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Verizon Communications (NYSE:VZ) is trading at a P/E ratio of 44.8 in a telecommunication industry where a sizable percentage of companies are trading at a P/E ratio of close to 10. Verizon's high P/E ratio seems largely due to the positive tailwinds in the wireless data business and increased adoption of smartphones, which markets are expecting to continue. Many people would label the stock as expensive, given the average P/E ratio in this industry and even the average P/E ratio of Verizon in the last five to seven years. However, while the stock does look expensive, it may still be suitable for many investors who are more concerned about limiting the downside in their investments. What gives Verizon a safety cushion in current uncertain economic times?

Company Profile

Verizon is a broadband and telecommunications company, with fixed-line and wireless voice and data as its product and service offerings. The company has benefited from tailwinds in the wireless data services and increased adoption of smartphones. During Q3 2012, Verizon activated 3.4 million Android smartphones and 3.1 million iPhones. However, the company is also struggling with challenges in enterprise and wholesale markets (part of fixed-line products and services).

Tracking Financials

If we look at the balance sheet of the company, Verizon is doing pretty well in managing its working capital. In the last few years, the gap between assets and liabilities was never large. Most of the money invested in Verizon is tied to fixed assets, as compared to working capital. The ratio of fixed assets to working capital is approximately 21.

The current dividend yield of the company is about 4.7%. The company has a good track record of paying dividends in the last five years. The current 20-year AAA bond yield in the U.S. is close to 3.6%. If an investor looks for a reasonably safe and sound investment for a period of couple of years, an investment in Verizon stock may be better than a fixed-income investment, given the high dividend yield. A high dividend yield gives a cushion to the investor, and it makes sense to invest in stocks with this when the options for allocating capital are limited.

Verizon's ROE is approximately 7.5%. However, the measures for the cash generated by the company paint a better picture. The ratio of average cash earned in the last five years to present market capitalization is approximately 21%. The ratio of average cash flow divided by the money invested in the business (estimated as average fixed assets plus average working capital) is close to 35%. These numbers indicate that Verizon has been generating surplus cash in the last five years.

What Does the Future Hold?

The potential upside in any stock in the future is limited if you pay a high price for it. Verizon is trading at a P/E that is relatively high compared to its average P/E in the last few years. The high P/E of the stock can only be justified by the ability of the company to deploy cash in projects, which would yield a positive net present value.

The fixed asset base of Verizon has not increased over the last five years. The depreciation in the last five years has been close to the amount invested in new property plants and investments.

2007

2008

2009

2010

2011

Depreciation & amortization

14377

14565

16532

16405

16496

Investments in property, plant, and equipment

-17538

-17238

-17047

-16458

-16244

(U.S. dollars in millions)

Thus, while Verizon is generating positive cash flows, it seems that the company has not found enough investment opportunities in the last five years. The cash and investments on the balance sheet represent approximately 39% of the net worth of the company, and 11% of market capitalization. In the future, markets will not be very kind to surplus cash on balance sheets, if it feels that the management is unable to find new projects with high IRR and positive NPV. While an analysis of management statements suggest that Verizon will find such projects, due to an increase in demand for mobile services, most of this growth seems to be factored into the price already.

Make or Break for Investors

Out of the 10 analysts reviewing and rating Verizon on Morningstar, five recommend a Buy rating, three prefer a neutral Hold rating, one has an Underperform rating, and the other has a Sell rating. While waiting for next quarter's results, a Hold position is indeed wise. However, Verizon's future prospects still look better than its competitors. This situation creates a bit of uncertainty for the average retail investor -- should he or she jump in with both feet (Buy) or remain on the sidelines (Hold) for the time being until additional guidance is received?

The discounted earnings plus equity model, developed by EFS Investment Partners and applied to Verizon, suggests the following: At a price of about $45, Verizon stock is overvalued. EFS's fair stock price valuation indicates that Verizon's stock is trading at a 12% premium over the fair value.

If one was to analyze Verizon as a possible bond investment, the investment would appear sound. It is useful to analyze the bond hidden in a stock investment; a stock can never be worth less than a bond a company can finance. The ratio of average cash flow generated in the last five years to the maximum interest paid in any of the last five years is close to 10 (a very sound number for the industry). The ratio of the average market value of the firm to the debt on the balance sheet is 2.5. Both of these ratios indicate that a bond investment in Verizon would be sound. We can extend this argument further to arrive at a valuation for Verizon. If we agree that Verizon is a sound fixed-income investment, then it can raise some money in the market. Let's assume that Verizon wants to maintain an interest coverage ratio of 5. Given the average cash flow in the last five years ($29,413 million) and the interest coverage ratio of 5, we can assume that Verizon can comfortably service an interest of $5,882 million ($29,413 million/5).

If we estimate that Verizon can raise debt at a rate of 5.6% (the number is derived from interest expense paid and balance sheet debt and is a conservative number, given that the current 20-year AAA bond yield is close to 3.4% and Verizon's Moody rating is A3), then Verizon has a debt capacity of $104,763 million. The current market capitalization of Verizon is approximately $127,000 million. Thus, a significant percentage of market capitalization can be explained by the debt capacity of the company.

To facilitate comparison, a rule of thumb from the value investing school of thought says that the value of a company is at least 175% of debt capacity + any surplus cash on the balance sheet. The surplus cash on the balance sheet is $13,194 million. Thus, the value of company (calculated as 175% of debt capacity + any surplus cash) is approximately $197,000 million. If this estimate is correct, then an investor will have a significant margin of safety to fall back on while buying stock in Verizon at the current price.

Bottom Line

To justify investment in Verizon at a high P/E, an investor needs to analyze the growth opportunities present in the stock. If such growth opportunities cannot be found, then Verizon may still be suitable as a conservative investment if better capital allocation opportunities are not found. If an investor is already invested in Verizon, he or she is advised to hold on to the stock. An investor should not invest in the stock if he or she is looking for a big upswing in returns, unless he or she is really sure that Verizon will have has some terrific capital allocation opportunities in the near future.

Source: What Gives Verizon A Safety Cushion?