If you’ve ever taken a course in finance or accounting, you’re probably familiar, at least conceptually, with the dividend discount model (DDM). The DDM is one of the simplest ways to value a security and reflects one of finance’s core principles: the time value of money, or the idea that $1 today is worth more than a $1 in the future. Even in today’s environment, some inflationary pressure exists, albeit dramatically less than in the 1970s, ‘80s and ‘90s. This general increase in the price of goods and services means that rational investors would regard $1 paid a year later as less valuable than $1 received today.

Opportunity cost also factors in to the equation. That is, if I lend someone $100 today, I give up the opportunity to invest that $100 in a portfolio of stocks or bonds or to put that $100 in a savings account. To compensate, I would seek some sort of return on the loan.

The DDM assumes that a stock is worth the net present value (NPV) of its future dividend payments to shareholders. This approach requires the analyst to estimate how much a company will pay in dividends over the holding period and discount the total based on desired annualized rate of return determine what these disbursements are worth in today’s dollars. The sum of all these discounted payments represents the security’s current value.

This valuation technique has a number of shortcomings. First and foremost, predicting the dividends a company will pay in the future is rife with uncertainty and subject to significant error.

Selecting an appropriate discount rate is another challenge. An analyst usually increases the discount rate for a stock that entails more risk or volatility, a decision that reduces the security’s NPV. The required discount rate should also vary with prevailing interest rates. When 10-year US Treasuries yielded almost 7 percent in early 2000, few investors would take on the additional risk involved in holding a stock expected to offer 6 percent annualized return. However, the prospect of a 6 percent annualized return is far more enticing today, with 10-year US government bonds yielding less than 2 percent.

Despite these drawbacks, the DDM is ideally suited for evaluating US oil and gas trusts. Subscribers unfamiliar with these securities should consult my lengthy special report, Oil and Gas Trusts: Buys and Sells. I also wrote extensively about US royalty trusts in The Yield Issue and Income Traps and Treasures.

Unlike operating companies that can grow through acquisitions, trusts have a finite life span and hold royalty interests in specified oil and gas wells. Usually, the company sponsoring the trust contributes acreage with existing wells and agrees to sink a certain number of additional wells on this acreage over a predetermined period.

After fulfilling its drilling obligations, the sponsor is usually responsible for routine maintenance to keep the wells in operating condition. Production from these wells naturally declines over time. Whereas an operating company might grow production by drilling more aggressively or targeting another oil- or gas-bearing formation, trusts are bound by the terms laid out in their prospectus.

Finally, most trusts terminate at a predetermined date, at which point unitholders receive a final distribution based on the sale price of the underlying properties.

These characteristics make a trust’s oil and gas production relatively uncomplicated. That being said, a trust’s cash flow hinges on oil and natural gas prices, though some of this uncertainty is often mitigated by hedges during the pass-through entity’s early years.

Because trusts pass on virtually all of their royalty earnings to unitholders as quarterly distributions, predicting these payouts involves multiplying estimated production by estimated price realizations in a given quarter. Although these predictions are prone to error, trusts present analysts with fewer variables relative to exploration and production companies.

Most trusts also outline their quarterly distribution targets and provide a third-party estimate of the underlying property’s liquidation value in a final sale. Investors can find this information in the S-1 registration statements that trusts file with the Securities and Exchange Commission.

The DDM in Action: SandRidge Mississippian Trust I (NYSE: SDT)

Let’s examine Growth Portfolio holding SandRidge Mississippian Trust I to demonstrate how I generate the buy targets for the oil and gas trusts in the model Portfolios.

First, let’s look at the trust’s targeted quarterly distributions as outlined in an S-1 registration statement filed on March 23, 2011.

Source: SandRidge Mississippian Trust I S-1/A

The targeted distributions (red line) depicted on this graph reflect the trust’s structure. SandRidge Energy (NYSE: SD), the trust’s sponsor, agreed to drill 123 wells in the area of mutual interest between the beginning of 2011 and the end of 2014. The trust is entitled to receive a 50 percent royalty on production from these 123 wells and 90 percent of the proceeds from the 37 existing wells. As SandRidge Energy drills new wells, total production and the trust’s royalties will increase steadily from early 2012 to early 2015.

After SandRidge Energy’s drilling program ends in late 2014, output from the trust’s wells will flatten and slowly decline as the wells mature. At this point, commodity prices will be the sole driver of distribution growth. However, even assuming a substantial increase in energy prices, distributions to untholders will decline after 2015-16 until the trust terminates in 2031. Management forecasts that the trust will disburse a final payment of $3.19 per unit in the first quarter of 2031, a prediction that’s based on the underlying acreage’s expected liquidation value.

In addition to the targeted distribution, the graph also includes a subordination threshold and an incentive threshold. If a quarterly distribution falls below the corresponding subordination level, SandRidge Energy will forego its own distributions to support public unitholders’ quarterly payments. By the same token, if the quarterly distribution exceeds the corresponding incentive threshold, the sponsor receives a bonus fee from the trust.

Management based its quarterly distribution targets on its forecast for quarterly production, prevailing oil and natural gas futures prices, and the trust’s existing hedge contracts.

