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Telefonica, S.A., (NYSE:TEF) is one of the largest telecom service providers in the world. While the company is headquartered in Madrid, Spain, it offers fixed and mobile phone services in Europe, as well as Latin America. 64% of Telefonica’s costumers reside in Latin America. The company derives near half of its revenues and earnings from this division.

As of the time of writing, Telefonica stock was trading at $18.55 with a 52-week range of $16.89 – $27.31. It has a market cap of $85 billion. Trailing twelve month [ttm] P/E ratio is 5, and forward P/E ratio is 7.5. P/B, P/S, and P/CF ratios stand at 3.5, 1, and 7.25, respectively. Operating margin is 14.9%, and net profit margin is 6.4%. The company has a significantly high debt/equity ratio of 3.41. However, it pays double digit dividends with a yield of 11.65%.

Telefonica has a 4-star rating from Morningstar. Out of 2 analysts covering the company, 2 have buy, and 2 have hold ratings. Wall Street has diverse opinions on Telefonica’s future. Average five-year annualized growth forecast estimate is 5.2%.

What is the fair value of Telefonica given the forecast estimates? We can estimate Telefonica’s fair value using discounted earnings plus equity model as follows.

Discounted Earnings Plus Equity Model

This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:

V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value

V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]

The earnings after the last period act as a perpetuity that creates regular earnings:

Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r

While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my growth estimates. You can set these parameters as you wish, according to your own diligence.

Valuation

Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate. In order to smoothe the results, I will also take the average of ttm EPS of $3.62 along with the mean EPS estimate of $2.41 for the next year.

E0 = EPS = ($3.62 + $2.41) / 2 = $3.02

Wall Street holds diversified opinions on the company’s future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 5.2%. Book value per share is $5.34.

The rest is as follows:

Fair Value Estimator

V (t=0)

E0

$3.02

V (t=1)

E0 (1+g)/(1+r)

$2.76

V (t=2)

E0((1+g)/(1+r))2

$2.53

V (t=3)

E0((1+g)/(1+r))3

$2.32

V (t=4)

E0((1+g)/(1+r))4

$2.12

V (t=5)

E0((1+g)/(1+r))5

$1.95

Disposal Value

E0(1+g)5/[r(1+r)5]

$17.70

Book Value

BV

$5.34

Fair Value Range

Lower Boundary

$32.4

Upper Boundary

$37.7

Minimum Potential

80%

Maximum Potential

110%

(You can download FED+ Fair Value Estimator, here.)

I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5-year discounted-earnings-plus-book-value model, the fair-value range for Telefonica is between $32.4 and $37.7 per share. At a price of $18, Telefonica is at least 80% undervalued.


(Click to enlarge)

Summary

Telefonica is one of the cheapest telecommunication stocks in the market. Its U.S. competitors are trading at significantly higher ratios. AT & T (T) has a trailing P/E ratio of 14.65 and forward P/E ratio of 11.6. Verizon (VZ) has similar trailing and forward P/E ratios of 15.18 and 14.77. Compared to Telefonica’s single digit P/E ratios, AT&T and Verizon are priced with almost 100% safety premium.

Telefonica is also in much better shape when it comes to Free-Cash-Flow. AT&T and Verizon have P/FCF ratios of 30, and 22.68. On the other hand, Telefonica has a P/FCF ratio of 7.25. Surely both AT&T and Verizon are nifty dividend stocks with yields of 6% and 5.3%, but Telefonica offers a double-dividend compared to these two stocks.

Mr. Market gives Telefonica a valuation of $82.5 billion, which is almost 14% lower than a year–ago valuation. Surely, there is a lot going on in Europe, and European stocks have been badly punished in 2011. However, telecommunication services became an essential part of our society. Whether there is a recession or not, people will keep communicating with each other. Besides, Telefonica derives near half of its revenues and profits from Latin America, which will be the driving force in company’s future. Therefore, I rate Telefonica as a strong buy, particularly when compared to its U.S. peers.

Source: Telefonica Offers A Better Value Than AT&T Or Verizon