Finding the Intrinsic Value in These Dow Giants
Nikhil is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
In this investing series, I seek to find the intrinsic value of the Dow Jones Industrial Average through a brief fundamental analysis of each of the 30 companies included in the average, with the goal of deriving an intrinsic value for the market as a whole through a ‘sum of the parts’ analysis. I will also attempt to make recommendations on how to play each company on the DJIA for optimal investing performance.
In this article, I will use a brief fundamental analysis to look at market prospects for Verizon Communications Inc (NYSE: VZ) and AT&T, Inc (NYSE: T) in 2012 and beyond:
The Businesses:
Verizon and AT&T compete for customers in the same major markets: communications and cell services. Almost everyone I know is split into three main categories: Verizon, AT&T, and Sprint (although Sprint has been losing the battle in both my social circles and the stock market). The issue of smartphones and data has become a huge selling point and revenue creator for these businesses as it's now extremely common for the average adult (or kid!) to own and carry an internet enabled device. Of course, this issue has only increased with the introduction of the iPhone into Verizon's markets, allowing Verizon to compete with AT&T on a more equal level. Of course, as soon as I saw that the Verizon iPhone had been released, I had to look at the differences between the products. Here's an article I found on the subject. From what I can see in the article, the biggest pro for the Verizon iPhone is the WiFi hotspot, and the biggest con is the inability to use data and calling at the same time. In my opinion the Wifi hotspot will create more customers than the inability to multitask will remove, but altogether I don't think these differences will change much in the AT&T-Verizon relationship. Overall, just the fact that Verizon has an iPhone will push it back into the race.
Growth/Prospects:
Of course, the major issue now is that AT&T has a head start. The race is plowing forward and most people who got in were in early and in with AT&T. Verizon going forward needs to find a way to convince people that not only is AT&T bad, but that Verizon is better, and that it is worth their time to actually switch over. So forward prospects? AT&T is cheap, and Verizon is cheaper. According to EV/EBITDA at least(7.8 and 5 respectively). They are both dividend kings and I really don't see that changing in the near (1-3 years) future, so grabbing both of their 5% yields now may be a nice way to diversify into telecommunications based income. However, analysts don't see a bright future for their businesses, with expected EPS growth for the next 5 years for AT&T and Verizon respectively at -9.88% and -19.28%, which diverges with analyst expectations of their dividend yields, which should increase by 5% and 4% respectively.
Intrinsic Value:
So what's the best way to find the intrinsic value of these companies? I could use, as I have used in my past DJIA analysis blogs, the Discounted Cash Flow Terminal Value method; however, I don't think that's how telecommunications stocks are valued on the market. With the seemingly neutral battle between AT&T and Verizon, the best way to find their intrinsic values is not their cash flows, but their dividends. So I will use the dividend discount method to value both of these stocks. As AT&T is beating Verizon in the battle already, and seems to have the edge in analyst opinions, I will give AT&T a discount rate of 10% and Verizon a discount of 12.5%. I will also use their dividend growth rates as the growth rate in the formula. The formula is Price=Annual Dividend/(discount rate-growth rate), which actually comes from the formula for the sum of an infinite geometric sequence(for you math geeks out there).
AT&T = 1.76/(.1-.05) = $35.2
Verizon = 2/(.125-.04) = $23.5
Recommendation:
These rough models indicate that AT&T is undervalued by 15% and that Verizon is 65% overvalued. To take advantage of this, I think an investor would be advised to take a long-short approach to this, to eliminate market risk and simply bet that AT&T will perform better than Verizon in the coming year. Go Long AT&T and Short Verizon. I think this is a great idea also because you have a net 0.5% dividend yield, so you won't be losing dividend payments by shorting Verizon.
Of course, these valuations are rough estimates, so I encourage you to share your thoughts on the futures of these companies in the comments as well.
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