Last month in the Valuation Zone, we covered AT&T (T). The conclusion was that T was 17% below fair value.
Since that article was published, T’s price has popped up by 11%. It’s just luck, folks, although as Branch Rickey used to say, “Luck is the residue of design.” (For younger readers, Branch Rickey is in the MLB Hall of Fame. As a Brooklyn Dodgers executive, he was responsible for bringing up Jackie Robinson as the first African-American player in the majors.)
Like AT&T, Verizon is a cornerstone holding in many dividend growth portfolios.
Before we take a look at Verizon’s valuation, we want to make sure that its dividend is safe.
I always do that first, because if the dividend isn’t safe, I wouldn’t be interested in it as a dividend growth investment anyway.
I use Simply Safe Dividends to assess dividend safety. They use this scale.
Here is how Simply Safe Dividends scores Verizon:
Simply Safe Dividends’ score of 73 out of a possible 100 points for dividend safety suggests that its dividend is safe and unlikely to be cut. The grade is in their 2nd-highest safety ranking category.
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 current price-to-earnings (P/E) ratio to the historical average P/E ratio of the whole stock market. That historical average is 15.
That fair-value reference is shown by the orange line on the following graph, while the black line is Verizon’s actual price.
By this first way of estimating valuation, Verizon is a little undervalued.
To calculate how much, we divide the stock’s actual P/E ratio of 14.0 (shown at the upper right) by the ratio of 15 that was used to draw the orange reference line.
We get 14 / 15 = 0.93, or 93%. This suggests that Verizon is 7% undervalued. As a conservative investor, I call anything within 10% of fair value “fair.”
We can use the ratio to calculate Verizon’s fair price. Just divide VZ’s current price by 0.93. That’s $53 / 0.93 or about $57 as a fair price. (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 Verizon itself rather than by how the market has valued all stocks over many years.
This doesn’t change things much. Verizon’s long-term average P/E ratio is 15.1 (see the dark blue box in the right-hand panel). That’s almost the same as the market’s long-term average of 15.
Verizon’s current P/E is 14. Using the same math as in the first step, the degree of undervaluation is 14 / 15.1 = 0.93, or 7% undervalued again. In this step, we also get a fair price of about $57.
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, 3 stars means that they think that Verizon is fairly valued. They calculate a fair price of $50.
Step 4: Current Yield vs. Historical Yield
The 4th and final 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.
VZ’s current yield is 4.5%. According to Morningstar, its 5-year average yield is also 4.5%. Thus under this valuation method, Verizon is fairly valued at its current price of $53.
My overall valuation is an average of the 4 approaches just described.
The average of the 4 fair-price estimates is $54 compared to Verizon’s actual price of about $53. That’s a 2% discount to fair value, making the stock fairly valued according to the methods that I use.
I consider a stock at fair value to be purchasable, provided that I think highly of its quality, business model, and execution. Plus, of course, it has to fit into my portfolio and further my investing goals.
Disclosure and Caution
The fact that a stock’s price is at fair valuation – or even undervalued – 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 VZ. 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[ad#fool]