Fundamentally Speaking
AT&T Inc. (NYSE:T) is one of the most honored companies in the world. Recently, PCWorld/TechHive ranked the company's 4G LTE network as the fastest for a second consecutive year. AT&T has always been a solid name to consider for dividends with relatively low risk.
Dividend stocks have always outperformed nondividend stocks over the long term. This is the case whether it is a bull or bear market. The encouraging sign for AT&T is that it appears to be a better investment as a dividend stock than even IBM (NYSE:IBM) and we all know how much I love IBM.
Source: The Motley Fool
There is a lot more to love about AT&T. AT&T's P/E ratio may be on the high side at 28.78, but it appears to be healthy considering that its closest competitors have astronomically high or no P/E values reported. Verizon Communications Inc. (NYSE:VZ) has a P/E of 129.50 and Sprint Nextel Corporation (NYSE:S) has an unreported P/E.
Additionally, AT&T leads the way even with its EPS and it has the largest market cap of the three telecommunications firms with a value of $199.5B.
Present Value of FCFF
Valuing AT&T using the present value of free cash flows (FCFF) makes a very big case to buy the stock right now. The Present value of FCFF is an easy to use tool for investors to quickly assess a stock as it is great at finding intrinsic stock value estimates.
The Present Value of FCFF is based on a discounted cash flow (DCF) valuation technique. The idea is that if the value obtained from this method is higher than what the shares are currently trading at, then the stock is undervalued.
Free cash flows are basically cash flows minus direct costs and payments made to capital suppliers.
Intrinsic Stock Value
This is using the free cash flows.
Year 
Value 
FCFF_{t} or Future Value [FV_{t}] 
The Math 
Present Value at 4.13% 
0 
FCFF0^{1} 
25,921 

1 
FCFF_{1} 
25,657 
=25,921*(1+ 1.02%) 
24,639 
2 
FCFF_{2} 
25,172 
=25,657*(1+ 1.89%) 
23,215 
3 
FCFF_{3} 
24,480 
=25,172*(1+ 2.75%) 
21,681 
4 
FCFF_{4} 
23,594 
=24,480*(1+ 3.62%) 
20,068 
5 
FCFF_{5} 
22,537 
=23,594*(1+4.48%) 
18,408 
5 
Terminal Value (TV_{5}) 
250,027 
=22,537*(1+4.48%)/(4.13% 4.48%) 
204,224 
Intrinsic Value of capital 
312,235 

Less: Debt (Fair Value) 
81,576 

Intrinsic Value of common stock 
230,659 

Intrinsic Value of common stock (per share) 
$42.00 

Current share price 
$36.70 
1 FCFF_{0} = 2012 Values
It is easy to see that AT&T is undervalued from the table above and so it makes for a great investment idea. But there must be a number of questions on your mind. Specifically, what is the "calculation" column and how are the growth rates obtained. The good thing is that I am going to show you everything so that you will be able to do a Present Value of FCFF valuation on any stock you wish to analyze.
First, here is how the FCFF for 2012 is arrived at.
12 months ended 
Dec 31, 2012 
EBIT* ( 1  T ) 
9,725 
Add: Depreciation & Amortization 
18,143 
Investment in Long Term Assets 
(863) 
Investment in Working Capital 
(1084) 
Free Cash Flow to the Firm [FCFF] 
25,921 
USD $ in millions
Weighted Average Cost of Capital  WACC
To calculate the WACC simply take the weight of the source of financing and multiply it by the corresponding cost. There is one exception: you should multiply the debt portion by one minus the tax rate. Then sum the totals. The equation looks something like this:
WACC = W_{d} [k_{d}(1t)] + W_{ce}(k_{ce}) 
Where:
 WACC = weighted average cost of capital (firm wide required rate of return)
 W_{d} = weight of debt
 k_{d} = cost of debt financing
 t = tax rate
 W_{ce} = weight of common equity
 k_{ce} = cost of common equity
The effective tax rate for AT&T is 27.8%. The cost of debt financing is calculated by first obtaining the current yield to maturity of a 10year Tbill which is about 2%. Then the 10year spread of AT&T of 135 basis points is added to the 10year yield on a Treasury security. This gives a K_{d} value of 3.35% as 100 basis points equals a percentage point.
Then for k_{ce},we look up AT&T's beta value which is 0.55. We then subtract the riskfree alternative rate which is the current yield to maturity of a 10year Tbill which is about 2% from the overall market return which is taken here as the return of the S&P 500 over the last 10 years. So we subtract 2% from 7.1% to get 5.1%.
We then multiply this figure by the stock's beta value and we end up with 2.8%. The riskfree rate is added to this to calculate the required rate of return on equity. In this case it is 4.8 percent.
To get W_{d}, we note the fair value of debt which is $81.58B and the fair value of equity which is $206.1B.
So W_{d} = fair value of debt/(fair value of debt + fair value of equity)
= $81.58B/($81.58B + $206.1B)
= 0.28
Then W_{CE} will be 0.72. We proceed to put these values in the WACC equation above:
WACC = 0.28 [3.35%(127.8%)] +0.72(4.80%)
WACC = 4.13%
FCFF growth rate [g] implied by DuPont Analysis
Dec 31, 2012 
Dec 31, 2011 
Dec 31, 2010 
Dec 31, 2009 
Dec 31, 2008 

