I Intend to Hold Shares of This Stock for the Long Term

Valuations change all the time, because prices change all the time.

Think about that. When we talk about valuation, we’re always looking for whether a stock is a good buy or a bargain, at its current price.

So price is always an element of valuation. Price appears in all valuation ratios: P/E = price divided by earnings. P/B = price divided by book value. P/S = price divided by sales (revenue). And so on.

[ad#Google Adsense 336×280-IA]So the question answered by valuation is always this: Does the stock represent a good value at its current price?

A company’s earnings may not change in a day, but it price may change 1% or 5% or 10%.

Obviously, a massive price change in a stock may significantly change its valuation.

A stock that was a bargain yesterday may be a bad buy today if its price went up 10%.

Or a stock that was overpriced yesterday may be a good buy today if its price fell 10%.

At Macy’s they may take a nice jacket that was $150 yesterday and move it to a sale rack with a new price of $75. It’s the same jacket, but its price changed. The same thing happens with stocks.

Today, I am going to go back and re-value a past Dividend Growth Stock of the Month. We need to do this from time to time, because prices change, and company realities change. So we need to re-value stocks when we are considering purchasing them.

Today’s stock is the very first stock that I presented as a Dividend Growth Stock of the Month. In January, 2015, I analyzed AT&T (T). At that time, AT&T was selling for about $33.50 per share, yielding 5.5%, and I evaluated it as fairly valued at the time.

Since then, AT&T has increased its dividend, just as it has every year for 32 straight years. They bought DirecTV. The company’s price has gone up 15% to about $38.45. T’s yield is now 5.0%, less than last year despite the dividend hike in the meantime.
AT&T’s dividend is A-rated for dividend safety by Safety Net Pro.

CaptureBut is the company still fairly valued? Let’s apply my 4-step process to find out.

Step 1: FASTGraphs Default Valuation

First we compare T’s current price to FASTGraphs’ default estimate of its fair value. FASTGraphs’ default estimate is based on a price-to-earnings (P/E) ratio of 15. That is the long-term historical average for the whole stock market.

This fair value is shown by the orange line on the following graph, which tracks AT&T’s earnings per share multiplied by 15. The black line is T’s actual price. The thin lines are 10% increments above and below the orange fair-value line.

2You can see that T is trading just a bit lower than the orange fair-value line. So it is slightly undervalued by this first method.

Let’s put a number on “slightly.”

To do that, we simply make a ratio between T’s actual P/E ratio at its current price and the value 15 used for the orange line. T’s actual P/E ratio is shown in the upper right: 13.9. So the ratio is 13.9 / 15 = 0.93.

Thus the conclusion is that T is 7% undervalued at its current price. That suggests a fair price of about $41.

That 7% undervaluation counts as “fairly valued” in my book. I usually don’t consider a stock truly undervalued until it gets to the 10% mark.

Step 2: FASTGraphs Normalized Valuation

Next, we use T’s long-term average P/E ratio to define “fair value.” This lets us adjust for the fact that many stocks typically trade at valuations above or below the default P/E ratio of 15 that we used in the first step.

A stock’s long-term average P/E ratio reflects the sentiment that investors typically have about the company and its stock. Higher long-term P/E ratios suggest more confidence in the company or more greed on the part of its investors. Lower P/E ratios suggest less confidence in the company or more fear or uncertainty about it as an investment.

I usually select the 10-year average P/E to represent “normal.” That ensures that I am including the Great Recession of 2007-2009 in the calculation as well as more conventional years.

That fair value estimate is shown by the blue line in the following graph.

3As you can see, T’s price is right on the blue line. Its current price’s P/E of 13.9 is just a whisker above the average P/E ratio of 13.8.

Specifically, the numbers are 13.9 / 13.8 = 0.01 = 1% overvalued. I consider AT&T to be fairly valued at its current price by this second method.

Step 3: Morningstar Star Rating

Now we try another approach. Morningstar uses a comprehensive net present value (NPV) technique for valuation. It involves discounting all of the stock’s future cash flows back to the present. When this technique is done right, many investors consider it to be the finest way to value a stock.

4Morningstar thinks that AT&T is ovevalued. On their 5-star grading scale, 2 stars means overvalued. And in fact, they have computed a fair value price of $33 for T, which is about 14% under T’s current price.

Step 4: Current Yield vs. Historical Yield

A quick review of a stock’s historical dividend yield gives us yet an additional way to estimate fair value. A higher current yield compared to the stock’s historical average suggests better valuation, because dividend yield is higher when valuation is lower.

This display from Morningstar shows AT&T’s current yield compared to its 5-year average yield (see the last line).

CaptureMorningstar is showing T’s current yield as 4.9% here. In the last column, the 5-year average yield is shown as 5.4%. That suggests that the current yield is 9% lower than the 5-year average. If we divide 4.9 by 5.4, we get 0.91 = 91%.

That suggests that T is 9% overvalued, with a fair price of $35 compared to its actual price of $38.45. Since that is not quite 10% overvalued, I consider T to be at the end of its fair-value range by this 4th method.

Valuation Summary

Now we put the 4 steps together and average them out.

CaptureI conclude that AT&T is about 4% overvalued at the present time. Its current price of about $38.45 is around 4% more than its fair value price of $37.

I would probably not buy AT&T here, but I would not criticize anyone who did. Historically, AT&T is a steady-eddie kind of stock. Its price will almost certainly fall back to a better valuation at some point.

AT&T over the past year illustrates how valuation can work in your favor. Last year, the stock was more solidly fairly valued, and its price has risen 15% since then. If you were a trader, you might consider selling it to cash in your profits.

I am not a trader. As a dividend growth investor, I took advantage of T’s fair valuation last year to purchase shares that I intend to hold for the long term. I don’t wish to cash in my shares. I prefer to hold onto them and keep receiving T’s quarterly dividend payments.

— Dave Van Knapp

Postscript: Do not interpret T’s yield being lower than last year as its dividend payout being lower. Its dividend payout is actually higher after T’s dividend hike in February this year. The reason T’s dividend yield is lower is because its price went up, not because its dividend went down. Its dividend did not go down, it went up.

In the equation for yield, Yield = Dividend / Price, so when price goes up, yield goes down. If the price goes up more than the dividend went up, the yield percentage still goes down even though the dividend payout has increased.

To brush up on the important relationship among price, dividend, and yield, please refer to DGI Lesson 6: Yield and Yield on Cost.

[ad#wyatt-income]