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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.

(click to enlarge)

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

FCFFt or Future Value [FVt]

The Math

Present Value at 4.13%

0

FCFF01

25,921

1

FCFF1

25,657

=25,921*(1+ -1.02%)

24,639

2

FCFF2

25,172

=25,657*(1+ -1.89%)

23,215

3

FCFF3

24,480

=25,172*(1+ -2.75%)

21,681

4

FCFF4

23,594

=24,480*(1+ -3.62%)

20,068

5

FCFF5

22,537

=23,594*(1+-4.48%)

18,408

5

Terminal Value (TV5)

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 FCFF0 = 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 = Wd [kd(1-t)] + Wce(kce)

Where:

  • WACC = weighted average cost of capital (firm wide required rate of return)
  • Wd = weight of debt
  • kd = cost of debt financing
  • t = tax rate
  • Wce = weight of common equity
  • kce = 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 Kd value of 3.35% as 100 basis points equals a percentage point.

Then for kce,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 Wd, we note the fair value of debt which is $81.58B and the fair value of equity which is $206.1B.

So Wd = fair value of debt/(fair value of debt + fair value of equity)

= $81.58B/($81.58B + $206.1B)

= 0.28

Then WCE 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 rate1

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 tax2

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 capital4

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

gt

1

g1

-1.02%

2

g2

-1.89%

3

g3

-2.75%

4

g4

-3.62%

5 and thereafter

g5

-4.48%

where:

g1 is implied by the DuPont formula

g5 is implied by single-stage model

g2, g3 and g4 are calculated using linear interpolation between g1 and g5

Calculations

g2 = g1 + (g5 - g1) × (2 - 1) ÷ (5 - 1)

= -1.02% + (-4.48% - -1.02%) × (2 - 1) ÷ (5 - 1) = -1.89%

g3 = g1 + (g5 - g1) × (3 - 1) ÷ (5 - 1)

= -1.02% + (-4.48% - -1.02%) × (3 - 1) ÷ (5 - 1) = -2.75%

g4 = g1 + (g5 - g1) × (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.

Source: AT&T: Trading Below Its Intrinsic Value