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 non-dividend 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}(1-t)] + 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 10-year T-bill which is about 2%. Then the 10-year spread of AT&T of 135 basis points is added to the 10-year 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 risk-free alternative rate which is the current yield to maturity of a 10-year T-bill 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 risk-free 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%(1-27.8%)] +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 |
Short-term debt | 3,486 | 3,453 | 11,282 | 11,531 | 17,968 |
Long-term 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(1-Tax Rate) = 3,444(1-28.53%) = 2,461
3 EBIT*(1-tax 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*(1-tax rate) = 7,264 + 2,461 = 9,725
4 Total Capital = Short-term debt + Long-term 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(1-Tax 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.
Single-stage 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 single-stage 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 long-term 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.