative overvalued

• Fundamental slightly overvalued = S\$ 1.93
• Relative overvalued = S\$ 2.08
• To meet both requirements, price = S\$ 2.08
ii) Fundamental overvalued AND relative slightly overvalued
• Fundamental overvalued = S\$ 2.02
• Relative slightly overvalued = S\$ 2.05
• To meet both requirements, price = S\$ 2.05
The lowest of both scenarios is S\$ 2.05. Similar to the above analogy, as the figure is already rounded down in the previous calculation, so I would add 0.1 cent to it, which is S\$ 2.06 in this case.

Summary

Buy Range = ≤ S\$ 1.93

Hold Range = S\$ 1.94 to S\$ 2.05

Sell Range ≥ S\$ 2.06

Optionally, we can further define a strong buy range and a strong sell range. I use the value below 0.95 x max. price as strong buy range and the value above 1.05 x min. sell price as strong sell range. After computation, the result would be as below:

Strong Buy Range ≤ S\$ 1.83

Buy Range = S\$ 1.84 to S\$ 1.93

Hold Range = S\$ 1.94 to S\$ 2.05

Sell Range = S\$ 2.06 to S\$ 2.16

Strong Sell Range ≥ S\$ 2.17

From the above picture, the current price of S\$ 2.00 for BAO HUAT REIT is within the hold range.

Conclusion

These steps provide me a systematic way to make decisions instead of plucking figures from the sky. The end result could be a big difference with different criteria set though. Below is the infographic for my thought process flow, starting from the fundamental analysis:

How about technical analysis? There are quite a lot of investors who are using it to times their entry and exit price for REITs, which is a very useful way as well. I have seen some investors make quite some nice gains with it. However, I do not use it as the price movement would generally be reflected in the price relative table, albeit with a longer time frame.

Hope this post could provide a better picture of my thought process. Feel free to contact me if you need any clarification or help. And, please help to share it if you find my post useful.