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By Cagdas Ozcan

AT&T (NYSE:T) is a leading provider of communications services in the country. The company has strong presence in several states where customers use AT&T-branded telephone, Internet, and VoIP services. In addition, AT&T sells digital TV under the U-verse brand. AT&T's stock has experienced a steady rise in 2013, and the stock has gained about 10% since January. Does AT&T have any upside left? In order to assess the future growth potential of the stock, we decided to use our fair value model to see what the fair value of the stock is. Details of the model and results are discussed below.

As of the time of writing this article, AT&T stock was trading at around $36.47, with a 52-week range of $29.95 - $38.58. It has a market cap of about $198.5 billion. The trailing twelve-month P/E ratio of 28.90 is above the forward P/E ratio of 13.60. P/B, P/S, and P/CF ratios stand at 2.1, 1.7, and 5.4, respectively. The operating margin is 10.2% while the net profit margin is 5.7%. The company has a low debt load, with a debt/equity ratio of 0.7.

AT&T has a 2-star rating from Morningstar. Out of ten analysts covering the stock, five have a hold recommendation and three analysts are neutral. On the other hand, two analysts have market outperform and overweight ratings. Average five-year annualized growth forecast estimate is 5.85%.

We can estimate AT&T's fair value using 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 AT&T is $2.51.

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 5.85%. Book value per share is $16.32.

 

 

Fair Value Estimator

V0

E0

$2.42

V1

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

$2.31

V2

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

$2.20

V3

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

$2.10

V4

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

$2.00

V5

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

$1.91

D

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

$17.35

BV

Equals

$16.32

Fair Value Range

Lower Boundary

$30.28

Upper Boundary

$46.60

Potential

28.92%

(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 AT&T is between $30.28 and $46.60 per share. At a price of about $36, AT&T is trading close to the lower boundary of its fair value range. The stock still has up to 29% upside potential to reach its fair value maximum.

Summary

AT&T is one of the two leading services providers of the country, and future growth potential in the 4G LTE segment makes it an attractive investment. According to our valuation model, the stock is currently undervalued, and it should offer substantial capital gains. We believe AT&T will grow by more than 25% over the next few years, and reward its investors handsomely. Furthermore, the stock also offers attractive dividend payments, which should further enhance the total return of the stock. The current dividend yield of 5% is also one of the safest in the telecom sector. So, if you are looking for a safe dividend stock with modest upside potential, AT&T is the right one.

Source: How Much Is AT&T Worth?