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 | 19.5 | 1.23 | 48.26 | 12.69 | 16.60% | |
(B) Average: | 13.04% | |||||
Empresa N. E. | 28.2 | 1.28 | 37 | 6.79 | 17.70% | |
Dominion | 18.8 | 3.29 | 25.98 | 7.78 | 8.37% | |
(C) Average: | 5.46% | |||||
NextEra | 16.8 | 2.76 | 15.66 | 5.48 | 9.39% | |
Public S. E. | 22.3 | 3.43 | 17.85 | 4.77 | 2.99% | |
National Grid | 15.7 | 3.5 | 13.75 | 5.49 | 4.00% | |
(D) Average: | 5.32% | |||||
Entergy | 17.2 | 2.34 | 9.71 | 3.50 | 2.34% | |
Xcel Energy | 17.1 | 3.83 | 5.66 | 2.77 | 8.87% | |
PPL Corp. | 15.6 | 3.07 | 4.16 | 2.32 | 2.25% | |
American E. | 17 | 3.52 | 3.99 | 2.21 | 5.57% | |
Con. Ed. | 16.3 | 4.78 | 3.37 | 2.50 | 7.59% | |
(F) Average: | 4.27% | |||||
Southern Co. | 17.5 | 4.16 | 2.07 | 1.78 | 7.97% | |
Centrais E.B. | 24.6 | 0.54 | 6 | 1.33 | 3.65% | |
Progress | PGN | 23.9 | 4.93 | 0.91 | 1.22 | 6.73% |
FirstEnergy | 15.8 | 2.99 | -0.31 | 0.85 | 0.53% | |
PG&E Corp. | 17.2 | 2.79 | 3.54 | 1.84 | 4.50% | |
Edison Int. | 13.9 | 2.42 | 2.18 | 1.65 | 2.21% | |
(Sub -F) Average: | 3.60% | |||||
TransCanada | 19 | 2.76 | -6.45 | -0.97 | 9.95% | |
Veolia E.S.A. | 29.9 | 1.45 | -5.32 | -0.65 | -7.61% | |
Sempra Energy | 13.4 | 2.14 | -3.97 | -0.68 | 5.56% | |
Duke Energy | 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 | 5.73 | 7.33% | 9.43% | 21.02 | |
Brookfield I.P. | 5.35 | 5.09% | 6.00% | 15.12 | |
Dominion | 8.88 | 4.18% | 5.98% | 8.07 | |
TransAlta | 24.09 | 5.47% | 22.00% | 6.84 | |
Entergy | 9.63 | 4.98% | 2.20% | 6.31 | |
PPL | 11.57 | 5.04% | 2.80% | 5.57 | |
Edison Int. | 10.46 | 3.29% | 4.69% | 5.39 | |
Pinnacle W. C. Co. | 15.38 | 4.81% | 6.58% | 5.27 | |
Great Plains Inc. | 14.74 | 4.02% | 7.13% | 5.15 | |
NextEra | 13.82 | 3.95% | 5.66% | 4.91 | |
American Electric | 14.37 | 4.91% | 4.23% | 4.89 | |
Xcel Energy | 14.56 | 4.28% | 5.64% | 4.88 | |
TECO Energy | 17.03 | 4.63% | 6.89% | 4.74 | |
DTE Energy | 14.78 | 4.68% | 4.39% | 4.65 | |
Progress Energy | PGN | 16.1 | 5.29% | 3.91% | 4.50 |
Hawaiian Electric | 19.59 | 5.19% | 7.18% | 4.48 | |
Southern Co. | 17.42 | 4.80% | 5.60% | 4.36 | |
Duke Energy | 17.74 | 5.31% | 4.03% | 4.13 | |
ITC Holdings | 23.46 | 1.92% | 15.44% | 4.11 | |
Covanta Holding | 82 | 1.83% | 61.60% | 3.98 | |
Centrais E. Brasil | 10.48 | 7.00% | 3.34 | ||
NSTAR | 19.54 | 3.82% | 5.06% | 3.25 | |
FirstEnergy | 19.76 | 5.04% | 2.62% | 3.21 | |
Cleco Corp. | 15.37 | 3.28% | 3.00% | 3.11 | |
OGE Energy | 20.69 | 3.05% | 6.63% | 3.08 | |
Pepco Holdings | 25.35 | 5.53% | 3.28% | 2.83 | |
NRG Energy | 42.66 | 22.03% | 2.58 | ||
Companhia P. En. | 14.4 | 0.71% | 5.50% | 2.40 | |
Huaneng Power | 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.
