Using the Wrong Framework - Again

This process of reviewing my Biggest Mistake of the Day (BMD) is going to make for a painful and humiliating 2016.  I'm hoping that I will have less to write about in 2017 as a result.

Today I was reviewing the financial information of Public Storage (PSA) which is the largest owner and operator of self-storage space in the U.S.  PSA operates as a Real Estate Investment Trust (REIT) which means that it does not have to pay taxes at the corporate level as long as it pays all of its earnings to the shareholders. 

(As an aside on this favorable tax treatment, misconceptions have abounded. REIT operators have claimed that they do not benefit from favorable treatment because the dividends are taxed at ordinary income rates that top out at nearly 40% while normally dividends are taxed at 20%.  This logic is faulty because it ignores that the REIT, unlike a corporation, avoids taxes.  A quick comparison.  Company A is a REIT and earns $10 million and pays out all earnings to its shareholders.  Company A pays $0 in taxes and its shareholders (assuming taxable) pay roughly $4 million.  Company B, in the same business, earns $10 million and pays out all earnings to its shareholders.  Company B has a tax bracket of roughly 35%, so it pays $3.5 million in taxes with the remaining $6.5 million in earnings going to shareholders.  These shareholders (again assuming taxable) pay at roughly 20% and so pay $1.3 million.  Company A earnings end up with tax of $4 million and Company B earnings end up with tax of $4.8 million.  REIT operators do have tax advantages.)

Back to my BMD.  I started closely studying PSA in 2005.  I analyzed it with the wrong framework because I focused on traditional income statement measures such as earnings, cash flow and revenues.  I even looked more closely and used a widely- used real estate measure called "funds from operations" (FFO) which is a measure that takes earnings and adds back depreciation and amortization costs.  Using this measure, I estimated that I would pay $36 per share for PSA.  During 2005, the stock's price ranged from $51 to $72.  I thought, "Wow. This stock is pricey!"

Two times a year, every year since then, I have studied the FFO and revised my pricing as the FFO steadily rose.  The only time PSA's stock price went beneath my buy price was briefly in 2009 as the world moved into fire sale mode.  I blamed the pricing disconnect between my pricing and the stock market's pricing on the huge operating margin of 60%+, in a world where I am happy with margins in excess of 12%.  But, as I discussed in my BMD of 1/1/2016, operating margins are not a relevant metric (despite wide usage - even on the quarterly discussions of the company) on a "balance sheet" company.

PSA is definitely a balance sheet company because its service is its balance sheet of a collection of self-storage units.  Once it is clear that a valuation metric needs to use the balance sheet, it is necessary to find the most useful metric.  In the case of PSA, that is not easy.  The balance sheet is primarily made up of real estate whose value is understated due to a combination of historical values and depreciation.  For this reason, book value and equity are misleading. However, with enough digging and without the wrong framework (again), there are sensible ways to get to a valuation.  This is something I should have done earlier. 

Since 2005, PSA stock has risen over 250% in contrast to the stock market, which on average, has risen about 100%.  That's a big penalty for using the wrong framework.