Verizon Stock Upgraded: What You Need to Know

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Verizon (NYSE: VZ) stock is in free fall -- down 12% in 28 days after 10-year U.S. Treasury bonds spiked to nearly 2.8% earlier this month. (They're at 2.85% today, by the way.)

How are those two facts connected? More closely than you might think. In a note carried on (requires subscription) this morning, "boutique" research shop MoffettNathanson argued that rising "bond yields and higher expectations for inflation" are directly responsible for Verizon's sell-off this month -- but they're also directly responsible for giving you a chance to buy Verizon stock on the cheap.

Here's what you need to know.

What are U.S. Treasurys?

Debt issued by the U.S. government, Treasury bonds, notes, and bills -- all broadly referred to as "Treasurys" -- mature in different durations. You can buy a Treasury note maturing two, three, five, or even 10 years after issuance. You can buy a Treasury bond that doesn't mature until 30 years in the future. You can even buy someone else's bond, and shorten your wait to maturity.

Most of the talk up on Wall Street lately, though, has concerned the 10-year Treasury note -- said by some to be the most popular debt instrument in the world -- and its rapidly rising yield.

What's going on with bonds?

Ten-year Treasury notes haven't yielded 3% since way back in January 2014, but they're getting closer to hitting that watershed mark with every passing day. Ten-year Treasury bonds already yield a full percentage point more than the average dividend on the S&P 500 (1.8%). And up on Wall Street, the worry is that once 10-year Treasurys hit a 3% yield, investors will finally notice that they can earn a decent interest rate by investing in U.S. government debt -- and will sell their dividend stocks to do so.

The selling is expected to get even more intense if interest rates rise further. On Tuesday, Fundstrat Global Advisors co-founder Tom Lee told CNBC that, in his opinion, the 10-year Treasury could rise as high as 4% within the next 18 months. And if the yield goes even higher than that -- say, 4.5% -- Goldman Sachs predicts that the stock market could fall as much as "20% to 25%."

What that means for Verizon

So what does all this have to do with Verizon? Simply this: With a dividend yield of 4.9% today, Verizon is currently one of the most popular big U.S. dividend stocks. For the time being, Verizon pays better than the average stock on the S&P 500, and the 10-year U.S. Treasury note as well. But Verizon's advantage over Treasurys is dwindling. Problem is, the very fact that Verizon may number among investors' first choices when buying dividend stocks may push Verizon to the front of the line when they decide to sell dividend stocks to buy T-bills instead.

The fact that Verizon's sell-off coincided almost precisely with analysts voicing worries over Treasurys hitting 3% yields earlier this month tells you this is something weighing on investors' minds. And yet, according to MoffettNathanson, maybe it shouldn't be. After all, thanks to this month's sell-off, Verizon stock has become 12% cheaper to own. Verizon shares can be bought today for the almost laughably low price-to-earnings ratio of 6.5.

Granted, P/E only captures Verizon's $196 billion market capitalization, and compares this to its $30.1 billion in GAAP earnings. It does not reflect the fact that Verizon is carrying $110.4 billion more debt than cash on its balance sheet. Factor that into your equations, and Verizon's enterprise value rises swiftly past $306 billion, giving it a price-to-enterprise-value ratio of 10.2.

Valuing Verizon

Is that too much to pay for Verizon? MoffettNathanson doesn't think so, but personally, I'm not so sure.

On the one hand, I recognize that rising bond yields and rising inflation might actually not be such a bad thing for a company like Verizon, which carries a lot of debt. As inflation eats away at the value of the dollar, it also eats away at the value of Verizon's dollar-denominated debt -- making it easier to pay off.

On the other hand, though, there's still the fact that analysts, on average, don't expect Verizon to be able to grow its earnings much faster than 4% annually over the next five years. I also worry that Verizon's $30.1 billion in GAAP profits -- the big "E" that makes Verizon's P/E look so very low -- may not be all they're cracked up to be.

According to data from S&P Global Market Intelligence, you see, only about $8 billion of Verizon's GAAP earnings are backed up by real free cash flow, meaning that for every $1 in accounting profits Verizon reports, it's only actually generating about $0.26 in actual cash profit. Result: Valued most conservatively, Verizon stock is selling for an enterprise value-to-free-cash-flow ratio of about 38 -- and that, Fools, does look to me like too much to pay for 4% growth.

Maybe investors who sold off Verizon stock this month weren't overreacting after all.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Verizon Communications. The Motley Fool has a disclosure policy.