There are a number of valuation models investors can choose from. When analyzing dividend growth stocks, the Dividend Discount Model is among the most commonly used valuation methods.

The Dividend Discount Model, or DDM, estimates the fair value of a stock based on its dividend payout and future dividend growth, discounted to the present.

Dividend growth investors would be well-advised to consider the DDM for valuation purposes. According to the DDM, telecom giant AT&T Inc. (T) is an undervalued dividend stock.

Business Overview

AT&T is a large telecommunications company with over 100 million customers in the United States. The company provides a wide range of telecom services, including wireless, broadband, and television through its cable operations and its DirectTV satellite brand. AT&T generates more than $170 billion in annual revenue and the company has increased its dividend for 35 consecutive years, qualifying it for inclusion in the Dividend Aristocrats.

AT&T is widely known as a stalwart dividend stock, but it also provides an element of growth as well. In its most recent quarter, the company generated $48.0 billion in revenue, up 15% from the year ago quarter. Revenue growth was primarily driven by the Time Warner acquisition that closed in June 2018. Adjusted earnings-per-share totaled $0.86 against $0.78 in the same period a year ago, for growth of 10%. For the year, AT&T reported revenue of $170.8 billion in 2018, up 6% as compared to 2017. Adjusted earnings-per-share came in at $3.52 versus $3.05 in 2017, once again driven by the Time Warner acquisition as well as a boost from tax reform.

AT&T’s strong fundamentals and impressive free cash flow make it a high-quality dividend stock. AT&T anticipates free cash flow to be in the $26 billion range in 2019. Because the company generates so much free cash flow, it can return lots of cash to investors in the form of dividends. AT&T has an attractive dividend yield above 6%, and the stock appears undervalued according to the Dividend Discount Model.

Valuation Analysis

According to the Dividend Discount Model, the fair value of a stock is equal to next year’s expected dividend divided by an appropriate discount rate, less the expected dividend growth rate. The discount rate is typically calculated with the Capital Asset Pricing Model, or CAPM, whereby the discount rate is equal to the stock’s beta value multiplied by the sum of the market risk premium and the risk-free rate. The current market risk premium is 5.8%, calculated by the long-term inflation-adjusted return of the market (2.2%), plus the S&P 500 Index current dividend yield (1.9%), and the expected future inflation rate of 1.7%.

With the above inputs, we can use the Dividend Discount Model. For AT&T, the forward 1-year dividend payout is expected to be $2.04 per share. Therefore, the appropriate discount rate is 5.8%, using a risk-free rate of 2.4%, beta value of 0.59, and a market risk premium of 5.8%.

If investors assume a 2% annual dividend growth rate, AT&T shares are worth approximately $54 per share according to the Dividend Discount Model. Currently priced at $32 per share, it appears AT&T stock is significantly undervalued using the DDM.

Ben Reynolds is CEO of Sure Dividend. Sure Dividend helps individual investors build high quality dividend growth stock portfolios for the long run.