Since charging to a 10-year high in February, shares of Telstra Corporation Ltd (ASX: TLS) have fallen more than 10% to again trade below $6 today.
This comes despite the Reserve Bank of Australia lowering official interest rates to a record low of just 2%.
Telstra, Australia's leading telecommunications company, has a reputation as a solid dividend-paying stock. Moreover, it's a reputation which is unlikely to change anytime soon.
Looking out over the longer term, Telstra's international growth strategy bodes well for increased shareholder returns.
So with growth potential and dividends, what's going wrong with Telstra shares?
Personally, I believe speculating over short-term share price movements is a waste of time. However, Telstra's share price has more than doubled over the past five years and with the RBA recently dropping its easing bias, investors may simply be taking profits off the table.
Is this your golden opportunity to buy Telstra shares?
With prices falling, savvy investors are likely asking themselves if now is a good time to buy.
To answer that question, it's important to have an understanding of the valuation of Telstra's shares.
After all, a lower share price does not necessarily mean they're good value.
How much are Telstra shares really worth?
At the most basic level of valuation Telstra shares have a P/E ratio of around 18x, compared to the market's 16.6x, which could imply it's not a standout bargain at today's prices unless it is expected to grow strongly in coming years.
Unfortunately, Telstra's management is forecasting only broadly flat revenue and EBITDA (earnings before interest, tax, depreciation and amortisation) growth in the coming year.
Based on the market's average P/E, fair value for Telstra shares is approximately $5.60 based on analysts' forecasts for earnings per share of 33.7 cents in financial year 2016.
Looking at enterprise value however, Telstra's relative valuation appears more compelling.
Enterprise value, or EV, provides a truer picture of the worth of the core business by excluding cash and adding back debt. It's the theoretical price you'd have to pay to buy the business outright.
| Company | Enterprise Value | EBITDA | EV/EBITDA |
| Telstra | $87,549.00 | $11,135.00 | 7.86 |
| TPG Telecom Ltd (ASX: TPM) | $7,093.10 | $362.80 | 19.55 |
| M2 Group Ltd (ASX: MTU) | $2,234.50 | $160.10 | 13.96 |
| Woolworths Limited (ASX: WOW) | $33,471.76 | $4,771.00 | 7.02 |
Source: Financial Year 2014 Annual Reports and Google Finance.
Based on a somewhat arbitrary average EV/EBITDA multiple of 8x, Telstra shares are worth $7.28 a pop.
However, Telstra is largely unrivalled in terms of market penetration and product offering, so any relative valuation (such as EV/EBITDA or P/E ratio) has its limitations.
I believe the best way to value Telstra shares is to use a discounted cash flow analysis. It takes the future cash generating ability of the company (after accounting for reinvestment in the business) and discounts the sum of future cash flow back to today's prices using a risk-adjusted discount rate.
Based on my conservative forecasts of low-mid single digit free cash flow growth until 2022, Telstra shares are worth approximately $5.80 using my DCF model.
Obviously, with shares trading around $6.00, my DCF suggests Telstra shares currently trade slightly above fair/intrinsic value.
| Target | Weighted | |
| EV/EBITDA | $7.28 | 20% |
| DCF | $5.85 | 70% |
| P/E | $5.60 | 10% |
| Intrinsic Value: | $6.11 | |
Using an arbitrarily weighted average of the three above valuation metrics (P/E, EV/EBITDA, and DCF), my fair value estimate for Telstra shares lies somewhere around $6.11.
Remember models of intrinsic value are only ever as good as the information which goes into them (or the analyst making the forecasts!) and will ultimately always prove to be wrong.
In my opinion qualitative research is always more important than quantitative analysis.
To adjust for the likelihood of being wrong on valuation, investors should always demand a margin of safety between what they think a stock is worth (i.e. intrinsic/fair value) and what they can buy it for (i.e. market price).
I think a margin of safety of around 30% is great.
Therefore, buying Telstra shares around $4.30 (70% of $6.11) would be great.
However, the chances of buying a reputable blue-chip stock like Telstra at a 30% discount to fair value are normally few and far between. That's why dyed-in-the-wool value investors, such as Warren Buffett, prefer a falling market to a bull market.
While they wait, they'll place companies like Telstra on their watchlist and search for other compelling stock ideas…
