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Verizon (VZ) has advanced nicely since the beginning of the year, but recently its shares have come under pressure. In this article, let's examine what Verizon is worth (where shares are fairly valued). We think a further retracement is warranted based on our point fair value estimate.

But first, a little background to help explain how we look at stocks at Valuentum. We think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators, is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below):

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If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Verizon posts a VBI score of 5 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its unattractive relative valuation versus peers, and neutral technicals. We compare Verizon to peers AT&T (T), Centurylink (CTL), and Sprint (S).

Our Report on Verizon

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Investment Considerations

Investment Highlights

  • Verizon Comm's average return on invested capital has trailed its cost of capital during the past few years, indicating weakness in business fundamentals and an inability to earn economic profits through the course of the economic cycle. We think there are better quality firms out there.
  • Verizon offers broadband, video and other wireless and wireline services to consumers, businesses, governments and wholesale customers. The firm operates one of America's fastest 4G wireless networks and provides services over one of America's most advanced fiber-optic networks.
  • Verizon has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 15.3% in coming years. Total debt-to-EBITDA was 1.8 last year, while debt-to-book capitalization stood at 61.1%.
  • Although we think there may be a better time to dabble in the firm's shares based on our DCF process, the firm's stock has outperformed the market benchmark during the past quarter, indicating increased investor interest in the company.
  • The firm sports a very nice dividend yield of 4.2%. We expect the firm to pay out about 74% of next year's earnings to shareholders as dividends. Despite the high payout ratio, its Dividend Cushion is solid.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital [ROIC] with its weighted average cost of capital [WACC]. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Verizon Comm's 3-year historical return on invested capital (without goodwill) is 6.8%, which is below the estimate of its cost of capital of 10.2%. As such, we assign the firm a ValueCreation™ rating of POOR. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Verizon Comm's free cash flow margin has averaged about 12.6% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow [FCFF], which we use in deriving our fair value estimate for the company. (For more information on the differences between these two measures, please visit our website at Valuentum.com). At Verizon Comm, cash flow from operations decreased about 6% from levels registered two years ago, while capital expenditures expanded about 22% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Verizon's shares are worth between $34.00 - $56.00 each (our point estimate is $45 per share). Our model reflects a compound annual revenue growth rate of 4% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 2.4%. Our model reflects a 5-year projected average operating margin of 16.8%, which is above Verizon Comm's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.1% for the next 15 years and 3% in perpetuity. For Verizon Comm, we use a 10.2% weighted average cost of capital to discount future free cash flows.

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $45 per share, every company has a range of probable fair values that are created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Verizon Comm. We think the firm is attractive below $34 per share (the green line), but quite expensive above $56 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Verizon Comm's fair value at this point in time to be about $45 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Verizon Comm's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $56 per share in Year 3 represents our existing fair value per share of $45 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

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Source: Verizon Is Due For A Correction