A lot of people tend to look at companies like AT&T (NYSE:T) as pure dividend plays, but a look at the stock chart since 2009 tells us that the story is not just about dividends, but about price appreciation also.
Source: Yahoo Finance
AT&T is the world's largest telecommunications company with revenues of $126 billion and net profit of $3.9 billion in 2011. It generates 81% of its revenues from wireless telecommunication and Data/Managed services. Wireless revenues grew by 6.6% in Q3, 2012 and wireless service revenues were up by 4.5% in the same period. It recorded the strongest growth in post-paid wireless subscriber ARPU (average revenue per user) in six quarters and now stands at $65.
The company generated $11.5 billion in operating cash flow in Q3, 2012 and a record $6.5 billion of free cash flow. To utilize this cash in an efficient manner, AT&T had earlier approved a buyback program to the tune of 300 million shares. In addition to this, the management has approved another 300 million shares to be bought back. A share buyback will generally result in an up-trending stock price, which explains the graph above.
In this article, we are going to try and estimate a fair value of the stock on the basis of the dividend discount model. The dividend discount model says that the price of a stock is equal to all its expected future dividends. Below is a mathematical representation of the model:
Price = Dividends 2013 / (r - g)
Where, r is the cost of capital
and, g is the growth rate of the dividends in the future.
The cost of capital for AT&T is 7%. We have to estimate the growth rate and it is always prudent to make this estimate based on historical figures. For the past 15 years, the dividends paid by the company have grown by an average of 5% each year. To build in a margin of safety, we estimate the dividends in the future will grow at the rate of 2.5%. On the basis of this growth rate, we estimate the dividend in 2013 to be 1.81.
Plugging these numbers into the dividend discount model, we get the fair value of the stock to be equal to $40.3. At the current price of $33, the stock is trading at 20% discount to its fair value. The dividend yield for the stock is currently around 5.5% (pre-tax). Given all this, investors who are investing for dividends should definitely buy AT&T and enjoy the yield plus a price appreciation that will further boost returns.