Many analysts have been downgrading the electric utility sector, citing valuation concerns. We believe those worries are off the mark. Indeed, we believe just the opposite is true: most utilities we follow are still undervalued, according to our Dividend Valuation Models.
As an example, let's look at Southern Company (SO) through the eyes of the model. SO is one of our favorite utilities for reasons that we explained in an article, entitled "6 Reasons Investors Should Look At Southern Company." Please see that article for the fundamentals we believe will drive Southern Company's business over the next few years.
In this blog, let us focus on the Dividend Valuation Model above. Remember the red line is the actual annual price of SO, and the blue bars are our model's predicted valuation for SO for each of the last 20 years. The R2 of the fit between the predicted value and the actual annual price has been .85, a very tight fit.
The December 2011 actual price of $45.50 is now lower than the top of the valuation bar at $49.40. That is a signal that the stock is undervalued on a current basis. Importantly however, the blue checkered bar at the far right is our model's estimate of SO's fair value for 2012. That price is almost $53 per share. Adding in SO's 4.1% current dividend yield means our model is suggesting the stock is nearly 20% undervalued.
The analysts are yelling that SO's PE of 18 is too high and is unsustainable. That might be so in normal times, but in these times where 30-year U.S. Treasury bonds are yielding under 3%, we believe SO's growing 4.1% dividend yield will continue to attract buyers, including us.