Shares of Vodafone (LSE: VOD) haven’t performed too well since the group’s game-changing sale of Verizon Wireless in 2014. They traded above 200p (and as high as 255p) for the two years between late 2014 and late 2016 but have dipped below 200p on three occasions in recent months. The latest dip came last week, with the price at Friday’s close being 198.75p.
How soon can the shares get back above 200p? What are the company’s longer-term prospects? And is the stock worth buying today?
Valuation conundrum
Vodafone presents an unusual picture when we look at its valuation metrics of price-to-earnings (P/E) ratio and dividend yield. Typically, a low P/E is associated with a high yield, and high P/E with a low yield. However, over the last few years, Vodafone has sported both a high P/E and a high yield, as you can see in the table of 12-month forecasts below.
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| Share price | P/E | Yield | |
| April 2015 | 220p | 35.6 | 5.4% |
| April 2016 | 220p | 37.1 | 5.2% |
| Today | 198.75p | 29.1 | 6.3% |
The reason for this high-P/E and high-yield anomaly is that Vodafone lost a big chunk of its earnings from the sale of Verizon Wireless but management continued with a progressive dividend policy.
However, acquisitions and substantial organic investment since the Verizon sale are set to bring powerful earnings growth through over the next few years. I think now could be a great time to buy a slice of the business because, as the table above shows, Vodafone is terrific value today, compared with this time last year and two years ago.
Now, some may argue that the current P/E of 29.1 is still too rich and that a 6.3% yield indicates a high risk of a dividend cut. Let me explain why I disagree with these propositions.
Free cash flow
On the face of it, Vodafone’s earnings, compared with the amount it’s paying out in dividends, do suggest the payout is unsustainable. When the company announces its results for its financial year ended 31 March on 16 May (reporting in euros for the first time), the expectation is for earnings per share of 6.75 cents but a dividend of 14.75 cents.
However, accounting earnings can be deceptive for dividend sustainability. Free cash flow (FCF) — the amount of cash left over after all the costs of running and maintaining the business — is the crucial yardstick. Vodafone has guided on FCF of “at least €4bn” for the year, while that 14.75 cents dividend, multiplied by 26.6 shares in issue, will require a gross payout of €3.9bn.
So, in contrast to accounting earnings, Vodafone’s FCF more than covers the dividend. Of course, this also means that while the P/E is high at 29.1, the P/FCF is considerably lower — namely, 16. This rating and the juicy dividend look highly attractive to me for a business with prospects of healthy growth over the next few years and in the longer term.
The shares have nudged back above 200p in early trading this morning but remain a compelling ‘buy’ in my view. If the market warms to next month’s results and outlook statement, it could be a case of onwards and upwards for the shares.
