Although master limited partnerships (MLP) and oil and gas trusts offer similar tax advantages, MLPs are operating businesses that can raise capital by issuing bonds, taking on credit lines from banks or issuing additional units. The proceeds from these activities are often used to fund organic expansion projects or acquisitions that will grow the partnership’s cash flow and enable the firm to increase its distribution.

These differences don’t preclude using a standard dividend discount model (DDM) to estimate an MLP’s fair value. Let’s use Conservative Portfolio stalwart Enterprise Products Partners LP (NYSE: EPD) as an example. The blue-chip MLP recently disbursed $0.62 per unit for the fourth quarter and has boosted its payout for an unparalleled 30 consecutive quarters. On average, the partnership increases its payout at an annualized rate of 6 percent.

Enterprise Products Partners owns and operates pipelines and other midstream energy assets that generate fees regardless of commodity prices and economic conditions. As the company’s business entails less volatility and risk than oil and gas production, let’s use a discount rate of 6 percent for this exercise.

Assuming that the MLP grows its distribution by 6 percent annually over the next seven years and maintains the payout thereafter, Enterprise Products Partners’ fair value is about $70.75 per unit. That’s considerably higher than the stock’s current price of about $52 per unit.

But DDM isn’t the best approach to calculating an MLP’s fair value. Not only is it unrealistic to forecast consistent distribution growth in perpetuity, but a discount rate of 6 percent also has its shortcomings when valuing 40 years’ worth of payouts.

Instead, examining the yield spread between an MLP and other income-generating investments helps me to determine the buy targets for MLPs in the model Portfolios and identify attractive entry points.

Although MLPs tend to hold their value relatively well, these securities are subject to occasional bouts of extreme volatility. For example, a number of MLPs swooned shortly after Standard & Poor’s downgraded the US government’s credit rating. Growth Portfolio Linn Energy LLC (NSDQ: LINE), for example, lost 10 percent to 15 percent of its value in a short period, providing savvy investors with an opportunity to lock in an above-average yield.

These short-lived selloffs are often caused by investors who set stop-loss orders or trailing stops on their MLP holdings. These orders instruct their broker to liquidate the position if the unit price slips below a certain threshold. Investors often set these orders at similar prices, triggering a wave of stock sales that often saddles the hapless seller with outsized losses.

For this reason, investors should avoid setting stop-loss orders on any of the MLPs in the model Portfolios. Instead, investors should place a buy-limit order that instructs their broker to purchase a particular MLP when the unit price dips to attractive levels. Examining yield spreads can help us set appropriate buy-limit thresholds for our MLP holdings.

Conservative Portfolio holding Kinder Morgan Energy Partners LP (NYSE: KMP) last week disbursed $1.16 per unit to investors. The stock’s indicated yield, which annualizes the MLP’s most recent quarterly payout, is 5.14 percent–well under the Alerian MLP Index’s 5.75 percent yield. This 12-month yield is also considerably less than year-ago levels, largely because the stock has rallied by more than 30 percent in the past 12 months.

However, investors shouldn’t assume that the stock is overvalued just it trades near a record high and the yield is on the low side relative to its historical average.

Some commentators argue that the MLPs are overvalued because the Alerian MLP Index has handily outperformed the broader market and the average MLP yields less than the group’s long-term average. Though elegant in its simplicity, this argument doesn’t hold water because it fails to account for a dramatically different interest-rate environment.

The Federal Reserve has slashed interest rates to almost zero and recently announced that it’s likely to maintain that accommodative stance through the end of 2014. Some analysts also speculate that the Fed might initiate a third round of quantitative easing (QE III) to support the economy, buying bonds directly to reduce yields. Whether or not QE III materializes, low yields on most bonds and savings products practically guarantee that you’ll lose money on an inflation-adjusted basis.

