Most analysts love Digital Realty Trust, which has an average rating of buy. But there's reason to believe the stock may be overvalued at today's price of $138.61 per share. Let's look at the fundamentals ourselves and see if we reach a different conclusion than the analyst community.
The first step in determining whether a stock is overvalued is to check its price to book (P/B) ratio. This is perhaps the most basic measure of a company's valuation, which is its market value divided by its book value. Book value refers to the sum of all of the company's assets minus its liabilities -- you can also think of it as the company's equity value.
Traditionally, value investors would look for companies with a ratio of less than 1 (meaning that the market value was smaller than the company's book value), but such opportunities are very rare these days. So we tend to look for company's whose valuations are less than their sector and market average. The P/B ratio for Digital Realty Trust is 2.4, compared to its sector average of 2.24 and the S&P 500's average P/B of 2.95.
Modernly, the most common metric for valuing a company is its Price to Earnings (P/E) ratio. It's simply today's stock price of 138.61 divided by either its trailing or forward earnings, which for Digital Realty Trust are $2.88 and $1.24 respectively. Based on these values, the company's trailing P/E ratio is 48.1 and its forward P/E ratio is 111.8. By way of comparison, the average P/E ratio of the Real Estate sector is 24.81 and the average P/E ratio of the S&P 500 is 15.97.
The problem with P/E ratios is that they don't take into account the growth of earnings. This means that a company with a higher than average P/E ratio may still be undervalued if it has extremely high projected earnings growth. Conversely, a company with a low P/E ratio may not present a good value proposition if its projected earnings are stagnant.
When we divide Digital Realty Trust's P/E ratio by its projected 5 year earnings growth rate, we obtain its Price to Earnings Growth (PEG) ratio of -5.97. Since a PEG ratio between 0 and 1 may indicate that the company's valuation is proportionate to its growth potential, we see here thatDLR is overvalued because it has a negative PEG ratio. One important caveat here is that PEG ratios are calculated on the basis of future earnings growth estimates, which may turn out to be wrong.
If a company is overvalued in terms of its earnings, we also need to check if it has the ability to meet its financial obligations. One way to check this is via the so called Quick Ratio or Acid Test, which is the sum of its current assets, inventory, and prepaid expenses divided by its current liabilities. Digital Realty Trust's Quick ratio is 0.84, which indicates that that it does not have the liquidity necessary to meet its current liabilities.
Investors are undoubtedly attracted by Digital Realty Trust's dividend of $3.5%. But can the company keep up these payments? Dividends are paid out from levered free cash flow, which is the money left over after the company has accounted for all expenses and income -- including those unrelated to its core business. In Digital Realty Trust's case, the cash flows are negative which calls into question the firm's ability to sustain its dividends.
Despite the quantitative evidence that Digital Realty Trust is overvalued, analysts are mostly bullish on the stock. What do they know about the stock's that trumps its weak valuation and growth potential? We will look into this question in a future report focusing on qualitative factors that might be favoring DLR.
