Why I believe BT is worth more than 400p

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Over the past two years, BT (LSE: BT.A) has become one of London’s most hated stocks. After peaking at around 500p at the end of 2015, the shares have plunged to a low of 233p at present, a loss of more than 50% excluding dividends over a two-year period, underperforming the broader FTSE 100 index by a staggering 66%. 

Battling headwinds 

A number of factors have contributed to this performance. For a start, BT has attracted plenty of negative attention from regulators, who are taking an increasingly hard line with the telecoms monopoly. The firm has also had to struggle with accounting fraud at its Italian division, which resulted in writedowns, fines and a massive hit to its reputation.

And third, BT is facing increasing competition from all angles which, when coupled with the above factors, means that the group is having to do more with less. 

The firm’s third-quarter earnings, released at the beginning of February, summed up the company’s position succinctly. Overall revenue declined by 3% with most divisions suffering a contraction in sales apart from EE, BT’s mobile division. EE reported a 4% rise in revenue during the quarter. Overall, earnings before interest tax depreciation and amortisation grew 25% to £660m, although this was primarily thanks to cost-cutting at the group’s Global Services division. 

For the past few years, much of BT’s growth has come from its pay-TV division. Unfortunately, even this division experienced weakness last quarter with a fall in the number of customers willing to pay for its services. 

Still the market leader 

Even though BT is facing headwinds, and revenues are starting to contract, the fact remains that the company is the most significant provider of telecommunication services in the UK. This is unlikely to change any time soon. Revenue may contract further, but it’s unlikely to vanish entirely overnight. With this being the case I believe that the shares currently offer value as they are trading at a discount when compared to the group’s peers. 

For example, at the time of writing, shares in BT are trading at a forward P/E of 8.3, 35% below the telecommunications sector average of 12.8. For a company like BT that is loaded with debt, a more appropriate metric to use to value the business might be EV/EBITDA, which takes into account debt on the balance sheet. On this basis, the shares are trading at approximately a 41% discount to the rest of the sector with a multiple of 5.4 compared to the sector average of 9.2. 

If shares in BT were to trade up to sector average multiples, the stock would be worth 357p on a P/E basis and 476p according to the EV/EBITDA alternative. 

Another more appropriate metric to use for a telecoms giant like BT, which has to deal with high levels of debt and capital equipment depreciation, is free cash flow. Last year the company generated free cash flow of approximately £3bn, or 30p per share giving a free cash flow yield of 13%. For a large-cap like BT, a free cash flow yield of around 8% is suitable implying that today the stock is severely undervalued on this metric. At 375p the shares would support a free cash flow yield of 8%. 

Added all together these three possible price targets suggest an average target price of 403p, a gain of 73% from current levels.

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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.