Thus far, the trust’s three declared distributions have all exceeded the targeted level, suggesting that management’s projections were overly conservative. In fact the trust’s two most recent distributions were more than 20 percent above the target and surpassed the incentive threshold.

The most recent distribution of $0.790905 per unit exceeded the targeted distribution of $0.63 by more than 25 percent. Unitholders of record on Feb. 10, 2012, will receive this payout on Feb. 29.

The better-than-expected distribution in the fourth quarter reflected higher production: Whereas the prospectus called for the trust to lift 298,000 barrels of oil equivalent in the final three months of 2011, actual output came in at 446,000 barrels of oil equivalent. In a conference call hosted on Feb. 17, 2012, management stated that oil production exceeded estimates by 28 percent and that natural gas output outstripped the forecast by 72 percent. About 50 percent of this outperformance stemmed from better-than-expected well results, while accelerated drilling activity accounted for the remaining upside.

Although fourth-quarter oil and gas prices fell short of the levels projected in the trust’s prospectus, a strong hedge book ensured that energy prices didn’t affect the trust’s cash flow. During the quarter, gains on hedges accounted for about 11 percent of total revenue, while oil sales chipped in 66 percent and natural gas contributed the remaining 23 percent.

The inaccuracy of the trust’s initial forecast underscores the challenges of using the DDM to calculate SandRidge Mississippian Trust I’s fair value. Accordingly, I prefer to consider a number of potential scenarios to produce a range of valuations.

Let’s start with a basic scenario: that SandRidge Mississippian Trust I meets its targeted distributions for the remainder of its existence. I’ve labeled this hypothetical situation conservative because the trust has consistently exceeded production expectations in its short life. (I promise that this will be the first and last time I bore you with the full calculation.)

Source: SandRidge Mississippian Trust I S-1/A, The Energy Strategist

The middle column lists the targeted quarterly distribution, while the adjacent column lists the current value of that distribution after an annual discount of 7.5 percent. In other words, the estimated value of the targeted distribution assumes that the investor requires a 7.5 percent annualized rate of return from his or her investment in the trust. My calculations begin with the distribution for the first quarter of 2012 (to be paid in May); that’s the first payment you’d receive if you bought units of SandRidge Mississippian Trust I today.

Some pundits claim that trusts are difficult to value because forecasting oil and natural gas prices twenty years into the future is fraught with uncertainty. Although there’s a kernel of truth to this argument, the 7.5 percent annual discount limits the extent to which distributions made 19 years from now impact the trust’s NPV. For example, management estimates the trust’s liquidation value at $3.19 per unit, but this final payout is worth only $0.81 per unit in today’s dollars.

Based on this conservative scenario, the DDM estimates SandRidge Mississippian Trust I’s current value at $22.62. This valuation estimate is comfortably higher than the trust’s unit price when we added the stock to the Growth Portfolio in early October but considerably less than my buy target of $30 and the current stock price of $35.

I performed the same calculation for SandRidge Mississippian Trust I under two additional scenarios:

1. The trust’s distributions exceed the quarterly targets by 20 percent over its life span. For this to happen, well results would need to beat forecast output and/or commodity prices would need to surge after the trust’s hedges expire in 2015.

2. The trust accelerates drilling activity, pulling production forward and fueling rapid distribution growth. This scenario implies that the trust’s quarterly payout will peak earlier than expected.

In the first scenario, SandRidge Mississippian Trust I’s fair value comes in at $27.14 per unit; the second set of assumptions yields an estimated value of about $25.80 per unit. Both valuations are well below the current unit price of about $35.

Manipulating these calculations to produce a valuation greater than $35 requires substantial adjustments. If we assume that the trust disburses a quarterly distribution that’s 1.25 times the target level for the remainder of its life span and we drop the discount rate to 5 percent, the model yields an estimated value of $32.76. Dropping the rate of desired rate of return to 4 percent yields a valuation that approaches the current unit price.

But numbers alone omit qualitative factors and the “animal spirits” of fear and greed that drive the stock market. I added SandRidge Mississippian Trust I to the Growth Portfolio because the trust’s units traded below my DDM estimates of fair value. The units also yielded about 14 percent because the market had yet to appreciate the pass-through entity’s potential to grow its distribution in coming years.

Investors’ growing preference for high-yielding securities will be a major tailwind for oil and gas trusts, particularly with real estate investment trusts (REIT) and corporate bonds offering yields near decade lows. For that matter, even 10-year sovereign bonds issued by Italy and Spain currently yield less than 5.5 percent. To worsen matters, the Federal Reserve recently indicated that interest rates would likely remain near zero through the end of 2014.

In many instances, the yields offered by traditional income-paying investments don’t even offset inflation. Retirees seeking to live off the income generated by their portfolios will have to institute their own austerity measures if their investments yield only 2 percent to 3 percent. These challenges should increase demand for the higher-yielding fare in the model Portfolios: our royalty trusts, MLPs and deepwater contract driller SeaDrill (NYSE: SDRL).

