Please ensure Javascript is enabled for purposes of website accessibility

Are AT&T Inc. and Verizon Communications Inc. Getting Overvalued?

By Leo Sun - Apr 15, 2016 at 10:18AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Have both telco stocks risen too quickly over the past year?

Last year, I bought shares of AT&T (T 0.66%) and Verizon (VZ 1.10%) as defensive income generating plays for a volatile market. I didn't expect either stock to rally, but shares of AT&T and Verizon respectively rose 18% and 6% over the past 12 months -- easily outperforming the S&P 500's 2% decline.

But now that both stocks are sitting at multi-year highs, is it too late for new investors to start a position? Let's take a look at both companies' valuations, tailwinds, and dividends to decide.

Image Source: Pixabay, modified by author.

Historical valuations
The first metric most investors will check is the trailing P/E ratio. AT&T currently has a P/E of 16, while Verizon has a P/E of 12. Both ratios are lower than the average P/E of 20 for the domestic telecom industry and the S&P 500's current P/E of 23. The following chart of AT&T and Verizon's P/E ratios over the past five years also indicates that both stocks remain at fairly "cheap" historical levels.

T PE Ratio (TTM) Chart

Source: YCharts

AT&T and Verizon both need to generate lots of free cash flow to fund dividends and buybacks. In 2015, AT&T's free cash flow rose 60% to $15.9 billion, thanks to its acquisition of DirecTV. Verizon's free cash flow, excluding proceeds from tower sales, rose 40% to $18.8 billion last year.

To ascertain how cheap AT&T and Verizon are relative to their FCF, we should use the EV/FCF ratio. The following chart reveals that both companies' EV/FCF ratios have spiked to multi-year highs, although they have gradually declined over the past year.

T EV to Free Cash Flow (TTM) Chart

Source: YCharts

AT&T and Verizon's EV/FCF ratios have risen due to higher debt loads impacting their enterprise values. AT&T took on debt to finance its acquisitions of spectrum licenses and DirecTV, while Verizon spent billions on spectrum licenses and its purchase of AOL. However, revenue from DirecTV, new wireless customers in Mexico, and the potential divestment of Latin American assets should keep AT&T's debt levels manageable. Verizon can do the same by divesting more of its slower-growth wireline businesses.

Forward valuations
Looking ahead, analysts expect AT&T to grow its earnings 5% this year and for Verizon's to stay roughly flat. AT&T and Verizon both trade at around 13 times forward earnings, so both stocks are trading at a premium to their earnings growth potential.

Over the next five years, AT&T is expected to grow its earnings 5.1% annually, which gives it a 5-year PEG ratio of 2.7. Verizon is expected to grow its annual earnings 4.5% during that same period, which gives it a higher PEG ratio of 2.9. Both ratios indicate that investors should expect slow earnings growth, since neither ratio comes close to dipping below the "undervalued" PEG threshold of 1.

Dividend yield
However, most investors don't buy AT&T and Verizon because they think they're "value" stocks -- they buy them because they pay big and steady dividends. AT&T has hiked its dividend annually for over three decades, while Verizon has done the same for nearly a decade. AT&T currently has a yield of 4.9%, while Verizon has a yield of 4.3%. Both payouts are significantly higher than the S&P 500's average yield of 2.1%.

T Dividend Yield (TTM) Chart

Source: YCharts

To many investors, income generating stocks like AT&T and Verizon only become "overvalued" when their price growth causes yields to dramatically decline. AT&T and Verizon's yields have indeed fallen slightly, but their 4%+ yields still remain above multi-year lows. Over the past 12 months, AT&T has paid out 64% of its FCF as dividends, while Verizon has paid out 76% -- meaning that both companies still have plenty of room to boost their payouts.

Are AT&T and Verizon overvalued?
Whether or not AT&T and Verizon are overvalued depends on your perspective as an investor. Both stocks trade at a discount to the industry and overall market, but neither stock can be defined as a "deep value" stock which trades at a discount to its earnings growth potential.

But if you're an income investor like me, AT&T and Verizon's hefty yields and rising cash flows remain impressive. Therefore, I think AT&T and Verizon are neither cheap nor expensive. Instead, I believe that both telco stocks are still "fairly" valued based on their earnings growth potential and dividend yields, and it still isn't too late for new investors to jump aboard.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

AT&T Inc. Stock Quote
AT&T Inc.
$21.30 (0.66%) $0.14
Verizon Communications Inc. Stock Quote
Verizon Communications Inc.
$51.24 (1.10%) $0.56

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning service.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 05/26/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.