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Basic Training: US Oil and Gas Trusts

By Elliott H. Gue on Oct. 26, 2012

Subscribers often ask whether MLPs, as operating companies without a predetermined termination date, are superior investments to US royalty trusts. The answer depends entirely on valuation: The best trusts boast significantly higher yields than the average MLP, which compensates for their limited time frame for distribution growth.

For this reason, investors should adhere to our buy targets for the trusts in our Focus List and Coverage Universe; we update these ratings regularly based on our valuation model.

Our valuation model is based one of the core concepts of finance: net present value (NPV), or the time value of money. That is, the dollar received today has more value than a dollar received in one year or a dollar received in two years; you can invest the dollar that you have today in stocks or bonds and earn a return. By forgoing the receipt of that dollar, you incur the opportunity cost of missing out on potential investment returns.

Our model discounts future cash flows by a predetermined rate–our required rate of return. For example, if we assume a required return rate of 10 percent, the value of $1 paid in one year’s time is about $0.91 today ($1 divided by 1.10, or $0.9091).

US royalty trusts are particularly suited for an NPV model: Based on estimates of the trust’s future distributions, we can calculate the trust’s fair value in today’s market.

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