Consolidated Edison: A Good Buy For The Yield

Feb.12.12 | About: Consolidated Edison (ED)

Established in 1884, Consolidated Edison (NYSE:ED) is one of the oldest utility companies in the U.S. history. The company primarily operates as a diversified utility provider, operating in the New York and adjacent areas. ConEd's electricity distribution network serves around 3.5 million households in the New York, New Jersey, and northeastern Pennsylvania. In addition, the gas business serves to more than one million customers around the New York City. Similar to other utility stocks, ConEd was an outperfomer, returning near 25% in 2011. However, the year-to-date return of -5% is in the red territory.

As of the time of writing, ConEd stock was trading at $59 with a 52-week range of $48.55 - $62.7. It has a market cap of $17.2 billion. Trailing twelve month [ttm] P/E ratio is 15.7, and forward P/E ratio is 15.2. Compared to the industry leader, Southern Corporation (NYSE:SO), ConEd is relatively cheaper in terms of fundamental ratios. ConEd's P/B, P/S, and P/CF ratios stand at 1.5, 1.3, and 4.8, whereas the same ratios for Southern Company stand at 2.2, 2.2, and 7.5, respectively. ConEd is a stable dividend payer. Current yield is 4.1% which is more or less in line with that of Southern Corporation.

ConEd has a 2-star rating from Morningstar. Out of 5 analysts covering the company, 3 have hold, 1 has underperform, and 1 has sell ratings. Wall Street has diverse opinions on ConEd's future, but the average five-year annualized growth forecast estimate is 4.2%.

What is the fair value of ConEd given the forecast estimates? We can estimate the fair value using discounted earnings plus equity model as follows.

Discounted Earnings Plus Equity Model

This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:

V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value

V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]

The earnings after the last period act as a perpetuity that creates regular earnings:

Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r

While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my growth estimates. You can set these parameters as you wish, according to your own diligence.

Valuation

Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate. In order to smooth the results, I will also take the average of ttm EPS along with the mean EPS estimate for the next year.

E0 = EPS = ($3.57 + $3.86) / 2 = $3.71

Wall Street holds diversified opinions on the company's future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 4.2%. Book value per share is $39.11.

The rest is as follows:

Fair Value Estimator

V (t=0)

E0

$3.71

V (t=1)

E0 (1+g)/(1+r)

$3.49

V (t=2)

E0((1+g)/(1+r))2

$3.27

V (t=3)

E0((1+g)/(1+r))3

$3.07

V (t=4)

E0((1+g)/(1+r))4

$2.88

V (t=5)

E0((1+g)/(1+r))5

$2.71

Disposal Value

E0(1+g)5/[r(1+r)5]

$24.62

Book Value

BV

$39.11

Fair Value Range

Lower Boundary

$44

Upper Boundary

$83

Minimum Potential

-25%

Maximum Potential

40%

Click to enlarge

(You can download FED+ Fair Value Estimator here.)

I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5-year discounted-earnings-plus-book-value model, the fair-value range for ConEd is between $44 and $83 per share. At a price of $59, ConEd is trading at the middle of my fair value range (click top enlarge image):

Click to enlarge

Summary

ConEd is a great stock to buy on market weaknesses. With a low beta of 0.25 it can be a solid anchor to stabilize your portfolio. It is also a slow, but stable dividend-growth stock. In the last 5 years, dividends have grown from $2.32 to $2.40. I am in favor of utility stocks, and I think they offer great value to long-term oriented investors. ConEd is no exception, the stock has been a sustainable dividend payer with plenty of room for dividend growth.

Given the low interest rates on government bonds, dividend paying stocks offer more buck for the money. However, I have my doubts on utility stocks' expected performance in 2012. After beating the market with significant margins in 2011, utility stocks show signs of weakness in this year. The year-to-date performance of most utility stocks are in the red territory. ConEd also lost near 5% so far in 2012. I think the timing is not right to enter into utility stocks. I would not buy ConEd for capital appreciation, but it is a good buy for the yield.

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