Utility stocks have long been coveted by investors seeking above-average yield and stable prices. Currently, many high-quality regulated utilities offer bond-like characteristics, but with yields higher than what is available from the 30-year treasury. They have historically been considered very conservative investments, and as such, have often been used to augment a bond portfolio or even as substitutes for bonds. Utility stocks offer the allure of modest capital appreciation and the potential for modest dividend increases over time, while simultaneously providing a higher degree of safety than most equities.
However, regulated utility stocks have certain characteristics that need to be carefully considered by investors before laying their money down. First and foremost, due primarily to the fact that they are regulated, utilities do offer only very modest growth usually ranging between 3% to 6%. Consequently, there is very little margin for error when attempting to ascertain fair value. Investors need to keep at the forefront of their minds the reality that capital appreciation and dividend income is both a function of and highly correlated to earnings growth. Therefore, if you overpay for utility stocks, you may still receive a modestly increasing dividend each year, but the capital appreciation component of your investment is put in jeopardy.
Historically, PE ratios for quality utility stocks range from approximately 14 to 16 times earnings. These average PE ratios are in line with the PE ratios of the average company. Furthermore, because of the stability and predictability of their earnings and earnings growth rates, utility stocks generally command PE ratios that are equal to other equities possessing faster growth rates. However, because of their low potential for growth, there is actually less margin of error regarding valuation. On the other hand, if purchased at sound valuations, utility stocks can provide an above-average stable source of income, and modest capital appreciation that together provide a reasonable hedge against inflation.
The following table summarizes five eastern regulated utilities that appear to be reasonably valued, and lists them in order of dividend yield highest to lowest. From left to right, the table shows the company's stock symbol and name. Next, two valuation metrics are listed side-by-side; the current PE ratio followed by the historical normal PE ratio for perspective. Then the five-year estimated earnings per share growth is shown next to each company's historical EPS growth, providing a perspective of the past versus the future growth potential of each company. The final three columns show the current dividend yield, the company sector and its market cap.
A Closer Look at the Past and the Future Potential
Since a picture is worth 1,000 words, we'll take a closer look at the past performance and future potential of each of our five candidates through the lens of F.A.S.T. Graphs™.
Earnings Determine Market Price: The following earnings and price correlated historical graphs clearly illustrates the importance of earnings. The Earnings Growth Rate Line or True Worth™ Line (orange line with white triangles) is correlated with the historical stock price line. On graph after graph the lines will move in tandem. If the stock price strays away from the earnings line (over or under), inevitably it will come back to earnings. The historical normal PE ratio line (dark blue line with*) depicts a PE ratio that the market has historically applied.
The orange True Worth™ line and the blue normal PE ratio line provide perspectives on valuation. The orange line reflects the fair value of each company's earnings relative to its growth rate achievement, and the blue line reflects how the market has traditionally valued the company's stock relative to its fair value. The blue line represents a trimmed historical normal PE ratio (the highest and lowest PEs are trimmed). These lines should be viewed as barometers or aids for ascertaining sound buy, sell or hold decisions. Rather than seen as absolutes, they should be seen as guides to better thinking.
"PSEG Services Corporation was formed in 1999 to provide quality, value-added services to internal clients within the Enterprise family of companies. Services Corp. employs approximately 927 associates, who in turn provide 159 transactional and professional products and services, in 23 practice areas. The Services Corp. achieves results for Enterprise through innovative leadership, superior service and leading-edge technology solutions."
The consensus of 20 leading analysts reporting to Capital IQ forecast Public Service Enterprise Group's long-term earnings growth at 2%. Public Service Enterprise Group has medium long-term debt at 45% of capital. Public Service Enterprise Group is currently trading at a P/E of 11.6, which is inside the value corridor (defined by the five orange lines) of a maximum P/E of 17.4. If the earnings materialize as forecast, Public Service Enterprise Group's True Worth™ valuation would be $40.07 at the end of 2017, which would be a 8.4% annual rate of return from the current price.
"SCANA Corporation, a Fortune 500 company headquartered in Cayce, SC, is an energy-based holding company principally engaged, through subsidiaries, in electric and natural gas utility operations and other energy-related businesses."
