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Verizon Communications – Could It Be Possible to Have a Negative Dividend Growth?

February 28, 2014 | About:
Victor Selva

Victor Selva

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Verizon Communications Inc. (VZ) is the largest U.S. wireless carrier. The firm also offers wire line and broadband services primarily in the northeastern U.S. The company provided wire line service to a million voice connections, and millions of wireless customers are gained due to the joint venture with Vodafone Group (VOD). The firm's competitors include AT&T Inc. (T) and Sprint Corp. (S).

Now, turning our attention to the future direction of the stock, let's take a look at the intrinsic value of this company and try to explain to investors the reasons it is a good buy or not. In this article, we present a model that is by no means the be-all and end-all for valuation. The purpose is to force investors to evaluate different assumptions about growth and future prospects.

Valuation

In stock valuation models, dividend discount models (DDM) define cash flow as the dividends to be received by the shareholders. Extending the period indefinitely, the fundamental value of the stock is the present value of an infinite stream of dividends according to John Burr Williams.

Although this is theoretically correct, it requires forecasting dividends for many periods, so we can use some growth models like: Gordon (constant) growth model, the Two or Three stage growth model, or the H-Model (which is a special case of a two-stage model).

To start with, the Gordon Growth Model (GGM) assumes that dividends increase at a constant rate indefinitely.

Let´s estimate the inputs for modeling:

Required Rate of Return (r)

The capital asset pricing model (CAPM) estimates the required return on equity using the following formula: required return on stockj = risk-free rate + beta of j x equity risk premium

Assumptions:

Risk-Free Rate: Rate of return on LT Government Debt: RF = 2.67%

Beta: β =1.4

GGM equity risk premium = (1-year forecasted dividend yield on market index) +(consensus long-term earnings growth rate) – (long-term government bond yield) = 2.13% + 11.97% - 2.67% = 11.43%[1]

rVZ = RF + βVZ [GGM ERP]

= 2.67% + 0.05 [11.43%]

= 3.24%

Dividend growth rate (g)

The sustainable growth rate is the rate at which earnings and dividends can grow indefinitely assuming that the firm´s debt-to-equity ratio is unchanged and it doesn´t issue new equity.

g = b x ROE

b = retention rate

ROE can be estimated using Dupont formula:

Because for most companies the GGM is unrealistic, let´s consider the H-Model which assumes a growth rate that starts high and then declines linearly over the high growth stage, until it reverts to the long-run rate. A smoother transition to the mature phase growth rate that is more realistic.

Dividend growth rate (g) implied by Gordon growth model (long-run rate)

With the GGM formula and simple math:

= ($46.35 ×3.24% – $2.12) ÷ ($46.35 + $2.12) = -1.27%. The negative sign means that dividends actually decline at a constant rate.

The growth rates are:

Year

Value

g(t)

1

g(1)

-29.92%

2

g(2)

-22.76%

3

g(3)

-15.60%

4

g(4)

-8.44%

5

g(5)

-1.27%

G(2), g(3) and g(4) are calculated using linear interpolation between g(1) and g(5).

Calculation of Intrinsic Value

Year

Concept

Amount

Present value

0

Div 0

2.12

 

1

Div 1

1.49

1.44

2

Div 2

1.15

1.08

3

Div 3

0.97

0.88

4

Div 4

0.89

0.78

5

Div 5

0.88

0.75

5

Terminal Value

19.14

16.32

Intrinsic value

   

21.24

Current share price

   

46.35

Final Comment

When the stock price is higher than the intrinsic value, the stock is said to be overvalued and it makes sense to sell the stock. We have covered just one valuation method and investors should not be relied on alone in order to determine a fair (over/under) value for a potential investment.

Hedge fund gurus have also been active in the company. Gurus like Bill Frels (Trades, Portfolio), Mario Gabelli (Trades, Portfolio), Ruane Cunniff (Trades, Portfolio), Jeremy Grantham (Trades, Portfolio) and Steven Cohen (Trades, Portfolio) have reduced their positions in fourth quarter 2013.

Disclosure: Victor Selva holds no position in any stocks mentioned.

[1] This values where obtained from Blommberg´s CRP function.


Rating: 4.8/5 (5 votes)

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