This Dividend Growth Stock Yields a Safe 6% and is Potentially 17% Undervalued

AT&T (T) is a cornerstone of many dividend growth portfolios. It is a Dividend Champion that has delivered 33 consecutive years of dividend increases.

AT&T has been getting knocked around in the market lately. Its price has dropped 15% in the last month.

But since price and yield are inversely related, the price drop has caused T’s yield to soar to nearly 6%, more than any other Champion.

There are a variety of reasons contributing to T’s being a market punching bag.

• T’s pricing ability on cell phone service is impeded by continuing price wars.
• People wonder whether their investment in DirecTV a couple years ago is paying off.
• Their attempt to acquire Time-Warner (TWX) is dragging out and could face regulatory objections. Some investors are not sure it’s a good idea anyway.
• The company’s debt load has some people worried, and it will get worse if the Time-Warner acquisition goes through.

On the TWX acquisition, multiple sources are reporting, as I was finishing this article, that the Department of Justice intends to approve the acquisition only if CNN (owned by TWX) is divested. That could be a huge stumbling block to the merger.

So some people are seeing T dangerously in trouble, but others are seeing it as a great company on sale. We’ll leave the “great company” question for another day, but in this article, let’s take a look at AT&T’s valuation.

Dividend Safety

I always take a look at a company’s dividend safety before seeing whether it’s a good value. If the dividend isn’t safe, I wouldn’t be interested in it as a dividend growth investment anyway.

For a complete discussion of dividend safety and reliability, see Dividend Growth Investing Lesson 17: Dividend Safety.

I use two services to assess dividend safety. The first is Simply Safe Dividends. They use this scale to score dividend safety:

Here is how Simply Safe Dividends scores T:

Simply Safe Dividends’ score of 78 out of a possible 100 points for dividend safety suggests that AT&T’s dividend is safe and unlikely to be cut. The grade is within their 2nd-highest safety ranking.

The other service that I use, Oxford Income Letter’s Safety Net Pro, sees T’s dividend as even safer, giving it their highest grade.

Now let’s see how the company’s stock stacks up in terms of fair price.

Valuation Steps

To value a stock, I employ 4 methods and then average them out. For a complete discussion of my process, please read Dividend Growth Investing Lesson 11: Valuation.

Step 1: FASTGraphs Default Valuation

In the the first step, we check the stock’s current price against FASTGraphs’ basic estimate of its fair value.

For its basic estimate, FASTGraphs compares the stock’s actual price-to-earnings (P/E) ratio to the historical average P/E ratio of the whole stock market, which is 15.

That fair-value reference is shown by the orange line on the following graph, while the black line is T’s actual price.

By this first way of estimating valuation, T is quite undervalued.

To calculate how much, we divide the stock’s actual P/E ratio of 11.4 (shown at the upper right) by the ratio of 15 that was used to draw the orange fair-value reference line.

We get 11.4 / 15 = 0.76, or 76%. This suggests that T is 24% undervalued.

We can use that ratio to calculate T’s fair price: Divide its current price by 0.76.

That’s $33 / 0.76 or about $43.

(I round prices off to the nearest dollar so as not to create a false sense of precision.)

Step 2: FASTGraphs Normalized Valuation

Next, we compare the stock’s current P/E ratio to its own long-term average P/E ratio. By doing this, we judge fair value by recognizing how the market has historically valued AT&T itself rather than by how the market has valued all stocks over many years.

This doesn’t change things much. T’s long-term P/E ratio is 14.3 (see the dark blue box in the right-hand panel). That’s below the market’s long-term average of 15, which is typical for slow-growth companies like T. T’s current P/E is 11.4.

Using the same math as in the first step, the degree of undervaluation is 11.4 / 14.3 = 0.80, or 20% undervalued. Using the same equation as in the first step, we get a fair value price of about $41.

Step 3: Morningstar Star Rating

The next step is to see what Morningstar has to say.

Morningstar ignores P/E ratios. Instead, they use a discounted cash flow (DCF) model. They discount all of the stock’s projected future cash flows back to the present to arrive at a fair value estimate. (If you would like to learn more about how this works, check out this excellent explanation at moneychimp.)

Under Morningstar’s 5-star system, 4 stars means that they think that AT&T is undervalued too. They calculate a fair price of $40.

Step 4: Current Yield vs. Historical Yield

The 4th valuation method is to compare the stock’s current yield to its historical yield. If a stock is yielding more than its historical average, that suggests that it is a better value than usual.

T’s current yield is 5.9%. According to Morningstar, its 5-year average yield is 5.2%. Thus AT&T’s yield is currently 13% higher than its 5-year average.

Doing the math, this suggests that T’s fair price is $37.

Valuation Summary

My overall valuation is a simple average of the 4 approaches just described.

The average of the 4 fair-price estimates is $40 compared to T’s actual price of about $33. That’s a 17% discount to fair value, making the stock undervalued according to the methods that I use. In other words, AT&T is on sale.

Disclosure and Caution

I own T in my Dividend Growth Portfolio. It comprises about 7% of the portfolio. Since my maximum position size is 10%, there is room in the portfolio for more T.

I will have a dividend reinvestment opportunity coming up in December. I will seriously consider adding more T to the portfolio. A safe 6% yield fits my strategy nicely, even at a very slow growth rate.

The fact that AT&T’s valuation is attractive does not mean that anyone should just go out and buy it. A fuller analysis would be required.

As always, this is not a recommendation to buy T. Perform your own due diligence. Check out the company’s dividend record, quality, financial position, business model, and prospects for the future. Also consider whether it fits (or does not fit) your long-term investing goals.

— Dave Van Knapp

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