Can These Utility Companies Power Our Dividend Growth Portfolio?

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Includes: AEP, D, SO
by: The Dividend Bro

Summary

Utility companies often offer attractive dividend yields.

The utility sector has had nice gains over the past few years, but many have experienced a pullback in recent months.

Are Southern Company, American Electric Power or Dominion Resources a good stock to own at current prices?.

My wife and I don't currently own any utility companies in our dividend growth portfolio. As we plan on living off of dividend income in retirement and these companies often offer robust yields, this is an issue. Whether the economy is humming along or is in the middle of a recession, people are probably going to do everything they can to pay the electric and gas bill. For this reason, I would like to add a utility company to our portfolio. Here are my guidelines for valuing and purchasing stocks:

The first group of stocks are what we consider the core holdings. For core holdings, we want companies that:

  • Have at least 10 consecutive years of dividend growth.
  • Are considered by S&P Capital/Morningstar to be no more than 5% overvalued.
  • Are considered by F.A.S.T. Graphs to have a current price to earnings ratio that is no more than 5% overvalued when compared to the five-year average price to earnings ratio.
  • Have a dividend yield above 2.0%.
  • Dominate their sector of the economy.

The next group of stocks is considered to be supporting holdings. For supporting holdings, we want companies that:

  • Have 5 years of dividend growth or 10 years of paying uninterrupted dividends.
  • Are considered by S&P Capital/Morningstar to be at least fair valued.
  • Are considered by F.A.S.T. Graphs to have a current price to earnings ratio no more than 5% overvalued when compared to the five-year average price to earnings ratio.
  • Have a dividend yield above 1.0%.

The last group of stocks is the speculative holdings. For speculative holdings, we want companies that:

  • Have recently initiated a dividend.
  • Or have an average dividend growth rate of at least 10% or higher for the life of the dividend.
  • Are considered by S&P Capital/Morningstar/F.A.S.T. Graphs to be at least 5% undervalued.

Southern Company (NYSE:SO)

Current Yield

# Years div growth

5 Year Div Growth Rate

4.56%

16

3.60%

S&P Capital 12-month price target

S&P Capital Fair Value

Morningstar Fair Value

$51

$44.60

$48

F.A.S.T Graphs Current PE

F.A.S.T Graphs 5 Year Avg PE

Price Target

17.1

16.2

Under $51

Click to enlarge

The Southern Company operates utility and nuclear power plants throughout the southeastern United States. The company has raised dividends each of the past 16 years and has increased the payments by an average of 3.6% each of the last five years. That raise may not be in the same ballpark as a Starbucks (NASDAQ:SBUX) or Visa (NYSE:V), but the stock currently sports a 4.56% yield. The only stocks we own that have a higher dividend yield are AT&T (NYSE:T) and Verizon (NYSE:VZ). So while the dividend growth isn't super exciting, the current yield certainly is.

FAST Graphs says the current price to earnings ratio is 17.1 and the 5 year average PE is 16.2. This means that shares are currently 5.26% overvalued by this metric. Morningstar says fair value is $48, or 2.36% lower than the 10/7/2016 closing price of $49.16. S&P Capital's 12-month price target is $51, which would offer a potential gain of 3.74%. S&P Capital's fair value is $44.60, which would part shares at 9.28% overvalued. Average these numbers out and I see shares as 3.29% overvalued. With more than 10 years of dividend growth, I am willing to pay a 5% premium to fair value. Any price under $51 or so would qualify Southern Company for purchase. Southern has fallen about 10% from its 52-week high of $54.64. That is a nice pullback if an investor is interested in shares at a reduced price.

American Electric Power Company (NYSE:AEP)

Current Yield

# Years div growth

3 Year Div Growth Rate

3.63%

6

4.7%

S&P Capital 12-month price target

S&P Capital Fair Value

Morningstar Fair Value

$64

$52.70

$61

F.A.S.T Graphs Current PE

F.A.S.T Graphs 5 Year Avg PE

Price Target

16.7

15.4

Under $55

Click to enlarge

American Electric Power provides gas and electric to states such as Michigan, Indiana and Ohio. The company offers a current yield of 3.63% and has raised dividends an average of 4.7% each of the past 5 years. Again, the dividend growth isn't out of this world, but the current yield is very appealing.

According the FAST Graphs, the company currently has a 16.7 price to earnings ratio and a 5-year average ratio of 15.4. By this figure, American Electric is almost 8% overvalued. Morningstar says fair value is $61 or 1.28% below Friday's closing price of $61.79. S&P Capital has a 12-month price target of $64 or 3.58% below current prices. Their fair value of the stock is $52.70, meaning that the stock is 14.71% overvalued. Average these numbers out and I find shares to be 5.05%% overvalued. That being said, the stock is more than 13% off of its 52 week high of $71.32. Utility companies as a group have done well over the past couple of years and are probably due for a pullback. It appears that the pullback is already here for AEP. With just 6 years of dividend growth, I would require the stock to trade at 5% undervalued in order to purchase. Any price under $55 would qualify the company for purchase.

Dominion Resources (NYSE:D)

Current Yield

# Years div growth

5 Year Div Growth Rate

3.92%

13

7.2%

S&P Capital 12-month price target

S&P Capital Fair Value

Morningstar Fair Value

$73

$59.60

$76

F.A.S.T Graphs Current PE

F.A.S.T Graphs 5 Year Avg PE

Price Target

19.3

19.7

Under $75

Click to enlarge

Dominion Resources produces and supplies energy and natural gas to customers in the eastern area of the United States. The utility company has raised dividends for the past 13 years and has rewarded shareholders with an average raise of more than 7% each of the past five years. This is the highest annual raise of the three utility companies discussed in this article. That is pretty solid growth for any company, let alone a utility one. The current yield is just under 4%.

FAST Graphs says the current PE ratio of 19.3 is 2% under the 5-year average of 19.7. Morningstar gives a fair value of $76. That would be good for a 6.29% gain in share price. S&P Capital says their 12-month price target is $73, or 2% undervalued based on Friday's closing price of $71.50. S&P Capital's fair value is $59.60 or 16.64% below the current share price. Average these numbers out and Dominion is over valued by just 1.54%. With more than a decade of dividend increases, I am willing to pay a 5% premium to fair value. Under $75 and Dominion would qualify for purchase. As with the other utility companies discussed, Dominion Resources has pulled back more than 9% from its 52 week high of $78.97. That is a healthy and attractive pullback.

Conclusion

Utilities are the one sector of the economy we don't own. I would like that to change, but only if I can get a utility company at a reasonable valuation. Southern Company , American Electric Power and Dominion have all pulled back from their 52-week high, which could offer a nice entry point. All of these companies offer nice yields as well as decent dividend growth. American Electric is a partially overvalued at the moment, but Dominion and Southern both would qualify for purchase under my investing rules. What utility companies are on your shopping list?

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in D, SO, AEP over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: We are not investment professionals. Please do your own research prior to making an investment decision.