At the current unit price of $35, SandRidge Mississippian Trust I still sports a 12-month yield of 9.7 percent based on its most recent distribution. This yield should increase as drilling accelerates and the quarterly payout grows.

Regardless of the estimates produced by my valuation model, SandRidge Mississippian Trust I and other high-yielding names will continue to attract investment dollars.

I’ve raised the buy target on SandRidge Mississippian Trust I twice since the stock joined the Growth Portfolio in early October. After the units had run up more than 50 percent from our initial entry price, I issued a Flash Alert on Feb. 9, 2012, suggested that investors sitting on substantial gains sell one-third to half of their position to turn these paper profits into real profits.

Many subscribers have asked if I plan to raise my buy target on SandRidge Mississippian Trust I or if I’ve changed my outlook on the trust in light of the recent jump in oil prices. The answer is a resounding “No.” Even if I attach less weight to my fair-value estimates because of investors’ preference for high and growing yields, I cannot justify the trust’s unit price without making extremely aggressive assumptions about commodity prices and discount rates.

Although I continue to like Sandridge Mississippian Trust I’s long-term prospects, investors should sell at least half their initial position. I’m also cutting SandRidge Mississippian Trust I to a hold because the shares appear overbought. If the stock pulls back to attractive levels during a market correction, I’ll consider assigning it a buy rating.

Investors seeking higher-yielding fare should consider rolling the proceeds into Growth Portfolio holdings SandRidge Permian Trust (NYSE: PER), a buy under 26, and Mid-Con Energy Partners LP (NSDQ: MCEP), a buy under 25. Both names offer 12-month yields of almost 10 percent.

The Others

Here’s a look at the conservative and aggressive valuation case for Growth Portfolio holdings Chesapeake Granite Wash Trust (NYSE: CHKR) and SandRidge Permian Trust, as well as SandRidge Mississippian Trust II (NYSE: SDR), which should go public in early April 2012.

Source: Company Reports, The Energy Strategist

Chesapeake Granite Wash Trust (NSDQ: CHKR)

My conservative valuation of Chesapeake Granite Wash Trust assumes that the spin-off of Chesapeake Energy Corp (NYSE: CHK) meets its targeted quarterly distributions through the remainder of its life span. This calculation factors in the 7.5 percent discount rate used to evaluate SandRidge Mississippian Trust I.

To date, the trust’s two quarterly distributions exceeded the targeted payout by more than 7 percent because of elevated oil prices, strong well results and an accelerated drilling schedule. My base valuation assumes that Chesapeake Granite Wash Trust’s quarterly disbursements will surpass the targeted payouts by 7 percent until the pass-through entity terminates in 2031.

Finally, my aggressive valuation model assumes that Chesapeake Granite Wash Trust’s quarterly distributions will exceed the targeted amount by 15 percent and factors in an annual discount rate of 6 percent.

Based on Chesapeake Granite Wash Trust’s drilling program and distribution growth potential, my current buy target of $25 appears warranted. However, one would need to lower the discount rate to 4 percent for my base model to yield an estimated value of $27 per unit. Buy Chesapeake Granite Wash Trust under 25. Investors who are sitting on substantial gains should book profits on about half their position.

SandRidge Permian Trust (NYSE: PER)

As with the two other oil and gas trusts in the Growth Portfolio, my conservative valuation model for SandRidge Permian Trust factors in a 7.5 percent discount rate and assumes that the trust always meets its targeted distributions. This approach is particularly cautious when you consider that crude oil accounted for 96.1 percent of the trust’s fourth-quarter production–a huge advantage in the current environment.

My base-case scenario assumes that the trust will continue to exceed its targeted distribution by 11 percent until the trust terminates. This model also includes a discount rate of 7.5 percent.

The aggressive valuation model assumes that the trust’s distributions exceed the forecast amount by 20 percent and applies a discount rate of 7 percent. My bullish outlook for oil prices, coupled with better-than-expected production in the Permian Basin, suggests that this hypothetical situation could pan out. SandRidge Permian Trust continues to trade at prices that are less than my fair-value estimates and current buy target. Buy SandRidge Permian Trust under 26.

SandRidge Mississippian Trust II (NYSE: SDR)

SandRidge Mississippian Trust II is expected to go public in April. I analyzed the basic structure of this trust in the Jan. 25 issue of The Energy Strategist Weekly, Eagerly Awaiting the IPO of SandRidge Mississippian Trust II. On paper, the trust appears as solid as SandRidge Mississippian Trust I and could be an outstanding investment at the right price.

My conservative scenario includes a discount rate of 7.5 percent and assumes that the trust will meet all of its quarterly distribution targets through the end of 2031, while the base case assumes that quarterly distributions exceed the forecast amount by an average of 12 percent. My aggressive valuation model calls for the trust’s distributions to exceed their target by 20 percent–in line with SandRidge Mississippian Trust I’s early payouts–and applies a discount rate of 6 percent.

Based on these fair-value estimates, SandRidge Mississippian Trust II would rate a buy under 26 after its initial public offering. Investors should consider the stock a steal for less than 23. I will keep readers apprised of my latest outlook for the stock once the trust goes public.