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Here is a look at how Realty Income Corporation (NYSE:O) fares in ModernGraham's opinion, based on an updated and modernized version of Benjamin Graham's requirements of defensive and enterprising investors from The Intelligent Investor:

Defensive and Enterprising Investor Tests (What is the significance of these tests, and what is PEmg ratio?):

Defensive Investor - must pass at least 6 of the following 7 tests: Score = 5/7

  1. Adequate Size of Enterprise - market capitalization of at least $2 billion - PASS
  2. Sufficiently Strong Financial Condition - current ratio greater than 2 - FAIL
  3. Earnings Stability - positive earnings per share for at least 10 straight years - PASS
  4. Dividend Record - has paid a dividend for at least 10 straight years - PASS
  5. Earnings Growth - earnings per share has increased by at least 1/3 over the last 10 years using 3-year averages at beginning and end of period - FAIL
  6. Moderate PEmg ratio - PEmg is less than 20 - FAIL
  7. Moderate Price to Assets - PB ratio is less than 2.5 or PB x PEmg is less than 50 - PASS

Enterprising Investor - must pass at least 4 of the following 5 tests or be suitable for a defensive investor: Score = 3/5

  1. Sufficiently Strong Financial Condition, Part 1 - current ratio greater than 1.5 - FAIL
  2. Sufficiently Strong Financial Condition, Part 2 - Debt to Net Current Assets ratio less than 1.1 - FAIL
  3. Earnings Stability - positive earnings per share for at least 5 years - PASS
  4. Dividend Record - currently pays a dividend - PASS
  5. Earnings growth - EPSmg greater than 5 years ago - PASS

Valuation Summary (Explanation of the ModernGraham Valuation Model)

Key Data:

MG Value$11.86
MG OpinionOvervalued
Value Based on 3% Growth$15.32
Value Based on 0% Growth$8.98
Market Implied Growth Rate13.56%
Net Current Asset Value (NCAV)-$24.59
PEmg35.62
Current Ratio0.39
PB Ratio1.47

Balance Sheet - 9/30/2013

Current Assets$42,100,000
Current Liabilities$108,700,000
Total Debt$3,738,400,000
Total Assets$9,880,900,000
Intangible Assets$971,600,000
Total Liabilities$4,870,700,000
Outstanding Shares196,330,000

Earnings Per Share

2013 (estimate)$1.40
2012$0.76
2011$1.01
2010$0.92
2009$0.94
2008$0.91
2007$1.03
2006$1.05
2005$1.00
2004$0.90
2003$0.98

Earnings Per Share - Modern Graham

2013 (estimate)$1.06
2012$0.89
2011$0.96
2010$0.95
2009$0.97
2008$0.98

Conclusion:

Like many REITs, Realty Income Corp does not fare well in the ModernGraham system. The company does not pass enough requirements for either the Defensive Investor or the Enterprising Investor. For the Defensive Investor, the fatal flaws are that its current ratio is far too low, it has not sufficiently grown earnings over the historical period, and it is trading at a high PEmg ratio. For the Enterprising Investor, the high level of debt relative to the current assets causes the first two tests to fail.

Either investor type should proceed carefully with further research as the company is considered to be speculative due to the level of risk inherent in its current financials. Maybe the risk ends up being worth it for some individuals, but keep in mind that following either the Defensive Investor or Enterprising Investor approach requires accepting minimal levels of risk as one of the 7 Key Tips to Value Investing is to never lose money.

From a valuation standpoint, the company's low growth in EPSmg, from $0.98 in 2008 to an estimated $1.06 for 2013, results in a poor valuation. The market is implying a growth rate of 13.56%, which is well above the growth seen in EPSmg over the historical period, and would indicate the company is currently overvalued.

What do you think? Do you agree that Realty Income Corporation is overvalued? Is the company not suitable for Defensive Investors and Enterprising Investors?

Disclosure: The author did not hold a position in Realty Income Corporation (O) at the time of publication and had no intention of entering into a position within the next 72 hours.

Source: ModernGraham Valuation Of Realty Income Corp.