The utility industry trade publication Public Utilities Fortnightly published an interesting article in 2007 that is still worth reading. Most utility investors focus on the wrong fundamentals by concentrating on dividend yield. According to the information compiled by Public Utilities Fortnightly, there is a negative -73% correlation factor between utility dividend yield and 3-year total stock returns for their top 40 utilities. Return on Invested Capital (ROIC) and Return on Equity (ROE) have the highest correlation factor of 58% and 51% respectively.
The following figures outlines the correlations between ROIC, ROE, dividend yield and several other fundamental numbers used in evaluating stock values and 3-year total stock investment returns. Total returns include both capital gains and dividend income. In addition, the plot graph correlates specific returns on invested capital with total stock returns for the three-year period 2004 to 2006.
Source: Public Utilities Fortnightly, How to Achieve High Performance, Lessons from the Top 40 Utilities
Some investors may sneer at the age of the data, but in my opinion, it still is very relevant. The essential approach remains the same: much as crops depend on rain falling from the sky, dividends depend on profitability of the utility. The higher the returns squeezed out of total capital deployed, the more those returns can be funneled back to shareholders.
The utility business is very capital-intensive and reviewing return on total capital deployed, or the firm's ROIC, is the best means of determining management's ability to generate a consistent profit using all the financial tools at their disposal.
While some formulas for calculating ROIC are complicated, there are others that are not. The "purest" formula is as follows: ROIC = (Net Operating Profit - Adjusted Taxes) / Invested Capital. However, this involves working with the individual company's balance sheet and income statement. An easier formula is: ROIC = ROE / (1+Debt to Equity). The latter formula's components are effortlessly accessible from most financial websites, such as Reuters or finance.yahoo.
The following table lists trailing twelve month ROE, 5-yr average ROE, debt to equity ratios, trailing twelve month ROIC, and 5-yr average ROIC for each of the large-capitalization Dow Jones Utility Index companies: American Electric Power (NYSE:AEP), AES Corp. (NYSE:AES), Centerpoint Energy (NYSE:CNP), Dominion Resources (NYSE:D), Duke Energy (NYSE:DUK), Consolidated Edison (NYSE:ED), Edison International (NYSE:EIX), Exelon Corp. (NYSE:EXC), FirstEnergy Corp. (NYSE:FE), NextEra Energy (NYSE:NEE), NiSource Inc. (NYSE:NI), PG & E Corp. (NYSE:PCG), Public Service Enterprise Group (NYSE:PEG), Southern Co. (NYSE:SO), and Williams Companies (NYSE:WMB)
Debt to Equity
Public Service Enterprise Group
American Electric Power
PG & E Corp.
According to the work published by Public Utilities Fortnightly, the three best DJ Utility Index companies would be Edison International, Public Service Enterprise Group, and Southern Company. Management of these firms produced the highest ROIC over the trailing 12 months and two of the top three generated higher short-term ROIC than their 5-year averages. This is a very important trend going forward for shareholder returns.
The latest investor presentations for each can be found here:
- Edison International investor presentation
- Public Service Enterprise investor presentation
- Southern Company investor presentation
Utility investors should expand their fundamental analysis to include comparisons for Return on Invested Capital. If Public Utility Fortnightly's analysis is correct, this one number is the best prelude to improving total stock returns.
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