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By: Ahmed Ishtiaq

Verizon Communications (NYSE:VZ) has had a nice year, and the stock has gained substantially. The stock has recorded gains of about 16.5% over the past twelve months. The 4G LTE network is the most lucrative market at the moment, and the company is trying to exploit this opportunity. Verizon has one of the best and most widely available networks, which gives it a distinct advantage over its competitors. Furthermore, the company offers an attractive dividend yield, which makes it an attractive investment for income investors. We decided to develop a valuation model for Verizon, in order to calculate the fair value and potential of the stock.

As of January 31, 2013, VZ stock was trading at around $43.61, with a 52-week range of $36.80 - $48.77. It has a market cap of about $124.5 billion. The trailing twelve-month P/E ratio of 40.5 is far above the forward P/E ratio of 14.2. P/B, P/S, and P/CF ratios stand at 3.3, 1.1, and 3.8, respectively. The operating margin is 13.3% while the net profit margin is 2.7%. The company has a slightly high debt load, with a debt/equity ratio of 1.2.

Verizon has a 3-star rating from Morningstar. A majority of the analysts have a strong buy recommendation for the stock, and they expect the stock to outperform the sector. Wall Street has diverse opinions about the company's future. Average five-year annualized growth forecast estimate is 8.33%.

We can estimate Verizon's fair value using the discounted earnings plus equity model as follows.

Discounted Earnings plus Equity Model

This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:

V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5+ Disposal Value

V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]

The earnings after the last period act as a perpetuity that creates regular earnings:

Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r

While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my estimates. You can set these parameters as you wish, according to your own diligence.

Valuation

Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate.

In order to smooth the results, I will also take the average of ttm EPS along with the mean EPS estimate for the next year. The average EPS for Verizon is $2.20.

Wall Street holds diversified opinions on the company's future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 8.33%. Book value per share is $29.97.

Fair Value Estimator

V0

E0

$1.79

V1

E0 (1+g)/(1+r)

$1.75

V2

E0((1+g)/(1+r))2

$1.70

V3

E0((1+g)/(1+r))3

$1.66

V4

E0((1+g)/(1+r))4

$1.62

V5

E0((1+g)/(1+r))5

$1.58

D

E0(1+g)5/[r(1+r)5]

$14.41

BV

Equals

$29.97

Fair Value Range

Lower Boundary

$24.52

Upper Boundary

$54.49

Potential

24.95%

(You can download FED+ Fair Value Estimator here.)

I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5-year discounted-earnings-plus-book-value model, the fair-value range for VZ is between $24.52 and $54.49 per share. At a price of about $43.61, Verizon is trading at a price within its fair value range. The stock still has up to 25% upside potential to reach its fair value maximum.

Peer Comparison

The biggest competitors for Verizon are AT&T (NYSE:T) and Sprint Nextel Corp (NYSE:S). The table below lists some important metrics for comparison.

VZ

T

S

P/E

40.50

45.7

N/A

P/B

3.3

1.9

2.0

P/S

1.1

1.6

0.5

EPS Growth

-27.80%

-32.60%

0.0

Operating Margin

13.30%

7.80%

-4.40%

Net Margin

2.70%

3.50%

-12.30%

ROE TTM

8.00%

4.10%

-40.00%

Debt to Equity

1.20

0.60

2.50

Source: Morningstar

Price multiples are considerably high in the industry. However, Verizon trades at a discount compared to its peers. EPS growth is negative for both VZ and AT&T. Nevertheless, Verizon demonstrated the best margins among these three companies.

Summary

Margins are tight in the telecom industry, and most of the companies are relying on volumes. However, Verizon has shown impressive progress over the past twelve months. Furthermore, growth opportunity in the 4G LTE market and data demand will prove to be an essential driver for the company. Our valuation shows that there is substantial upside potential available for investors. Moreover, Verizon is one of the best dividend paying companies in the market. The stock offers considerable growth opportunity with solid income.

Source: Verizon Has Substantial Upside Potential