In a previous article I looked at the past business and investment growth of Consolidated Edison (NYSE:ED). This is useful for two reasons: it gives you a historical view of the company and it allows you to better think about potential repeatability moving forward.
The historical look gives you much more insight than a simple stock price. Instead of seeing a line squiggle about, you can observe how revenues translate to earnings, earnings to earnings-per-share, EPS to share price growth and ultimately to your total return. There are a lot of factors at play that are not adequately captured in a stock chart.
Moving forward, this type of information allows you think about the business in the future, with a solid understanding of how it previously got to where it was. If past investment growth was driven by an uptick in the earnings multiple or reduction in the share count, for example, these would be areas that you might want to explore on a forward-looking basis as well.
Of course looking at a single security, even through the lens of various return drivers, does have its limitations. Its hard to tell whether revenue growth or investment growth is reasonable or not without also comparing this to other similar firms. As an illustration, let's compare Consolidated Edison to American Electric Power (NASDAQ:AEP), a similar-sized utility, to get a better feel for the company.
Here's a look at both companies historical business and investment growth during the 2005 through 2014 period:
ED | AEP | |
Revenue Growth | 1.1% | 3.9% |
Start Profit Margin | 6.2% | 8.6% |
End Profit Margin | 8.3% | 9.6% |
Earnings Growth | 4.5% | 5.2% |
Yearly Share Count | 2.0% | 2.4% |
EPS Growth | 2.1% | 2.6% |
Start P/E | 15 | 14 |
End P/E | 18 | 18 |
Share Price Growth | 4.0% | 5.6% |
% Of Divs Collected | 46% | 43% |
Start Payout % | 76% | 54% |
End Payout % | 70% | 61% |
Dividend Growth | 1.1% | 4.1% |
Total Return | 7.3% | 8.4% |
From this table we can learn a variety of things. First, note that AEP was able to grow its revenues at a faster rate than Consolidated Edison. AEP also began with a higher net profit margin, and grew this over the period. Interestingly, due to the lower starting base, Consolidated Edison actually made up some growth ground in this area.
Total earnings growth for Consolidated Edison came in at 4.5% per year against 5.2% for AEP. Part of the higher growth for AEP was offset on the shareholder level due to having to issue more shares. Once you get to earnings-per-share Consolidated Edison was growing at 2.1% per year against American Electric's 2.6% annual growth. Allow the companies got there a bit differently, shareholders saw markedly similar growth during the time.
Shares of both companies began the period trading around 14 or 15 times earnings and moved up closer to 18 times earnings by the end of the period. The P/E expansion was slightly higher for AEP, resulting in 5.6% annual share price growth versus Consolidated Edison's 4% annual growth. This is an important point. It's not just the ending valuation that matters, but also the expectations that lead up to that value.
Consolidated Edison started with a higher dividend yield, but grew its payout at a slower rate. Still, an investment in the New York utility would have provided more aggregate income, resulting in closer overall returns. An investment in AEP would have generated 8.4% annual gains, while an investment in Consolidated Edison would have provided 7.3% yearly gains. As a point of reference, based on a $10,000 starting position, that's the difference between accumulating $18,900 and $20,600.
American Electric Power was able to outperform Consolidated Edison in the past due to its slightly faster earnings growth rate and higher valuation uptick. Consolidated Edison provided more dividends per dollar invested, but still trailed slightly.
This type of view can illuminate a few things. First, even though the growth rates weren't spectacular the returns were reasonable. A high starting yield and an uptick in valuation for both companies drove this result. Perhaps just as important, it shows you why one company might have turned in better performance and not just that it happened. Moving forward you could think about an investment in either security in a similar light.
Here's where things get less compelling, in my view. Below I have presented the same table substituting what actually occurred in the past with a hypothetical example for the next decade:
ED Forecast | AEP Forecast | |
Revenue Growth | 1.1% | 3.9% |
Start Profit Margin | 8.3% | 9.6% |
End Profit Margin | 9.3% | 10.6% |
Earnings Growth | 2.3% | 4.9% |
Yearly Share Count | 2% | 2.4% |
EPS Growth | 0.4% | 2.4% |
Start P/E | 18 | 17 |
End P/E | 15 | 15 |
Share Price Growth | -1.6% | 1.1% |
% Of Divs Collected | 40% | 46% |
Start Payout % | 72% | 63% |
End Payout % | 72% | 63% |
Dividend Growth | 0.4% | 2.4% |
Total Return | 2.3% | 4.7% |
On the top line I used the exact same revenue growth, 1.1% per year for Consolidated Edison and 3.9% for AEP. Naturally these could be switched around or any number of different iterations, but the above is used specifically for a demonstration.
The next two rows show improvement in the net margin of each company. So you have two companies growing revenue at the same rate as before, and actually keeping more of those profits. Yet the overall growth rate for both companies would still be lower. As a result of coming off a higher base, formulating growth becomes more difficult - it's not enough to improve, you would need to improve by a greater and greater margin.
If the number of shares outstanding also increased at past rates, you would be looking at rather slow earnings-per-share growth rates. Not that the past growth rates weren't spectacular, but these would be noticeably lower still. With the same business performance, the growth rate is lower off a now higher base. It becomes more and more difficult to offer continued growth.
The big difference between 2005 and 2015 is that today you'd likely want to be more cautious in your future multiple anticipation. Its certainly possible that these two companies could trade with P/E ratios of say 20 in the future, but I would contend that this might not be altogether prudent to expect. As such, share price growth could trail the already quite slow earnings growth.
In turn, your main total return reliance would rest with dividends. Although the dividend yields are above average - sitting around 4% - they wouldn't be expected to grow very fast. As such, you might anticipate collecting the dividend yield, seeing it keep pace with or even trail long-term inflation and not much more. A lack of strong growth, coupled with average to above average expectations, makes for a less compelling value proposition.
Of course the above assumptions could be too pessimistic. Analysts are presently expecting 3% intermediate-term earnings growth for Consolidated Edison and 5% growth for AEP. Still, these assumptions would only bump the return anticipations up to the mid-single-digits. And to be complete, these higher assumptions can miss share count dilution and the possibility of a lower valuation in the future.
In short, both Consolidated Edison and AEP as businesses didn't grow very fast over the past decade. In spite of this, investors saw reasonable returns due to an uptick in what investors were willing to pay to go along with a solid ongoing dividend. In the future, you likely still wouldn't expect these companies to grow very fast. However, this time the returns might not be as reasonable. The valuations are higher and consequently dividend benefits a bit lower. As the growth rate of a security slows, the relative expectations and valuation paid become more and more important.