The consensus of 14 leading analysts reporting to Capital IQ forecast SCANA Corp.'s long-term earnings growth at 4.3%. SCANA Corp. has medium long-term debt at 53% of capital. SCANA Corp. is currently trading at a P/E of 14.7, which is inside the value corridor (defined by the five orange lines) of a maximum P/E of 18. If the earnings materialize as forecast, SCANA Corp.'s True Worth™ valuation would be $58.88 at the end of 2017, which would be a 9% annual rate of return from the current price.
"With 4.4 million customers and more than 42,000 megawatts of generating capacity, Atlanta-based Southern Company is the premier energy company serving the Southeast. A leading U.S. producer of electricity, Southern Company owns electric utilities in four states and a growing competitive generation company, as well as fiber optics and wireless communications. Southern Company brands are known for excellent customer service, high reliability and retail electric prices that are below the national average. Southern Company was named the World's Most Admired Electric and Gas Utility by Fortune magazine in 2011, and is consistently listed among the top U.S. electric service providers in customer satisfaction by the American Customer Satisfaction Index."
The consensus of 19 leading analysts reporting to Capital IQ forecast Southern Co's long-term earnings growth at 5.9%. Southern Co has medium long-term debt at 51% of capital. Southern Co is currently trading at a P/E of 17.2, which is inside the value corridor (defined by the five orange lines) of a maximum P/E of 18. If the earnings materialize as forecast, Southern Co's True Worth™ valuation would be $52.94 at the end of 2017, which would be a 7.2% annual rate of return from the current price.
"Dominion is one of the nation's largest producers and transporters of energy, with a portfolio of approximately 28,000 megawatts of generation. Dominion operates the nation's largest natural gas storage system and serves retail energy customers in 15 states."
The consensus of 20 leading analysts reporting to Capital IQ forecast Dominion Resources Inc.'s long-term earnings growth at 5.8%. Dominion Resources Inc. has medium long-term debt at 56% of capital. Dominion Resources Inc. is currently trading at a P/E of 16.4, which is inside the value corridor (defined by the five orange lines) of a maximum P/E of 18. If the earnings materialize as forecast, Dominion Resources Inc.'s True Worth™ valuation would be $61.94 at the end of 2017, which would be a 8% annual rate of return from the current price.
"Con Edison is a subsidiary of Consolidated Edison, Inc. , one of the nation's largest investor-owned energy companies, with approximately $13 billion in annual revenues and $37 billion in assets. The utility provides electric, gas and steam service to more than three million customers in New York City and Westchester County, New York."
The consensus of 15 leading analysts reporting to Capital IQ forecast Consolidated Edison Inc.'s long-term earnings growth at 3.9%. Consolidated Edison Inc. has medium long-term debt at 49% of capital. Consolidated Edison Inc. is currently trading at a P/E of 15.9, which is inside the value corridor (defined by the five orange lines) of a maximum P/E of 18. If the earnings materialize as forecast, Consolidated Edison Inc.'s True Worth™ valuation would be $67.44 at the end of 2017, which would be a 6.5% annual rate of return from the current price.
Summary and Conclusions
The five eastern regulated utilities covered in this article represent examples of companies providing stable and reasonably predictable dividends. However, we would point out that Consolidated Edison and Southern Company appeared to be modestly overvalued at today's levels. Although neither one appears to be dangerously overvalued, history would indicate that a better entry point might avail itself in the near future. On the other hand, if your objective is solely focused on yield, then either one of these extremely high-quality utilities should achieve your objectives without too much risk.
When reviewing the earnings and price correlated graphs on each of these five eastern utilities, it becomes crystal clear how relevant the earnings and price relationship is. Although the price earnings ratios of these companies stay within a reasonable range of normal, a review of long-term performance results show that the appreciation component closely matches each company's earnings growth rate. Consequently, it should be obvious that even though utilities can be a very conservative way to generate returns that are better than available from bonds, valuation risk needs to be given very careful consideration. However, when bought at appropriate valuations, regulated utilities can provide a great prescription to a good night's sleep.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
Disclosure: I am long (SCG).