Digital Realty Trust, Inc. Stock: Value or Value Trap?

Digital Realty Trust , a real estate investment trust that invests in and operates data centers, got crushed after reporting disappointing quarterly earnings. Not only did the company's third-quarter funds from operations or FFO, the REIT equivalent to earnings per share, fall year over year, but it also revised its full-year outlook downward, and the market responded with a 15% haircut off Digital Realty's share price.

Industry peers DuPont Fabros Technology and CoreSite Realty , by contrast, have held up much better than Digital Realty this year. Nevertheless, it's worth paying particular attention when the industry leader falls on hard times, as Digital Realty is the biggest of the group. Digital Realty's cascade downward likely has investors nervous, and the critical question now is whether Digital Realty is as cheap as it seems on the surface.

Is Digital Realty's valuation too good to be true?
It's often the case that the market panics first and asks questions later. Digital Realty's huge earnings sell-off may indeed have gone too far, as the company now holds a strikingly cheap valuation. Digital Realty earned $4.44 in per-share diluted funds from operation in 2012 and expects to earn $4.61 per share in 2013, at the midpoint of its guidance. That means that Digital Realty shares now trade for 11 times last year's FFO and 10 times current year FFO projections.

It's understandable that the market multiple would compress in light of the company's troubles. At the same time, it's not like Digital Realty's fundamentals are deteriorating. The company still expects FFO growth this year and next, albeit just 3.6% in 2013 versus 2012. What matters now is whether growth will continue to slow and possibly start to decline, and it appears the market does not believe that Digital Realty will continue to grow.

By contrast, Digital Realty's two smaller competitors have had nothing but great things to say about their own businesses. DuPont Fabros posted stellar 63% growth in adjusted funds from operation in its third quarter, year over year, and CoreSite Realty produced 17.5% FFO growth in the third quarter.Furthermore, both DuPont and CoreSite increased their full-year 2013 guidance, indicating that Digital Realty's struggles are not widespread through the industry.

As far as Digital Realty's valuation is concerned, the stock may be much closer to a value than a value trap. Much of its lowered 2013 outlook has to do with a change in accounting policy. The company has adjusted a non-cash rent expense; moreover, Digital Realty's tenant base remains high quality -- Digital Realty still expects mid-to-single-digit FFO growth in 2014.

Is the selling in Digital Realty overdone?
The market multiple for Digital Realty may not increase dramatically until business conditions improve, because the market isn't willing to pay a higher multiple for slowing earnings growth. That being said, Digital Realty's sell-off was likely overdone, as the stock now yields a whopping 6.5%, a yield far above both the broader market and its own industry competitors.

Investors might immediately decide to ignore Digital Realty in favor of DuPont Fabros or CoreSite Realty within the data center space based on the latter two's fundamentals. The temptation is understandable, but it should be noted that you'll have to pay a significant premium for DuPont Fabros and CoreSite Realty, which each trade for 17 times full-year 2013 FFO expectations. Moreover, due to Digital Realty's falling share price, it provides a greater dividend yield of several hundred basis points over its two peers. DuPont Fabros and CoreSite Realty yield 4% and 3.3%, respectively.

The market is pricing in no growth whatsoever, and possibly a dividend cut -- both of which may not happen at all. Again, it's true that Digital Realty's 2013 FFO growth will likely disappoint, but it's not as if earnings are deteriorating. If the company manages 3% to 4% FFO growth this year and single-digit growth next year, there's no reason to believe why the company can't maintain (and possibly slightly increase) its dividend next year.

Foolish final words
Put simply, while disappointing, investors should not succumb to market panic. A 6.5% dividend yield and 3% underlying earnings growth are still acceptable enough to hold or pick up shares of Digital Realty.

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The article Digital Realty Trust, Inc. Stock: Value or Value Trap? originally appeared on

Bob Ciura owns shares of Digital Realty Trust. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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