AT&T (NYSE:T) reported earnings on Wednesday and the stock was rudely greeted with a 5% selloff as worries persisted about a substantial reduction in capex spending. However, ignoring what happened as a result of earnings means that you can now buy Ma Bell 5% more cheaply than you could early this week. Given the stable, predictable nature of T's business and its steady cash flows, we can determine if the selloff in T shares is warranted or if it is a buying opportunity. To do this, we'll use a DCF type analysis in order to determine the value of T's business and the huge dividends that accompany it.
Any forecasting requires assumptions and mine are as follows for this analysis: 1) discount rate of 10% 2) perpetual growth rate of 3% 3) dividend growth rate of 5% per annum and 4) earnings estimates from Yahoo! Finance. I have used what I consider to be reasonable estimates, but all forecasting is subject to conjecture. You may disagree with some or all of my assumptions, but this risk is inherent to forecasting.
2013 
2014 
2015 
2016 
2017 
2018 

Earnings Forecast 

Reported earnings per share 
$2.53 
$2.71 
$2.86 
$3.01 
$3.18 

x(1+Forecasted earnings growth) 
7.00% 
5.50% 
5.50% 
5.50% 
5.50% 

Forecasted earnings per share 
$2.53 
$2.71 
$2.86 
$3.01 
$3.18 
$3.35 

Equity Book Value Forecasts 

Equity book value at beginning of year 
$16.55 
$17.19 
$17.91 
$18.68 
$19.51 
$20.39 

Earnings per share 
$2.53 
$2.71 
$2.86 
$3.01 
$3.18 
$3.35 

Dividends per share 
$1.80 
$1.89 
$1.98 
$2.08 
$2.19 
$2.30 
$2.41 
Equity book value at end of year 
$16.55 
$17.19 
$17.91 
$18.68 
$19.51 
$20.39 
$21.33 
x Equity cost of capital 
10.00% 
10.00% 
10.00% 
10.00% 
10.00% 
10.00% 

Normal earnings 
$1.72 
$1.79 
$1.87 
$1.95 
$2.04 
$2.13 

Forecasted EPS 
$2.53 
$2.71 
$2.86 
$3.01 
$3.18 
$3.35 

Normal earnings 
$1.72 
$1.79 
$1.87 
$1.95 
$2.04 
$2.13 

Abnormal earnings 
$0.81 
$0.92 
$0.99 
$1.06 
$1.14 
$1.22 

x discount factor (10%) 
0.909 
0.826 
0.751 
0.683 
0.621 
0.564 

Abnormal earnings disc to present 
$0.74 
$0.76 
$0.74 
$0.73 
$0.71 
$0.69 

Abnormal earnings in year +6 
$0.69 

Assumed longterm growth rate 
3.00% 

Value of terminal year 
$23.63 

Estimated share price 

Sum of discounted AE over horizon 
$4.36 

+PV of terminal year AE 
$13.33 

PV of all AE 
$17.68 

+Current equity book value 
$16.55 

Estimated Current share price 
$34.23 
Given my model's inputs, T has an approximate fair value of $34.23 today. With shares trading at $37.38 as of this writing, shares are trading at about 8% greater than my fair value estimate. It is important at this point to understand what the fair value estimate means. The model's output is a price at which, given the parameters specified, shares can be bought at a "good price" today. The estimated fair value is the net present value of the company's cash flows plus its current book value. Therefore, the fair value of the business today, according to my estimates, is about 8% lower than where shares are trading.
I would caution against allowing that particular number to scare you off from investing in T at this point. It is important to note that $34.23 is not a nominal price target; rather, it is the net present value of all the company's estimated future earnings and current book value. Given T's current forward PE of 13.6, if the company achieves $3.35 in earnings per share in 2018, a nominal price of nearly $46 is implied with no multiple expansion. Therefore, just because the NPV of the company's earnings and book value are slightly below where the stock trades today, it doesn't mean the investment will be a certain loser. However, it does mean there is less margin of safety available for a long position than if the fair value was higher than the current stock price. Essentially, more caution is warranted but it is not a reason to dismiss the shares entirely.
Additionally, my model is forecasting that over this same period, shareholders will receive something like $12.85 per share in cash dividends, or a whopping 34% of the current share price! This offers huge downside protection in the shares and provides tons of current income in the process.
There are risks, of course, to my estimates. First, T may not hit even the fairly moderate goal of 5.5% earnings growth annually. If that does not happen, there is potentially significant downside risk to my fair value. For instance, if only 2% earnings growth is achieved, the fair value decreases to about $30, implying T is quite overvalued at this point. If no earnings growth is achieved whatsoever, in a sort of Armageddon scenario, look out below as it will get ugly for holders of the stock. However, given the fact that shares are somewhat reasonably attractively priced with a reasonable 10% discount rate and the enormous amount of dividends that are due to shareholders in the coming years, I believe the margin of safety is probably large enough to warrant taking the risk at this point in order to receive the cash payouts the stock is offering.
AT&T is certainly no highflying, fastgrowing company; rather, it is a utility. This provides some benefits for incomeseeking investors, however, as T's shares boast low volatility and a payout that is nearly three times the yield of 10 year Treasuries. In addition, reinvesting dividends in the shares will provide compounding yield over time and, barring some disaster, should provide shareholders with steady, robust income with the advantage of lower volatility.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in T over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.