American Electric Power: Good Dividend Yield With Upside

| About: American Electric (AEP)

American Electric Power Company, Inc. (NYSE: AEP) is a vertically integrated electric utility. AEP owns almost 38 gigawatts of generation capacity and 39,000 miles of transmission lines. The company has operations in the states of Arkansas, Indiana, Kentucky, Louisiana, Michigan, Ohio, Oklahoma, Tennessee, Texas, Virginia, and West Virginia. This gives AEP substantial geographic diversification and exposure to various population growth rates, including Texas with strong population growth. A substantial portion of AEP's earnings are from regulated businesses.

AEP had about $14.4 billion in revenue in 2010 with $1.2 billion in net income. AEP has a market capitalization of $18.1 billion and an enterprise value of $35.9 billion, suggesting significant leverage. AEP has a strong track record of paying dividends, although recent growth has fluctuated.

AEP's estimated forward dividend yield is 5.0% based upon a closing price of $37.45 and the author's projected annual dividend of $1.88, which assumes a 1 cent increase in the quarterly dividend payment. The following table shows the estimated forward quarterly dividends as well as the recent historical quarterly dividends. AEP has resumed dividend growth after a period of no growth during the Great Recession.

Historical and Projected Dividends

Type Ex-Dividend Date Quarterly Dividend ($ per share) Change on prior year
Projected 8/8/2012 0.470 2.2%
Projected 5/6/2012 0.470 2.2%
Projected 2/8/2012 0.470 2.2%
Projected 11/8/2011 0.470 2.2%
Historical 8/8/2011 0.460 9.5%
Historical 5/6/2011 0.460 9.5%
Historical 2/8/2011 0.460 12.2%
Historical 11/8/2010 0.460 12.2%
Historical 8/6/2010 0.420 2.4%
Historical 5/6/2010 0.420 2.4%
Historical 2/8/2010 0.410 0.0%
Historical 11/6/2009 0.410 0.0%
Historical 8/6/2009 0.410 0.0%
Historical 5/6/2009 0.410 0.0%
Historical 2/6/2009 0.410 0.0%
Historical 11/6/2008 0.410 0.0%
Historical 8/6/2008 0.410 5.1%
Source: Author estimates, Yahoo Finance

The following graph (click to enlarge images) shows the historical trailing twelve month yield and spread to the 10-year Treasury bond. It shows that AEP has consistently paid dividends, providing a yield from 4.0 - 6.0%. The dividend spike in early 2003 was due to a drop in the stock price triggered by a reduction in the quarterly dividend from $0.60 to $0.35 per share.

Created from data from Yahoo Finance. Dividend yields are calculated on a trailing twelve months basis. So when there is a quarterly dividend cut, the current trailing twelve months dividend reflects 3 payments at the old rate and 1 payment at the new rate, while the stock price has adjusted to reflect the notion of the new rate going forward. This results in the spike in the yield and is essentially an artifact of the mathematics used and not a reflection of the fundamentals.

The next graph shows the normalized performance of the stock price, the dividend, and the trailing dividend yield.

Created from data from Yahoo Finance

The above chart shows that AEP has significantly underperformed its dividend increases, suggesting that its future growth opportunities are improving and investors are rewarding AEP. However, it should also be noted that a change to the graph time frame would change this result to show an outperformance in the stock price due to a dividend reduction in 2003.

Dividend Discount Model suggests it is undervalued

The first step to using the dividend discount model is to calculate an equity hurdle rate with the Capital Asset Pricing Model. AEP has a beta of 0.5 and with the risk free rate at a very low 1.8% this gives the discount rate to be a 5.3%. As noted above the forward dividend is approximately $1.88. Applying a long term growth rate of 1% gives an estimated price of $43.64 for AEP. This is approximately a 17% premium to the current price of $37.45. However, as with any dividend discount model, the result is highly sensitive to growth rate and equity hurdle rate assumptions.

Valuation Sensitivities

Sensitivity Equity Hurdle Rate
Growth Rate 4.3% 5.3% 6.3% 7.3%
-2.0% 29.80 25.73 22.63 20.20
-1.0% 35.42 29.80 25.73 22.63
0.0% 43.64 35.42 29.80 25.73
1.0% 56.83 43.64 35.42 29.80
2.0% 81.46 56.83 43.64 35.42
Source: Author calculations

AEP has shown a consistent track record of dividends. The dividend discount model suggests that it is slightly undervalued. With a forward P/E ratio of 11.6, AEP also looks to carry a reasonable valuation given a 5 year dividend growth rate of approximately 4%.

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

Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.

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