Most investors tend to weigh a stock’s valuation prior to purchasing.  This is a very important metric, because overpaying for shares can mean buying at the absolute top and feeling the pain as the stock declines.  Whether it’s using the company’s historical price to earnings multiple or some other metric, like price to sales or price to cash flow, it is important to have an understanding of a stock’s valuation.

One way to value stocks that dividend growth investors subscribe to is the Dividend Discount Model.  The dividend discount model estimates fair value for a stock using the expected growth rate, current dividend and a reasonable discount rate.  Let’s see how shares of one of my favorite dividend paying companies, Verizon (VZ), rates using the dividend discount model.

Company Background

Verizon is the largest wireless carrier in the U.S., covering nearly 300 million people in the United States.  The Wireless division is responsible for three-quarters of all sales for the company.  The remainder of sales come from Verizon’s broadband and cable services.  Verizon generated $126 billion in sales in 2017 and has a current market capitalization of more than $225 billion.

Recent Earnings Results

Verizon released 2nd quarter earnings results on July 24, 2018.  The company saw earnings grow 26% year over year to $1.20 per share.  EPS was $0.06 above the average analysis’ estimate.  Revenue for the company grew 5.4% to $32.2 billion.  This was $420 million higher than the average estimate.

Verizon added 531,000 postpaid net add during the 2nd quarter, more than doubling net adds from the 1st quarter of the year. Almost 400,000 of these adds were for smartphones.  Unsubsidized phones, meaning phones purchased by customers, made up 82% of Verizon’s customer base.  This was up from 75% a year ago.  Often referred to as the best wireless network, Verizon saw a postpaid churn rate of just 0.75%.  A low churn rate means very few customers are leaving Verizon.  This is the five consecutive quarter that the company’s wireless retail churn rate was below 0.80%.

Version’s management forecasts a midpoint for earnings per share of $4.35 for the year.  The company expects a lower tax rate, which should increase cash flow by almost $4 billion.

Dividend History and Valuation

Many investors own shares of telecommunications companies because of their often generous dividend yields.  With a dividend yield of 4.31%, Verizon is no slouch in this area either.  The company’s average yield over the last decade is 5%.  The current yield is near the low end of Verizon’s average dividend range for the last 10 years.  The current yield, however, is higher than that of both the S&P 500 (1.75%) and the 10-Year Treasury Bond (3.08%).

Verizon has increased its dividend for the past 13 years.  Over the last 3, 5 and 10-year time frames, the company has raised its dividend an average of 2.8%, 2.9% and 3.5%, respectively.  On September 6, Verizon hiked its dividend 2.1%.

Even with a generous dividend, Verizon’s payout ratio is rather low.  Based on expected dividends for 2018 ($2.38) and the midpoint for earnings per share ($4.35), the payout ratio is just slightly below 55%.  According to Value Line, the average payout ratio from 2008 through 2017 was 70.7%.  This leaves Verizon plenty of room to increase its dividend and also offers a cushion should EPS decline drastically.  Given this, it is highly unlikely that a recession would cause Verizon to cut its dividend.

How does Verizon’s stock look when using the dividend discount model?  Using a 4% growth rate for Verizon, which below the company’s ten-year average growth rate of 5%, current dividend of $2.38 and a discount rate of 7.6%, the dividend discount model estimates fair value for the stock be $68.38. Based on Wednesday’s closing price of $53.50, the dividend discount model sees shares of Verizon as nearly 28% undervalued.  Verizon’s stock hasn’t moved much in recent year as shares are up just 3.34% this year and only up 2.5% since the start of 2017.  Perhaps now is an opportunity to acquire shares of Verizon at a discounted price.

I should note that the dividend discount model isn’t the only valuation system that sees shares of Verizon as undervalued.  Verizon’s current P/E multiple of 12.3 is below the stock’s 10-year average P/E of 14.

Conclusion

Verizon had a solid 2nd quarter, with wireless postpaid net adds showing strength.  A low churn rate shows just how loyal Verizon customers are.  With a higher rate of unsubsidized phones making up its base, Verizon doesn’t have to be too concerned with paying for customer phones anymore.  With a generous dividend yield, a low payout ratio and more than a decade of dividend growth, Verizon is a stock income investors should consider owning.  Even better, the dividend discount model says shares are significantly undervalued at the current price.