The stock market can be chaotic. On any given day, a myriad of factors can drive the price of a company's shares in any direction, without any apparent reason.
This volatility is difficult for anyone to stomach, especially for a conservative investor like me who is against paying for 'projections' of future growth -- which are really just guesses in disguise.
Many investment professionals spend the bulk of their time trying to figure out and anticipate these events. With access to company management teams as well as the trading desks of big Wall Street firms, it is possible for institutional investors to gain an edge every now and then. However, the market has a knack for reflecting these expectations into the stock price fairly quickly. Should the companies miss Street expectations, shareholders can pay a heavy price.
I prefer an easier approach that generates more consistent returns. I buy companies that are trading below the fair value of their current (not future) earnings power. Assuming my analysis is correct, I can just sit back and wait for the market to price the shares correctly.
With my method, I estimate a company's normalized free cash flows, assume that there will be no additional growth and calculate the value of this earnings stream in today's dollars. This is a very conservative valuation model that can find stocks with very low (if any) market expectations built into the price.
Despite my conservatism, some of my calculations have pointed me to stocks that project a near 50% upside from current prices -- like the one I'm going to tell you about today.
To provide an extra layer of insurance and dampen some of the volatility that comes with investing in stocks, I also look for companies paying nice dividend yields.
That's exactly what I've found in CenturyLink, Inc. (NYSE: CTL), a $21 billion market cap integrated telecommunications company that is the third largest in the U.S. It provides voice, broadband, data and other communications services to residential, business, government and wholesale customers.
Applying my model, on an annual basis I estimate CTL's free cash flows to be just shy of $3 billion. Assuming there is no further growth from here, this translates into a per share amount of $54 on a present value basis (remember, that's not even considering potential future growth in cash flows) representing almost 50% upside from current prices!
If that's not enough to entice you, the company also pays a hefty dividend of $0.54 per share every quarter, equating to a 6% yield. That's on top of management's share repurchase activity that has accelerated recently, including $1.5 billion (or more than 7% of its market cap) over the past 12 months.
And there's a lot more to like about CTL...
In the ITU Telecom World 2012 Outcomes Report, specialists predicted that broadband demand will explode beyond current capacity within the next 5 years. This is due to its affordability, local relevance and government stimulus packages.
Similar to many of its peers, CTL has seen declining revenue from its legacy services, such as local and long-distance phone service. More than offsetting this, however, is the continued growth in its strategic services, which includes high speed Internet, networking, video and data hosting.
Although technological innovation and the proliferation of mobile devices have accelerated the current trend towards disconnecting landlines, the demand for broadband, DSL and other data services should remain robust over the long-term and provide a net benefit to CTL.
As you can see in the following chart, the company's top-line has been on an upward trajectory, even through the economic volatility experienced over the past several years.
Financially, CTL looks very compelling, with strong cash flow generation, stable-to-improving operating margins and shareholder-friendly capital return policies. Although its debt-to-capital ratio is somewhat high at 55%, I believe the company's leverage is manageable given its EBITDA (earnings before interest, taxes, depreciation and amortization) is sufficient to cover its annual interest expense more than five times over.
The stock has had a good run this year, returning 13% YTD versus the S&P 500's 7%. A big part of the outperformance occurred in early May, when the company reported better-than-expected earnings for the first quarter of 2014. However, based on my previous valuation analysis, I see an additional upside from here.
Risks to Consider: Risks related to CTL include increased competition from existing and new players, unexpected changes in technology or regulations, and a prolonged deterioration in the macro economy. A rising interest environment could also cause pressure shares of high dividend yielding stocks such as CTL.
Action to Take --> At current levels, I recommend purchase of CTL for a total return potential of 54%, including a 6% dividend yield.
