1 way to value Telstra Corporation Ltd shares in 2017

With the Telstra Corporation Ltd (ASX:TLS) share price falling, people are asking if it is a good time to buy.

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With the Telstra Corporation Ltd (ASX: TLS) share price falling, investors are asking if it is a good time to buy or sell shares in Australia's largest telco.

1 way to value Telstra shares

I have received a few emails this week, from people curious about the predicament in which Telstra finds itself.

Before I show you how I'm thinking about Telstra's valuation it's important to remind yourself that share price is different to value. One of the important points is that share price is what you will need to pay to own some shares. Value is what you should pay for them.

Also, the price is absolute in the sense that there is no arguing what it is — just look it up on the net.

Valuation, on the other hand, is subjective. My valuation can be different to yours. And there's no guarantee either of us are correct.

Telstra: The Old NBN

For anyone who isn't aware, Telstra shares have fallen from over $6.50 in 2015 to just $3.50 today. The share prices of its rivals TPG Telecom Ltd (ASX: TPM), the owner of TPG and iiNet; and Vocus Group Ltd (ASX: VOC), the owner of Dodo and other brands; have also been walloped by investors.

The key risk for Telstra is the arrival of the NBN because it means that Telstra has to forgo its copper cable network. For decades Telstra was able to charge other retailers for access to the network to sell their broadband and home phone connections. That offered Telstra a compelling advantage.

However, the NBN and falling demand for home phones will compress that business' profit margins.

Mobile remains key to Telstra

Over the past year, Telstra's profit margins from broadband and landlines fell. That saw the company's operating profit from both divisions fall considerably. Although the declines were large they were somewhat expected.

Unfortunately for Telstra shareholders, I think this trend will continue for at least a few more years. Therefore, a prudent valuation model for Telstra would assume no profit growth, at best, from these two businesses. And likewise for the Data & IP business, given the competitive nature of that market.

For me, the most concerning and equally uncertain area of Telstra's future is in mobiles. Can Telstra continue to charge its customers a premium for its services?

Given that the company has lost its advantage in other businesses, is it reasonable to expect mobiles to maintain profit margins around 43%?

In my opinion, the answer to that question is the most important one for investors to consider. Fortunately, although revenue per connection fell during the most recent full-year reporting period, the number of Telstra mobile subscribers increased.

How does the valuation stack up?

Taking into account the company's $16.2 billion in debt and $938 million in cash, Telstra shares trade on an enterprise value to EBITDA margin of around 5.5 times, which does not appear overly demanding. However, factoring an estimated $3 billion decline in EBITDA due to the impact of the NBN and competition, the ratio increases to 7.5 times.

Even still, it's only if we assume that the mobiles business begins to succumb to more pressure from rivals like TPG and Optus that Telstra's valuation stretches meaningfully higher.

Ultimately, Telstra shares do not appear to be a clear-cut bargain just yet — although they are getting closer to being tempting. However, if you are confident in the future of Telstra's mobiles business I think it is worth having them on your watchlist in 2017.

Motley Fool contributor Owen Raszkiewicz has no position in any of the stocks mentioned. You can follow him on Twitter @OwenRask.  The Motley Fool Australia owns shares of Telstra Limited, TPG Telecom Limited, and Vocus Communications Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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