Continuing with the theme of reviewing utilities according to a Modified Graham Number, this article focuses on the mid-cap area. The previous article on overvalued large-cap utility stocks can be found here.
The Graham Number is a calculation used to develop an intrinsic value of a company's stock based on current earnings per share and book value. The calculation does not consider eps growth, dividend growth or return on invested capital. Just eps and book value. As one piece of the puzzle of fundamental stock selection, the Graham Number has a place at the valuation table as a comparison tool. As shown in the previous article, in today's expensive stock market the large-cap utility stocks with the greatest undervaluation also have the most potential risk due to their exposure to the depressed merchant power markets.
The formula is Graham Number = Square Root of (Book Value * EPS * 22.5). With the advent of the excel spreadsheet, the old fashion abacas is no longer needed to do the calculation.
I modify this formula and substitute eps expectations for 2014 rather than using the recent past. As my goal is to find future value, looking at consensus forward estimates allows me to compare valuations as they may be in two years. However, the downfall of this approach is the reliance on the "pros" for their future estimates and the need to update the results as expectations change. It is somewhat comforting that utility earnings are usually pretty stable and relying on others is not as big a pitfall as with other sector projections.
Below are the components of the S&P Mid-Cap Utility Index. Keep in mind there is currently no ETF that follows this index. The table includes current price, percent undervalued or overvalued from the Modified Graham Number, the Graham Number based on 2014 anticipated earnings, 2012 eps, most recent quarter Book Value, anticipated 2014 earnings, and return on invested capital based on trailing twelve month return on equity and the most recent quarterly debt to equity.
% to Graham Over or Under Value
2014 Modified Graham
Book Value MRQ
2014 Est EPS
Return on Invested Capital
National Fuel Gas
The three most undervalued share prices according the Modified Graham Number are PNM Resources (PNM), Great Plains (GXP), and IDA Corp (IDA) while the most overvalued are Questar (STR), Aqua America (WTR), and National Fuel Gas (NFG).
The average of over/under valuations of these mid-cap utilities is an overvaluation of 13.5%. This compares to an average overvaluation for large-cap utilities of 6.7%. The percentage of undervaluation of the top two mid-cap utilities is vastly higher than the top undervalued large-caps: PNM Resources -27.7% and Great Plains -22.8 versus Entergy (ETR) -14.9, FirstEnergy (FE) -12.7, Exelon (EXC) -12.5, and Pepco (POM) -12.2. The other big difference is PNM and GPX are expected to generate much higher earnings in 2014 than 2012 while larger cap ETR and FE are expected to generate lower earnings.
As with the large-cap comparisons, it is interesting the "riskier" firms are undervalued according to the Graham number (modified or not) while the "safer" stocks are overvalued. In addition, like their larger brethren, the spread between the most undervalued and the most overvalued is substantial.
As stated in the previous article on large-cap valuations, it may be prudent to research both ends of the Graham Number - those that are higher risk with some degree of safety if earnings pan out and those that are lower risk but may not provide as much value in today's market.
Author's Note: Please review important disclaimer in author's profile.