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Utility stocks are known to be the dividend kings of the market. Among the utility companies, electric utility companies are among the safest investments, offering regular dividends. These companies are subject to regulations, yet most of them have almost monopoly power in their region. While their business looks pretty simple with limited growth potential, the recent merger between Duke (DUK) and Progress Energy (PGN) is a perfect example showing the dynamic complexity in the sector. A single company operates several power plants, providing electricity through a variety of distribution channels with differentiated prices to different types of customers. There are mainly two driving forces for increased profits. First, is the increased demand for energy. Next is the effective use of innovative cost control mechanisms. There is a possibility that if the consumer’s demand for electric vehicles gains momentum, the demand for electricity might also explode, boosting the profits. The question is which stocks shall we choose? One simple technique is using O-Metrix such that :

O-Metrix = [(Dividend Yield + EPS Growth) / (P/E Ratio)] * 5

Dividend Yield: Higher is better.
EPS Growth: Higher is better.
P/E Ratio: Lower is better.

I multiplied the original formula by 5 to get a scale over 10. The back-testing of this valuation technique on 40 large-caps shows that O-Metrix works very well over the long-term, such as 5 years. Since 2006, companies with A+ O-Metrix scores such as Petrobrasil (PBR) and Vale (VALE) returned an average of 16.92% whereas those with Sub-F grades such as General Electric (GE) had negative returns. Thus, higher O-Metrix scores resulted in significantly better returns. The following table shows a back-test of this technique's predictive power using data for electric utility companies: (data from finviz/morningstar, and is current as of Friday's close)

Company Name

Ticker

2006 P/E

2006 Yield

5 Year EPS Growth

T-METRIX

Annualized Return

(A+) Average:

16.13%

Enersis S.A

ENI

19.5

1.23

48.26

12.69

16.60%

(B) Average:

13.04%

Empresa N. E.

EOC

28.2

1.28

37

6.79

17.70%

Dominion

D

18.8

3.29

25.98

7.78

8.37%

(C) Average:

5.46%

NextEra

NEE

16.8

2.76

15.66

5.48

9.39%

Public S. E.

PEG

22.3

3.43

17.85

4.77

2.99%

National Grid

NGG

15.7

3.5

13.75

5.49

4.00%

(D) Average:

5.32%

Entergy

ETR

17.2

2.34

9.71

3.50

2.34%

Xcel Energy

XEL

17.1

3.83

5.66

2.77

8.87%

PPL Corp.

PPL

15.6

3.07

4.16

2.32

2.25%

American E.

AEP

17

3.52

3.99

2.21

5.57%

Con. Ed.

ED

16.3

4.78

3.37

2.50

7.59%

(F) Average:

4.27%

Southern Co.

SO

17.5

4.16

2.07

1.78

7.97%

Centrais E.B.

EBR

24.6

0.54

6

1.33

3.65%

Progress

PGN

23.9

4.93

0.91

1.22

6.73%

FirstEnergy

FE

15.8

2.99

-0.31

0.85

0.53%

PG&E Corp.

PCG

17.2

2.79

3.54

1.84

4.50%

Edison Int.

EIX

13.9

2.42

2.18

1.65

2.21%

(Sub -F) Average:

3.60%

TransCanada

TRP

19

2.76

-6.45

-0.97

9.95%

Veolia E.S.A.

VE

29.9

1.45

-5.32

-0.65

-7.61%

Sempra Energy

SRE

13.4

2.14

-3.97

-0.68

5.56%

Duke Energy

DUK

19.5

3.79

-11.86

-2.07

6.51%

I also included the large-cap international electric companies to see whether the formula works well with non-U.S. companies. Some large-cap companies are not in the list due to lack of data. The results are extremely promising. While there are individual noises, there is almost a perfect correlation between the O-Metrix score and 5 year annualized performance. The following graph makes it easier to visualize this correlation:

As the equation above states, for each point increase in O-Metrix score, the annualized return is expected to be 0.8% higher. As you might notice in the model, dividends are perfect substitutes for growth. Thus, they have equal weight in the formula.

