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AT&T Stock Upgraded: What You Need to Know

Rich Smith, The Motley Fool

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

It's been a little over a month since AT&T (NYSE: T) officially bought Time Warner, and less than a week since it reported earnings. Now, AT&T; stock is getting its reward, as analysts at Merrill Lynch announce an upgrade for America's No. 2 telecom -- to buy.

Here's what you need to know.

Businesswoman talking on phone

Merrill Lynch explains why it thinks now's the time to buy AT&T stock. Image source: Getty Images.

Upgrading AT&T

Merrill Lynch's upgrade of AT&T is laid out in a report covered this morning on TheFly.com. As the analyst explains, it expects AT&T; to benefit from its merger with Time Warner in the form of both "earnings accretion and expanding cash" generated from the new business. These gains could be magnified if AT&T is able to extract synergies from the merger, selling more Time Warner content (HBO in particular) and more ads over AT&T's distribution network.

Most important of all, though, is the fact that AT&T stock is incredibly cheap right now -- as in, the cheapest it's been in 20 years when valued on its P/E ratio.

A call option on cost-cutting

Merrill Lynch argues that AT&T's P/E ratio is at a "20-year low," and sufficiently underpriced to offer buyers a "call option" on the company succeeding in extracting synergies from the merger. (In other words, the analyst doesn't think investors are considering the possibility of cost savings in the price they're willing to pay for AT&T shares. If those savings do emerge, and AT&T produces more profit as a result, then investors would be expected to respond by paying more for the stock -- sending AT&T up to Merrill's $37-per-share target price.)

That argument has merit as far as it goes. I would point out, though, that AT&T stock is not quite at the "20-year low" that Merrill says it's at -- although it's close. With a market capitalization of $225.7 billion and trailing-12-month earnings of $31.9 billion, AT&T stock currently sells for a P/E ratio of just 7.1.

As valuations go, that's obviously a cheap one. Analysts polled by S&P Global Market Intelligence estimate that AT&T will grow its earnings at 6.6% annually over the next five years. The stock also pays a 6.1% dividend yield, giving AT&T stock a total expected annual return of 12.7%, and therefore a total return ratio (P/E divided by the sum of earnings growth and dividend yield) of less than 0.6.

That's very cheap. It's just not exactly the cheapest that AT&T stock has ever been. According to S&P Global data, AT&T's P/E dipped as low as 5.9 earlier this year. AT&T shares also sold for as low as 7.8 times earnings as recently as 2010 and 2011. All of which is to suggest that if you were hoping to buy AT&T stock at the cheapest price it's ever been on the hope that that's the cheapest it will ever get, well, the stock isn't quite there right now.

Cheap enough?

Even so -- paying 7.1 times earnings for an expected 12.7% annual return still sounds like a very nice bargain. But is it as good as it looks?

A couple quibbles bear considering. First off, AT&T's market cap doesn't take into account the stock's debt, which is substantial -- $176.7 billion net of debt, according to S&P Global data. That pushes AT&T's enterprise value up past $402 billion in total.

On the other side of the equation, AT&T's free cash flow isn't quite as robust as the company's reported net income might imply. Over the past 12 months, FCF -- actual cash profit generated by the business -- amounted to only $19.1 billion, or roughly $0.60 per $1 of reported profit.

What it means to investors

When valued on enterprise value and free cash flow, instead of price and earnings, AT&T stock sells for an EV/FCF ratio of 21. Relative to its anticipated 12.7% total return, that multiple looks a lot less attractive.

Long story short, Merrill Lynch thinks this stock is a buy. I have my doubts that this stock's as cheap as it seems. For its part, management at AT&T is promising to grow free cash flow and work down its debt load by about 38% over the next three to four years.

The closer they get to that goal, the closer AT&T will get to becoming the buy that Merrill thinks it already is.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.