What Would Benjamin Graham And John Neff Pay For Realty Income?

Jun.15.14 | About: Realty Income (O)


For investors who are satisfied paying fair value for Realty Income, a price range in the $37-$41 area would be appropriate (depending on whether you use 2013 or 2014 figures).

Investors that demand a 33% discount from intrinsic value won't find Realty Income appealing until its price hits the middle of the twenty dollar per share range.

Given the generally upward direction of the firm's funds from operations figure and a high starting dividend yield, paying slightly above fair value may make sense to some investors.

One of my favorite techniques for getting a conservative estimate of what a stock is worth is taking a hybrid Benjamin Graham-John Neff approach to valuing a stock. What you do is this: you take the past ten years of average valuation, you use common sense to manually remove three or four years of excessive valuation on either side (either unduly cheap or unduly expensive), and then you are left with an approximation of what a fair value for the stock would be (and if you want to incorporate a margin of safety in the spirit of Graham, you discount that value by 33%).

In the case of Realty Income (NYSE:O), there were three years in the past ten in which case the P/FFO ratio was out of sync, and common sense would dictate their manual removal in our calculations. They were the recession years of 2008 and 2009 (when the P/FFO rates were 13.1 and 12.1, respectively) and the unduly high year of 2012 when the P/FFO ratio was 20.1).

To calculate, then, a normalized P/FFO ratio for Realty Income, we would take the blended average of the following average P/FFO ratios that Realty Income experienced: 14.6 (2004), 15.0 (2005), 13.9 (2006), 14.6 (2007), 17.3 (2010), 17.2 (2011), and 18.5 (2013). That gives us a normalized P/FFO ratio for Realty Income of 15.87.

The next question you need to determine is whether you want to use the trailing year's figures or the 2014 estimates to arrive at a fair value estimate of what Realty Income is worth. If you want to use the 2013 figures, you will look to Realty Income's $2.34 in funds from operations generated in 2013 and figure that the fair value of the stock is somewhere around $37.14, if you only use the trailing earnings figures in your calculations.

Given that we are almost halfway through 2014, not much may be sacrificed in the interest of conservatism if we choose to use consensus analyst estimates of $2.60 as our baseline earnings figure for determining an appropriate valuation figure for the stock. Using the $2.60 figure and applying the 15.87 normalized P/FFO ratio, it would suggest that a fair price to pay for shares of Realty Income is somewhere around $41.26. Given that Realty Income closed on Friday at $43.85, it seems reasonable to conclude that we are within 6%-7% of what would be a fair historical value to pay for the stock (and given that Realty Income's occupancy rate has increased from 96% to over 98% over that time frame, and it diversified its client base in the past decade, you could fairly make the argument that a slight premium may be justified).

The final determination that you need to make is whether you are interested in applying the margin of safety principle espoused by Graham, or is it more appropriate for your needs to be a growth-at-a-reasonable-price investor? There's no right or wrong answer; the important thing is to be honest with yourself.

If you want to apply Graham's traditional margin of safety, which calls for buying a stock at two-thirds of its traditional value, you should be willing to pay either $24.88 (if you are super conservative and use only trailing year's calculations and insist on 33% reduction from fair value) or $27.64 (if you use the estimated 2014 figures, but insist on a one-third discount to intrinsic value). As you can see, applying strict Graham precepts would indicate that we are a far way off from an appropriate price to pay for Realty Income (based on Friday's closing numbers).

However, you may be interested in following John Neff's advice that it is perfectly okay to find sustainable dividend-paying stocks because the dividends act as hors d'oeuvres while you are waiting for the capital appreciation to arrive. Given that Realty Income yields nearly 5% (technically, 4.99% at Friday's close), investors would be forgiven for paying a premium for a high-quality real estate company that gives you almost triple the starting dividend yield that you would get from the S&P 500. And given that the long-term P/FFO direction for Realty Income has been generally upward, the estimates of fair value should also increase with time.

In short, if you want to apply Benjamin Graham's criteria strictly to Realty Income, then you would insist on a price of the stock in the mid-$20s, which is a price that would require significant discipline (one-third discounts to intrinsic value don't come along every day). If someone is interested in getting a handle on what the fair value of the stock should currently be, and is satisfied achieving total returns that mirror the actual growth of the firm (rather than trying to benefit from P/FFO expansion that comes with buying stocks at a discount), then an entry price range in the $37-$41 range would be appropriate. In relation to Friday's close of $43, we're not that far off.

Disclosure: The author is long O. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.