Three companies that does not fit well to the model are easy notice: Southern Energy, Duke, and Progress Energy have pretty low scores, yet their returns are well above average. One commong thing betweeen this companies is the fat dividend yield offered to shareholders. Since electric utility companies are most widely held among retirees, I think it will be more appropriate to put more weight to dividends. Thus the double-dividend weight adjusted formula will be as follows:

O-Metrix = (2 x Dividend Yield + EPS Growth) / (P/E Ratio)

Making this correction improves the predictive power of the above formula. As we can see in the next graph, the coefficient on O-Metrix score is higher:

Now, which companies shall we choose for the next 5 years? Based on the double-dividend adjusted formula, and analyst estimates for 5-year EPS growth, here is the double dividend O-Metrix scores of electric companies (data from Finviz) :

Company

Ticker

P/E

Dividend Yield

EPS Next 5 years

DD O-Metrix

Atlantic Power

AT

5.73

7.33%

9.43%

21.02

Brookfield I.P.

BIP

5.35

5.09%

6.00%

15.12

Dominion

D

8.88

4.18%

5.98%

8.07

TransAlta

TAC

24.09

5.47%

22.00%

6.84

Entergy

ETR

9.63

4.98%

2.20%

6.31

PPL

PPL

11.57

5.04%

2.80%

5.57

Edison Int.

EIX

10.46

3.29%

4.69%

5.39

Pinnacle W. C. Co.

PNW

15.38

4.81%

6.58%

5.27

Great Plains Inc.

GXP

14.74

4.02%

7.13%

5.15

NextEra

NEE

13.82

3.95%

5.66%

4.91

American Electric

AEP

14.37

4.91%

4.23%

4.89

Xcel Energy

XEL

14.56

4.28%

5.64%

4.88

TECO Energy

TE

17.03

4.63%

6.89%

4.74

DTE Energy

DTE

14.78

4.68%

4.39%

4.65

Progress Energy

PGN

16.1

5.29%

3.91%

4.50

Hawaiian Electric

HE

19.59

5.19%

7.18%

4.48

Southern Co.

SO

17.42

4.80%

5.60%

4.36

Duke Energy

DUK

17.74

5.31%

4.03%

4.13

ITC Holdings

ITC

23.46

1.92%

15.44%

4.11

Covanta Holding

CVA

82

1.83%

61.60%

3.98

Centrais E. Brasil

EBR

10.48

7.00%

3.34

NSTAR

NST

19.54

3.82%

5.06%

3.25

FirstEnergy

FE

19.76

5.04%

2.62%

3.21

Cleco Corp.

CNL

15.37

3.28%

3.00%

3.11

OGE Energy

OGE

20.69

3.05%

6.63%

3.08

Pepco Holdings

POM

25.35

5.53%

3.28%

2.83

NRG Energy

NRG

42.66

22.03%

2.58

Companhia P. En.

ELP

14.4

0.71%

5.50%

2.40

Huaneng Power

HNP

13.54

5.27%

-4.50%

2.23

While there is no guarantee that the above list will work, I think it is a good starting point. Investors might consider the ranking system, and add it into their knowledge database. It is easy to use and pretty convenient.

Consider Dominion, NextEra and Southern Company with rounded O-Metrix scores of 8, 5, and 4.5.

Expected Annualized Return = 0.85 x O-Metrix + 2.4

Based on the formula above, I expect Dominion to have an annualized return of 9.2%, NextEra to return 6.6%, and Southern Company to return 6.1% over the next five years.

While the returns from utility stocks might not look that exciting, they surely beat the government bonds with large margins. Dividend investors should consider making these estimations themselves, and use O-Metrix as an additional tool to other fair value estimation techniques. You can find a detailed analysis of methodology with application to a diversified list of dividend picks for the next 5 years, here.

Disclaimer: The article is a back-testing article which, shows that by the year 2011, stocks with higher O-Metrix scores in 2006 outperformed other stocks. I cross-checked the data from a variety of sources, but no data is perfect. Things get particularly complicated when there are mergers/break-ups involved. I am not a registered advisor [yet]. You should always do your own diligence before making any investment decision.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Picking the Best Electric Utility Dividends for the Next 5 Years