Selected Financial Data (USD $ in millions)  
Provision for Income tax 
2,900 
2,532 
(1,162) 
6,156 
7,036 
Net income 
7,264 
3,944 
19,864 
12,535 
12,867 
Tax rate^{1} 
28.53% 
39.10% 
6.21% 
32.94% 
35.35% 
Interest expense 
3,444 
3,535 
2,994 
3,379 
3,390 
Interest expense, after tax^{2} 
2,461 
2,153 
3,180 
2,266 
2,192 
Add: Dividends paid 
10,241 
10,172 
9,916 
9,670 
9,507 
Interest expense after tax and dividends 
12,702 
12,325 
13,096 
14,265 
11,699 
EBIT(1  Tax Rate)^{3} 
9,725 
6,097 
23,044 
14,801 
15,059 
Shortterm debt 
3,486 
3,453 
11,282 
11,531 
17,968 
Longterm debt 
66,358 
61,300 
58,971 
64,720 
60,872 
Total stockholders' equity 
92,362 
105,534 
111,647 
101,900 
96,347 
Total capital^{4} 
162,206 
170,287 
181,900 
178,151 
175,187 
1 2012 Tax Rate = [Provision for Income Tax/(Net Income + Provision for Income Tax)] * 100
=[ 2,900/(7,264 + 2,900)] * 100 = 28.53%
2 2012 Interest Expense After Tax = Interest Expense(1Tax Rate) = 3,444(128.53%) = 2,461
3 EBIT*(1tax rate) is the cash flow from the firm's operations assuming no debt financing. This is the net income added to the interest expense after tax. For 2012, EBIT*(1tax rate) = 7,264 + 2,461 = 9,725
4 Total Capital = Shortterm debt + Longterm debt + Total Stockholders' equity
From the values in the table above where we derived the "Total Capital" figure we need in this analysis, we compute the Retention Ratio (RR) and the Return on Invested Capital (ROIC) for the last 5 years. The calculations for 2012 are shown here.
RR = [EBIT(1  Tax Rate)  Interest expense after tax and dividends]/ EBIT(1  Tax Rate)
= [9,725  12,702] ÷ 9,725 = 0.31
ROIC = [EBIT(1Tax Rate)/total capital] * 100
= [9,725/162,206] * 100 = 6.00%
The values for the last 5 years are listed below.
RR 
0.31 
1.02 
0.43 
0.04 
0.22 

ROIC 
6.00% 
3.58% 
12.67% 
8.31% 
8.60% 
We will then find the averages of these RR and ROIC values and their product gives us the growth rate of FCFF or g. The averages are 0.13 and 7.83% respectively.
g = RR * ROIC = .13 * 7.83% = 1.02%
The growth rate can be difficult to predict and can have a drastic impact on the resulting value of the firm. This is why we use two growth rates and then use linear interpolation for the rest of the growth rates.
Singlestage model FCFF growth rate [g]
g = {Firm Value * WACC  FCFF0/(Firm Value + FCFF0)} * 100
= {287,676 × 4.13%  25,921)/(287,676 + 25,921)} = 4.48%
Year 
Value 
g_{t} 
1 
g_{1} 
1.02% 
2 
g_{2} 
1.89% 
3 
g_{3} 
2.75% 
4 
g_{4} 
3.62% 
5 and thereafter 
g_{5} 
4.48% 
where:
g_{1} is implied by the DuPont formula
g_{5} is implied by singlestage model
g_{2}, g_{3} and g_{4} are calculated using linear interpolation between g1 and g5
Calculations
g_{2} = g_{1} + (g_{5}  g_{1}) × (2  1) ÷ (5  1)
= 1.02% + (4.48%  1.02%) × (2  1) ÷ (5  1) = 1.89%
g_{3} = g_{1} + (g_{5}  g_{1}) × (3  1) ÷ (5  1)
= 1.02% + (4.48%  1.02%) × (3  1) ÷ (5  1) = 2.75%
g_{4} = g_{1} + (g_{5}  g_{1}) × (4  1) ÷ (5  1)
= 1.02% + (4.48%  1.02%) × (4  1) ÷ (5  1) = 3.62%
Conclusion: Buy AT&T for the dividends and longterm upside potential
It is true that we are in a "bubble" market and its best to do some profit taking now. But for dividend investors, this is not always possible. My suggestion is to go with companies that offer necessities people can't (or won't) live without. I know that food and hygiene are at the top of this list, but there are a few other bills that no one thinks about and always get paid: phone and electricity. These are bills that we write a check for regardless of the amount. What's more, many customers just let their electric and phone providers take money directly from their bank accounts or credit cards.
This is confirmed by the fact that sales at AT&T and Verizon were mostly unaffected during the recession. Furthermore, we are now going to see a nice revenue push for both these communications providers as a result of the increased data use with streaming video and music becoming more accepted. AT&T will have the advantage here with investors as it also has a long history of yearly dividend increases.
Moreover, the Present Value of Free Cash Flows reveals an intrinsic value of $42 a share and so AT&T is undervalued at its current share price of $36.70. And the recent pullback that we have seen in the stock price indicates that this is a perfect time to get in.
All material sourced from Morningstar and MSN Money.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.