This month the Valuation Zone visits the Telecommunications sector.

Verizon Communications (VZ) is the largest U.S. wireless carrier. Wireless provides 70% of its revenue and nearly all of its operating income. Verizon was created in 2000 when Bell Atlantic and GTE came together in one of the largest mergers in U.S. business history. GTE and Bell Atlantic themselves had evolved and grown through decades of mergers, acquisitions, and divestitures.

Quality Snapshot and Dividend Safety

Here is Verizon’s Quality Snapshot. To create this, I use:

  • Safety and Financial Strength grades from Value Line
  • S&P’s credit rating
  • Morningstar’s moat rating, and
  • Simply Safe Dividends’ dividend safety grade.

As you can see, Verizon is a very high-quality company. It earns high grades in 4 out of 5 categories. Its credit rating is middle-of-the-road, but it is still an investment-grade company according to S&P.

Verizon currently yields 4.4%, which I consider to be high-yield. It has raised its dividend for 14 straight years, which spans the Great Recession.

Simply Safe Dividends considers Verizon’s dividend to be very safe and unlikely to be cut.

Dividend growth has been slow, which is typical of a high-yielding “utility-like” company like Verizon.

I consider Verizon to be a high-quality, reliable, high-yield, slow-growth company.

Verizon’s Valuation

To value a stock, I use four different methods, then average them out. For more details, see 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.

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 for most stocks.

However, in Verizon’s case, FASTGraphs lowers the market P/E ratio, because Verizon’s growth is slower than the normal range for “average” companies. I’ll explain the adjustment below the chart.

The orange line is the fair-value reference line. I circled the P/E ratio assigned to Verizon, which is 12.3, adjusted down from the usual 15.

I also circled Verizon’s own P/E, which is 11.6. We’ll use these two P/E’s to determine Verizon’s valuation.

Under this first method, Verizon is slightly undervalued, because its actual price (black line) is a little below the orange reference line.

Here’s how to calculate the degree of undervaluation: Make a ratio out of the two P/Es.

Formula for Measuring Valuation on FASTGraphs

Actual P/E divided by Reference P/E

11.6 / 12.2  = 0.95

That translates to Verizon being 5% undervalued. I consider anything within +/- 10% to be “fairly valued,” because valuation assessment are estimates, not physical traits.

Using that valuation ratio, we can calculate Verizon’s fair price: Divide its actual price by the valuation ratio:

Formula for Calculating Fair Price

Actual Price divided by Valuation Ratio

$55 / 0.95 = $58

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

Step 2: FASTGraphs Normalized Valuation

In this step, we “normalize” the comparison to make it specific to the stock’s own long-term valuation rather than to the market as a whole.

We do this by comparing Verizon’s current valuation to its own historical valuation. I use the stock’s 5-year average P/E ratio (circled) for this step.

This 2nd step also suggests that Verizon is undervalued. Its 5-year average P/E ratio has been 13.5 (circled), which is higher than its current P/E of 11.6. The calculation is similar to the earlier step.

Valuation ratio: 11.6 / 13.5 = 0.86, or 14% undervalued

Fair price: $55 / 0.86 = $64

Step 3: Morningstar Star Rating

The next step is to see how Morningstar values the stock.

Morningstar takes a different approach to valuation. They ignore P/E and other conventional valuation ratios.

Instead, they use a discounted cash flow (DCF) model. Using conservative estimates for future projections, they discount all of the stock’s estimated future cash flows back to the present to arrive at a fair value estimate. (If you would like to learn more about how DCF works, check out this excellent explanation at moneychimp.)

Here is Morningstar’s conclusion:

On Morningstar’s 5-star system, 3 stars means that they think Verizon is fairly valued.

When you look at the details, they show a discount of 6% and a fair value of $58 per share. Morningstar follows a similar philosophy to mine: If their calculation of fair price is close to the stock’s actual price, they call that “fairly valued,” even though there is a 6% discount in this case.

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, because you are “paying less” for the stock’s dividends. You can buy more shares, and because dividends are paid per share, you will get more dividends for your purchase money.

[Source: Simply  Safe Dividends]

Verizon’s current yield of 4.4% is just below its average 5-year yield of 4.6%.

To calculate the degree of discount, we again form a ratio, this time comparing the yields:

Formula for Measuring Valuation by Comparing Yields

Historical Yield divided by Current Yield

4.6% / 4.4% = 1.05

That would suggest 5% overvaluation. Again, I count anything with +/- 10% as fairly valued.

Using 1.05 as our valuation ratio, we get a fair price of $55 / 1.05 = $52.

Verizon’s Valuation Summary

Now we average the 4 approaches.

The average of the 4 fair-price estimates is $58, compared to Verizon’s actual price of about $55. That’s a 5% discount to fair value. Being within +/- 10%, I think Verizon is fairly valued right now.

I see the fair price as $58 per share.

Closing Thoughts

One of my reasons for selecting Verizon to evaluate this month is that I have a dividend reinvestment coming up soon in my Dividend Growth Portfolio.

One of my “soft goals” for that portfolio is to raise its yield a little this year.

Since the portfolio currently yields 3.5%, it would take a stock with a higher yield to raise the whole portfolio’s yield.

Verizon fits that bill with its yield of 4.4%.

I will make my actual selection later this month.

It’s also a high-quality business, with a low investment-grade credit rating that is typical in its capital-intensive  business sector.

For comparison, Verizon’s chief rival AT&T’s credit rating is a notch lower at BBB.

For further insight, my colleague Brian Bollinger includes an analysis of Verizon in his current list of the 10 Best Stocks to Own for Retirement, published recently by Daily Trade Alert.

This is not a recommendation to buy Verizon. As always, perform your own due diligence. Check the company’s complete dividend record, business model, financial situation, and prospects for the future, as well as its effect on your portfolio’s diversification. And be sure to consider whether it fits (or does not fit) your long-term investing goals.

— Dave Van Knapp