In 2005 a one-year certificate of deposit (CD) sported an average yield of 4 percent to 5 percent, and 10-year US government bonds yielded well over 4 percent. Today, you’d be lucky to find a CD that pays an interest rate of 1 percent, while 10-year Treasuries yield less than 2 percent and the highest-yielding savings accounts sport yields of about 0.8 percent. In this low-yield world, the Alerian MLP Index’s yield of 5.75 percent is downright generous.

Relative yields provide insight into whether an MLP’s units are overvalued or undervalued. That is, how do the yields offered by MLPs compare to those available through US government bonds and other traditional income-focused products. This graph tracks the yield spread between units of Kinder Morgan Energy Partners and the 10-year Treasury note. Note that the graph features a reverse scale; when the yield spread declines, units of Kinder Morgan Energy Partners are relatively cheap.

Source: Bloomberg, The Energy Strategist

The graph includes three additional lines: The red line represents the average yield between units of Kinder Morgan Energy Partners and the 10-year Treasury note from 1998 to present, while the green and purple lines represent 1.5 standard deviations away from this mean. Here’s how to interpret the graph: When the yield spread approaches the green line, units of Kinder Morgan Energy Partner appear cheap; the stock is more expensive when the units approach the purple line.

At present, unit of Kinder Morgan Energy Partners offer about 318 basis points in additional yield relative to the 10-year Treasury bond–well above the long-term average yield premium of 241 basis points. According to this metric, units of Kinder Morgan Energy Partners appear undervalued.

Of course, you could argue that the current yield spread is distorted because the rate that the US government pays to borrow money for 10 years hovers near a record low. But even if the yield on the 10-year Treasury note increased to 2.75 percent, the yield spread relative to units of Kinder Morgan Energy Partners would tighten to average levels.

This graph also uncovers some underappreciated buying or selling opportunities. For example, in early 2000, the difference between the yields offered by units of Kinder Morgan Energy Partners and the 10-year US Treasury note slipped into negative territory, indicating that the stock was overbought. The stock price declined in the first half of 2000, returning the yield spread to normalized levels.

In contrast, units of Kinder Morgan Energy Partners appeared cheap in late 2008 and early 2009, presaging an explosive rally from these lows.

I also examine yield spreads on a shorter-term basis to identify buying opportunities.

Source: Bloomberg, Energy Strategist

The blue line on this graph once again tracks the yield spread between units of Kinder Morgan Energy Partners and the 10-year US government bond. However, the red line represents the 100-day moving average. The green and purple lines represent 1.5 standard deviations from this mean.

When the yield spread slips into the area between the red and green bands, the MLP’s units appear relatively inexpensive and ripe for purchase; when the yield spread climbs into the region between the red and purple bands, the units appear overvalued and should be avoided.

On this basis, investors should have accumulated the stock between May 10, 2010 and Dec. 22, 2010, and between May 31, 2011, and Nov. 29, 2011.

What do these longer-term and shorter-term yield spreads tell us about Kinder Morgan Energy Partners’ current valuation? Although the units appear inexpensive on a long-term basis, the recent run-up makes the stock vulnerable to a near-term correction.

Of course, any valuation that doesn’t consider company-specific developments and growth prospects overlooks a key driver of performance.

As I explained in a Flash Alert issued on Oct. 17, 2011, Kinder Morgan Inc. (NYSE: KMI)–Kinder Morgan Energy Partners’ general partner–should close its acquisition of pipeline company El Paso Corp (NYSE: EP) by mid-2012. A number of these pipelines would be a perfect fit for Kinder Morgan Energy Partners; we expect drop-down transactions from its parent to generate meaningful distribution growth in coming years.

In light of these developments and solid fourth-quarter results, Kinder Morgan Energy Partners LP rates a buy under 80. If the MLP’s unit price dips to this level, the yield spread relative to the 10-year Treasury bond would dip below the 100-day average.

Using these same valuation methods, I’ve updated the buy targets on the other MLPs in the model Portfolios. The table below also includes “dream prices” that would make for ideal limit orders.

Source: The Energy Strategist