Is Keppel DC REIT Really Worth S$1.05 A unit?

Keppel DC REIT (SGX: AJBU) closed at S$1.05 per unit on Friday, 23rd Oct 2015. But what does the unit price of the Real Estate Investment Trust REIT) mean to us?

Is Keppel DC REIT really worth S$1.05 a unit? Asked another way, is the value of Keppel DC REIT on a per unit basis really around the neighbourhood of S$1.05?

The art of value

Estimating the value of a REIT is a big aspect of investing. Consequently, its value should be a key deciding factor when it comes to making an investing decision.

There are two main ways for investors to estimate the value of a REIT. One method works forward, in that an investor will try to estimate the growth rates that a REIT will achieve in terms of its earnings per share, dividends per share, or cash flow per share.

The other works backward, where we can look at a REIT’s current price and work out how much growth the market is expecting the trust to achieve. From that, we can determine if the market’s expectations are either reasonable or ridiculous.

Moving backwards

In this example, we will use a variant of a simple dividend discount model, called the Gordon Growth Model, to figure out the market’s expectation of Keppel DC REIT’s future growth in distribution.

A dividend discount model is meant to value a company based on the total amount of dividends that the firm would distribute to shareholders from now until perpetuity. The Gordon Growth Model simply adds in a factor to account for a company’s future growth in dividends. The formula for the Gordon Growth Model is shown below:

Share Price = Expected Dividend Per Share One Year From Now / (Discount Rate – Dividend Growth Rate)

Keppel DC REIT’s expected distribution for the fiscal year ended 31 Dec 2015 (FY2015) was 6.3 Singapore cents per unit. Looking at the REIT’s first-half distribution for FY2015, the annualized distribution per unit is expected to be around 6.93 Singapore cents per unit, as well.

As for the Discount Rate, the textbook method – which follows the Capital Asset Pricing Model (it’s perfectly acceptable to not follow the CAPM when trying to estimate the value of a stock, but I’d still use the model here for the sake of completeness) – is to incorporate the risk-free rate as well as the beta of Keppel DC REIT.

The risk-free rate is normally taken to be the 10-year government bond yield – currently, the yield on a 10-year Singapore government bond is 2.40% and so, that shall be our risk-free rate.

Meanwhile, the beta of any stock is simply a measure of a stock’s volatility in relation to a broad market index. In Keppel DC REIT’s case, as it is still a new listing, we have to assume that its beta is similar to the market at 1.0.

With the explanations out of the way, here’s how the formula for the Discount Rate looks like:

Discount Rate = Risk Free Rate + Beta (Market Return – Risk Free Rate)

You will notice that there’s one last variable in the Discount Rate formula which I have not discussed, and that is the Market Return.

The Market Return is simply the long-term return of the stock market as a whole. In this exercise, I will be using the long-run return of the SDPR STI ETF (SGX: ES3), an exchange-traded fund that tracks Singapore’s market barometer, the Straits Times Index (SGX: ^STI). Since its inception in April 2002, the SPDR STI ETF has generated a total return (inclusive of reinvested dividends) of 6.69%.

So, when we input all the relevant figures into the Discount Rate formula, we end up with a Discount Rate of 6.69% for Keppel DC REIT.

The next thing we have to do now is to punch all the numbers we have obtained so far into the Gordon Growth Model. This is what we’d end up with:

1.05 = (0.0693) / (0.0669 – Dividend Growth Rate)

As you can see, the only variable now that’s now unknown in the Gordon Growth Model is Keppel DC REIT’s future growth in distribution. After some basic arithmetic, we thus arrive at the conclusion that the market expects Keppel DC REIT to be able to grow its distribution at an average pace of 0.1% per year over the long-term future. From its listing presentation, Keppel DC REIT expects to be able to grow its DPU at 4.5%.

So what’s the value?

We can then use the expected growth rate of 0.1% and compare it against our own assessment of what Keppel DC REIT may be able to achieve.

So, based on all the above assumptions, if you expect Keppel DC REIT to be able to grow its distribution at a faster clip than 0.1% annually, the trust will be undervalued at S$1.05. But, if you’re not confident at all about Keppel DC REIT’s growth and think that its future distribution will step up at a much slower pace, then S$1.05 might be too high a price to pay.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Stanley Lim doesn’t own shares in any companies mentioned.