AT&T (T 0.17%) is breaking up into three companies, which could unlock significant value for shareholders. The threefold split is very complicated, and many investors don't fully understand some parts of it. But those who hang on until the end of the deal next year should do quite well.

How is AT&T splitting up?

The three companies will be:

  • AT&T: A telecom company solely focused on 5G communications and broadband.
  • DIRECTV: via a "carve-out"  deal, recently closed on Aug. 2  as a separate company, with 70% owned by AT&T and a 30% minority stake sold to TPG, a large private equity buyout firm,
  • Warner Bros. Discovery: A spin-off of WarnerMedia, merged with Discovery (DISCA) (DISCK). This merger will close by mid-2022 under the ticker symbol WBD.

The DirecTV and Warner Bros. Discovery businesses will provide $50.7 billion in cash to AT&T to pay down its debt, which currently stands at more than $150 billion according to S&P Capital Intelligence.

A line of people against a wall stare at their own smartphones.

Image source: Getty Images.

So far, AT&T has not told shareholders much about how the split will work. But based on the brief description it shared in a May 17 press release    , investors could end up with three possibilities:

  • A spinoff: Shareholders receive a cash dividend, or get some ratio of WBD shares for each share of AT&T they hold.
  • A split-off: Shareholders must choose to either keep their existing AT&T shares, or receive a specified amount of WBD shares.
  • Some combination of the two, offering a choice like this:
    • If you keep all your AT&T shares, you will receive a set number of shares in WBD.
    • If you give up some but not all of your AT&T shares, you will receive a given, smaller number of WBD shares in return.

This last alternative would encourage AT&T holders to give back some or all of their AT&T shares, reducing the company's share count and effectively acting as a share buyback that could boost AT&T's stock price.

Will a greater number of shares in WBD be worth forgoing some lower combination of AT&T and WBD shares? We need more info on the spinoff, split-off, or combination to answer that.

What Warner Bros. Discovery might be worth

Analysts believe that WBD will be worth $7 to $8 per share of AT&T stock. In an interview with Yahoo! Finance on May 24 , AT&T's CEO, John Stankey, seemed to confirm those educated guesses.

With its 29% stake in WBD priced in, Discovery now has a market capitalization of about $18.37 billion  as of Aug. 17, counting all its share classes. By dividing that $18.4 billion by Discovery's 29% stake in WBD, we can estimate an implied market cap of $63.3 billion for the new company.

AT&T shareholders will own the other 71% of WBD, worth $44.97 billion – the $63.3 billion total, minus Discovery's $18.4 billion. Divide that $44.97 billion by AT&T's 7.14 billion shares outstanding, and AT&T's stake in WBD is worth $6.30.

But as CEO Stankey implied in his Yahoo interview , AT&T will likely want to deliver at least $7 per share in value to its shareholders. It can set the value at any price within reason, assuming an independent valuation firm confirms backs up its numbers in a related prospectus.

Investors should remember that as AT&T shrinks, so will its dividend. To devote more cash toward lowering its debt, the company said it's targeting a payout ratio of 40% to 43% of its expected $20 billion in free cash flow after the merger. This works out to about $8 billion, or a dividend per share of $1.16 -- a 44% hit to shareholders' income from the current $2.08.

This cut could lower AT&T's price by roughly the same percentage. Dividend investors keep an eye on yield – the percentage of a stock's share price that its annual dividend represents. When a company cuts its dividend, its yield falls. Dividend investors don't like that, and they tend to sell off the stock until its price shrinks enough to bring the yield back up around its previous level.

To limit that potential price drop, WBD will try to price the shares it's spinning off to give AT&T shareholders some of that lost dividend money back; think of it like a rebate. For those who keep their WBD shares, this "rebate" could help alleviate the burden from both the lower dividend and a potentially lower AT&T price.

How AT&T's breakup might play out

Unfortunately, most AT&T shareholders won't wait around to figure all of this out. Once they receive their unfamiliar WBD shares, many will likely sell. That usually happens with spinoff shares , although in the long term, spinoffs tend to do quite well .

However, long-term shareholders will do better. While the company hasn't yet announced any such plans, WBD might end up paying a dividend if it proves as profitable as expected. In addition, WBD might perform better for shareholders as an independent company focused entirely on entertainment. Its movie and TV studio executives will report to Discovery President and CEO David Zaslov, the CEO of the new company, not communications execs.

Zaslov and his predecessors appear to have been doing something right at the helm, because Discovery's stronger performance has led its shares to a better track record than AT&T. DISCA stock has had an average total return of 11.81% per year over the past 15 years , according to Morningstar. AT&T stock made just a total return of 4.13%.

Meanwhile, AT&T will benefit from cutting its debt by roughly one-third, freeing the company to invest more cash in its core telecom operations. AT&T expects its net debt-to-adjusted EBITDA ratio will fall from around 3.3 currently to 2.6  after the close.

What investors in AT&T stock should do

AT&T's price will fall by $6 to $7 -- the price of each new WBD share -- once the spin-off/split-off occurs. With a new price around $22 to 23 per share, and a dividend around $1.16, that would give AT&T a 5% to 5.3% dividend yield . However, the WBD shares will be worth $6 to $7 after the spin-off, bring the total value received back to $28 to $29.  

Given that many AT&T shareholders will automatically sell their WBD stock, the latter could fall to $5 to $6. If so, consider buying  those shares and hanging on to your AT&T shares. This volatility could last through the end of 2022 as people sell shares for tax reasons. After that, AT&T and WBD shares might rise, especially since AT&T will have less debt, and WBD will be valued independently of AT&T.  In the end, long-term shareholders of both stocks could likely do well as they recover.