Both AT&T (NYSE:T) and Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) are very large firms with well-known names (presuming Alphabet is read: Google). Aside from that, these potential investments don't seem to have much in common security-wise. Alphabet has been and is expected to grow quite fast, does not pay a dividend and has an above average earnings multiple. On the other hand, AT&T grows much slower, has a long and steady dividend increase streak to go along with a lower comparative earnings multiple.
It seems the companies are destined to take separate paths. And a lot of investors out there would ask why you would even mention the two in the same sentence. Yet this is what is so great about the investing world. Despite the dramatic differences in the expected growth rates and payout policy, the very different valuations allow for an interesting comparison to take place.
If the two potential investments were on level footing, you'd naturally much prefer Alphabet's growth compared to AT&T's slow moving nature. Of course we're not on equal footing.
It's sort of like racing an Olympic sprinter. If you both line up on the start line, the gun goes off and you're going to get crushed, no doubt about it. And a lot of investors make this rash comparison: "Alphabet grows faster, it's the future, that's the winner."
Yet what happens when you start at the 30-yard line against the Olympic athlete starting at the beginning? Or if you're at the 25-yard line and they have to start 10 yards behind the line? (Or any number of combinations.) This is where things get more interesting. You can beat an Olympic sprinter if you have a head start. It's just a matter of how much of a head start you need.
In the investing world this same concept comes into play. Instead of starting lines, it's about valuation and yield (if applicable) which can make up for varying business natures, or at the very least the perception of such.
AT&T can be in the same sentence as Alphabet as a potential investment because it gets a great head start in the valuation and dividend arena. Or if you like to think about it the other way, Alphabet's higher valuation can limit future investment performance from capturing all of the spectacular business performance. You could imagine an Olympic sprinter having to wear a weight vest while they compete.
Let's walk through a couple of scenarios to get a better feel for this concept. As I write this AT&T's share price is around $36.20. The quarterly dividend sits at $0.48, or $1.92 on an annual basis. Last year adjusted earnings were around $2.70 per share, indicating a P/E ratio of about 13.5 to go along with a "current" dividend yield of 5.3%.
Analysts are anticipating intermediate-term growth of about 5% annually, but let's scale that back a bit - call it 3% per year. If AT&T were able to grow by this amount, you might expect $3.50 in EPS after a decade to go along with $22 or so in collected dividends.
AT&T's current earnings multiple is more or less in line with the company's 10-year historical average. So we'll presume the multiple stays the same, equating to a future price around $48 after 10-years. In total this would sum to a total value near $70, or an annualized gain of about 6.8%.
The idea isn't to paint a rosy set of assumptions, instead it's about laying out a reasonable "base case" type of scenario. Certainly the results could be much better or worse, with a wide range of potential growth rates and ending multiples. Now let's do the same thing with Alphabet.
Alphabet's share price is around $703, does not pay a dividend and last year reported EPS around $24, equating to a trailing earnings multiple of about 29.
Analysts are expecting 16% to 17% annual growth in the coming years, but let's scale this back a bit. Especially when you're starting from high base, it becomes more and more difficult to grow through the years. For the next decade let's suggest that Alphabet can grow by 10% annually (an assumption potentially equating to future yearly profits of around $40 billion in the next decade) or future earnings-per-share of about $56.
Over the past decade the company's average earnings multiple has been in the 20 to 30 range, which was greatly skewed due to the first few years. In the last five years the average P/E ratio has been in the lower-20's, with three years or so below this mark. Recently the multiple has once more expanded, but let's keep caution in mind.
Should Alphabet grow by 10% for the next decade and shares trade with a 20 multiple, this equates to a future price of about $1,130. Expressed differently, this would represent an annualized gain of about 4.9%. Of course just as was the case with AT&T the actual results could be much better or worse.
If Alphabet began paying a 1.8% dividend and grew this by 10% annually with the same earnings, your total return would increase to about 6.6% per annum. Or if the company grew by 12% per year, the return would bump up to 6.6% as well. Or if the company both grew by 12% and had an end multiple of 22, you'd expect 7.6% annual gains.
The point is that despite the vastly different growth rates - 3% versus 10%-plus - you could anticipate very similar expected returns. In fact, as illustrated above, the slower growing security has a legitimate opportunity to provide a better investment result.
This is why the investing world is fun. If you said, "pick the growth winner," that's usually somewhat straightforward. A lot of people can pick out Usain Bolt from the crowd - just as they can pick Alphabet to grow faster than AT&T, or Visa (NYSE:V) over Consolidated Edison (NYSE:ED).
The more difficult part is figuring out if Average Joe can beat Usain Bolt with a 30 or 40-yard head start. That's not intuitively obvious. In the same way that it's not always obvious that a security like AT&T has the opportunity to be a better investment than Alphabet. Not all companies are built the same, but luckily the investment world throws in all sorts of head starts and hurdles to make the process a bit more competitive.
Disclosure: I am/we are long T.
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.