Thesis and Background
My last article on American Tower Corporation (NYSE:AMT) argued that it is a high quality REIT business that has reached its full valuation at this moment. An analysis based on yield spread relative to the risk-free rate also suggests a manageable risk profile at the current price level.
This article performs a cost of capital analysis, and the results show that the business sustainably earns a healthy return on capital invested. Combined with its secular support and growth prospects, a decent long term return can still be expected.
Overview and recap
Most of the detailed information has been covered in my earlier article and won't be the focus today. Here we will just briefly recap the most relevant information for readers new to the fund to facilitate the new analysis.
American Tower Corporation is a global leader in the broadcast tower industry. It is the largest independent operator of wireless telecom and broadcast towers. American Tower has a global presence and reach, with a portfolio of approximately 187,000 communications sites around the world. ~99% of the revenue is generated from leasing out the properties in their global portfolio. The business enjoys a terrific model and fundamental economics and a long term secular support.
As seen from the next charts, AMT investors have been handsomely rewarded in the past decade through a combination of earning growth, valuation expansion, and dividend. The average annual dividend per share growth has been a remarkable 21% since 2012. The stock delivered 533% of total return over the past decade, translated into a whooping CAGR of 18.2%, far outpacing the SP500 index as seen below.
Source: Seeking Alpha
Cost of equity and debt
REIT business is a good place to apply the discounted dividend model ("DDM") due to their relatively stable income and the fact that they pay out most of the income as dividend. A key variable in the DDM model is the discount rate, and this analysis uses the Weighted Average Cost of Capital ("WACC") as the discount rate due to AMT's relatively stable earnings and capital structure. The WACC is the average cost for a firm to raise capital, meaning equity and debt in AMT's case. The average was taken by proportionately weighing the portion of equity and debt.
Therefore, for the calculation of WACC, four inputs are need: the cost of equity, the cost of debt, the proportion of equity in the total capital structure, and the proportion of debt in the total capital structure. The following table shows the first two of these inputs over the past decade. The cost of equity is calculated using the Capital Asset Pricing Model ("CAPM"), considering the volatility of the stock (the beta) and the risk free return (the 10 year Treasury bond yield). As seen, the cost of equity for AMT has been quite stable around 9% in the past decade, and consistent with the typical range of 8~10% used in practice.
The cost of the debt has been steadily decreasing over the past decade, thanks to the secular decline of the interest rate. 
Source: author based on Seeking Alpha data
WACC analysis
The next two inputs are relatively straightforward. To figure out the proportion of equity and debt in the total capital structure, we will first need the so-call enterprise value ("EV"). EV is simply the summation of the market value of equity (i.e., market capitalization) and debt at a given time. And these data are organized in the table shown below. Once we have the EV, then we can compute the proportion of equity (market capitalization/EV) and debt (debt/EV).
Once we have the proportions, then the WACC is calculated as:
WACC = portion of equity * cost of equity + portion of debt * cost of debt * (1- tax rate)
Note the second term is adjusted for tax because there are tax deductions available on the interest paid for the debt. As a result, the real cost of debt is less than the normal interest rate on the debt and should be adjusted accordingly. The amount to be adjusted is the amount a business saves in taxes as a result of its tax-deductible interest payments. This is the reason why the second term of WACC calculation is multiplied by (1 - tax rate).
Source: author based on Seeking Alpha data
Now with all the pieces ready, the WACC for AMT over the past decade is calculated and shown in the last row of the table above. As seen, it has been quite stable in the range from 7.1% to 8.2%, with an average of 7.7%. Also, note that the portion of debt has been steadily decreasing, from 25% of the EV in 2011 to about 20% currently, largely thanks to the spectacular stock appreciation AMT has enjoyed in the past decade.
The next chart also compares the WACC against the ROIC for AMT. As seen, the ROIC has been systematically higher than WACC with a healthy margin. For a business like AMT, the calculation of ROIC considers the following items as capital invested: working capital (including payables, receivables, inventory) and total estate assets. WACC is the hurdle rate of return, or the minimum required return, that a business needs to make to overcome the cost of the capital. And this comparison shows that the business can sustainably earn a healthy return on capital raised.
Source: author based on Seeking Alpha data
Valuation and expected return
With the WACC obtained above, we can now value the business and analyzes potential returns. REIT business is a good place to apply the discounted dividend model ("DDM") due to their relatively stable income and the fact that they pay out most of the income as dividend. In the DDM model, the fair value of a business is the summation of all its future dividend payments discounted to their present value. And in this analysis, we will use the WACC as the discount rate. The reason that WACC is a good choice for the discount rate is that WACC is the minimum required return that a business needs to make to overcome the cost of the capital. Therefore, it is the minimum rate that future earnings should be discounted.
With the above understanding, the DDM calculations for AMT is shown below. These calculations considered different combinations of WACC and terminal dividend growth rate ("DGR"). Because as we have seen above, the WACC did and will fluctuate in a certain range. Many factors could cause such fluctuation such as interest rate and the capital structure of the firm. Therefore, it makes sense to explore a range of possibilities. These calculations also considered a range of terminal dividend growth rate, ranging from 4% to 7.5%.
Source: author based on Seeking Alpha data
Source: AMT Investor Presentation
The growth rates are a bit higher than those assumed for typical mature businesses. And I think such assumption is justified given the secular support. Our society will only use more and more wireless devices, and more and more data. As seen from the second chart below, mobile data usage is projected to grow at 23% CAGR until at least 2026 due to increasing number of devices and increasing usage per device. Such long-term secular support will provide a tailwind for the business for many years to come.
Based on these discussions, we can get back to the DDM model table shown above. The color in the background shows the possibility of each combination. The darker the background color, the more probable the scenario is expected to materialize. And as can be seen, the most probable scenarios are those in the middle highlighted with red.
With the above valuation, the marking of safety and expected return can be projected. And the projections are summarized in the next chart in this section.
- As a base case, I expect the fair value to be about $285. The base case considers an average WACC and an average growth rate. And if invested at the current price, the stock is about fully valued in this base case.
- The bull case considers a lucky combination of higher growth rate and a lower cost of capital. The fair value in this case will be about $425. In this case, investment at the current price is would be about 50% undervalued. And the 5 year projected return is around 8.5% when annualized.
- The bear case represents an unlucky combination of higher cost capital and lower growth rate. And in this case, investment at the current price is about 28% overpriced. And the 5 year projected return is around -6%.
Source: author based on Seeking Alpha data
Conclusion and final thoughts
At its current price levels, American Tower Corporation represents a quality REIT business that has reached its full valuation at this moment. This article performs a cost of capital analysis, and the results show that the business sustainably earns a healthy return on capital invested. Combined with its secular support and growth prospects, a decent long term return can still be expected. Lastly note that these results are quite consistent with my earlier analysis using the yield spread relative to the risk-free rate, which is based on a different and independent perspective.
Thanks for reading! And look forward to hearing your thoughts and comments.
