Telstra Corporation Ltd (ASX: TLS) has proven to be a great investment over the past five years, with its share price more than doubling and shareholders receiving a further 50% in fully franked dividends.
Meanwhile, the broader S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) has risen just 23%.
However despite a revitalised brand, stronger operating performance and falling interest rates, there's a chance Telstra's valuation has gotten ahead of itself.
Here's a quick snapshot of the $76 billion telecommunications company…
The balance sheet
Telstra's balance sheet is robust. Its strong cash flows (a result of its superior product offering) enable it to take on large amounts of debt at a great margin and improve shareholder returns dramatically. At 31 December 2014, Telstra also had billions of dollars in cash.
Although its low cost of capital (debt, shareholders equity etc.) allows stock analysts to justify bullish 12-month 'price targets' on Telstra shares, long-term investors need to remember that low interest rates won't justify high share prices forever.
Growth
With the National Broadband Network slowly being rolled out across the country, Telstra's focus has shifted away from leveraging big profit margins on its 100-year-old copper cable network to Asia. The full benefits from its international expansion may still be a few years away. However, so far, the strategy appears promising.
For example Autohome, Telstra's New York-listed subsidiary engaged in automotive advertising throughout China, has been performing strongly since its IPO a little over a year ago.
Telstra's partnership with existing telecommunications carriers and investment in data centres, subsea cables and related infrastructure also bodes well for future returns.
Valuation
Telstra's shares currently trade at 17x last year's profits. That means investors must be anticipating strong near-term profit growth or be prepared to hold the stock for the long term (five years at a minimum) to justify an investment today.
Unfortunately, management are forecasting broadly flat EBITDA (earnings before interest, tax, depreciation and amortisation) growth in the short term. Moreover, as I showed here, earnings per share (EPS) growth hasn't kept pace with the rise in share price.
As a result, shareholders may be exposed to a sell-off if management cannot deliver enough growth to justify its higher valuation.
Should you buy, hold, or sell Telstra shares?
Telstra remains the most dominant local telecommunications company, has a reliable 4.8% fully franked dividend yield and a promising international expansion underway. It is a good business.
However the question every investor must ask themselves before buying Telstra shares is: Do I believe it has a strong chance of generating market-beating returns from these prices?
Given its valuation, combined with the forecasts for mild medium-term profit growth, I think Telstra will struggle to achieve market-beating returns.
However that doesn't mean investors should rush out to sell their holding, in fact far from it!
