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Edited By Marianna Avilkina

Duke Energy Corporation (NYSE:DUK) is the largest regulated utility corporation in the United States. Over the last 150 years, the company has been providing electric power services and gas distribution, as well as renewable energy solutions. In July 2012, Duke Energy undertook a controversial merger with electricity and natural gas generator Progress Energy Inc (OTC:PREX). This merger created the largest electric utility company in the United States.

As of September 25, 2012, DUK stock was trading at around $65, with a 52-week range of $57.51 - $71.13. It has a market cap of about $45 billion. The trailing twelve-month P/E ratio of 19.2 is far above the forward P/E ratio of 14.6. P/B, P/S, and P/CF ratios stand at 2.0, 2.0, and 7.3, respectively. The operating margin is 17.6% while the net profit margin is 10.3%. The company has a reasonable debt load, with a debt/equity ratio of 0.8 that is well below the market average.

(click to enlarge)DUK Chart

DUK data by YCharts

Duke Energy pays solid dividends. The trailing yield is 4.66%, whereas the forward one is 4.73%. Upcoming dividends are expected to amount to $.765 per share. Over the last five years, the company has gradually increased its dividend amount by 16%. The five-year dividend history suggests that DUK is a dividend-growth company, as well as a stable dividend payer.

The utility has a 2-star rating from Morningstar. Out of three analysts covering the company, two have a "hold" rating, and the other one indicated an "underperform" rating. This is a good reason to suppose that Wall Street holds both neutral and negative opinions on the company's future. The average five-year annualized growth forecast estimate is 4.2%. What is the fair value of Duke Energy given the forecast estimates? We can determine the company's fair value using the 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 intimidating 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 = ($3.36 + $4.43) / 2 = $3.90

Wall Street holds both neutral and negative 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 $50.72. The rest is as follows:

Fair Value Estimator

V (t=0)

E0

$3.90

V (t=1)

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

$3.66

V (t=2)

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

$3.43

V (t=3)

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

$3.22

V (t=4)

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

$3.02

V (t=5)

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

$2.84

Disposal Value

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

$25.81

Book Value

BV

$50.27

Fair Value Range

Lower Boundary

$46

Upper Boundary

$96

Minimum Potential

-29%

Maximum Potential

49%

(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 DUK is between $46 and $96 per share. At a price of about $65, Duke Energy is trading at a price within its fair value range. The stock still has up to 49% upside potential to reach its fair value maximum.

Peer Performance

Duke's recent merger gives it an advantage in production scale over its rivals. Its closest industry competitors are Southern Co. (NYSE:SO) and SCANA Corp (NYSE:SCG). As my model suggests, both Southern and SCANA are also trading at a price of their fair value range.

In contrast to Southern, with a relatively lower debt/equity rate, Duke Energy follows a rather reasonable debt philosophy. However, a significant chunk of Duke's debts arose from investing in assets to replace environmentally harmful power plants. Southern looks to be twice as efficient as Duke, when comparing profits generated with the money invested by shareholders. Duke and Southern both provide strong dividend yields. Nevertheless, Duke Energy has a better economic outlook in terms of dividend policy and safe investment.

Duke Energy Company

Southern

SCANA

Trailing P/E

19.24

18.48

16.18

Forward P/E

14.59

16.25

14.67

Yield

4.71

4.25

4.07

Debt/Equity

0.8

1.1

1.2

Return on Equity

6.7

12.4

10.1

Duke's other noteworthy competitor, SCANA Corp, also has been offering a strong dividend yield over the last five years, but it is far below that of Duke's. In contrast to SCG, DUK has a better economic outlook in terms of dividend policy and safe investments. In addition to Duke's recent merger, its ambitious transition to gas and nuclear power seems likely to ensure that the company will stay ahead of its peers for the foreseeable future.

Current Economic Outlook

As the Environmental Protection Agency's pollution regulations put pressure on the energy industry, DUK is switching from its reliance on conventional coal and oil dependent power plants to combined cycle natural gas plants and lower carbon electricity generation. The switch from coal to gas is made more attractive by the cheap availability of unconventional gas. Nuclear and coal-based energy sources comprised approximately 88% of the company's power generation last year. However, this will have to change due to the stricter new restrictions. DUK has plans to retire 5,400MW of older coal plants by 2015, including 3,620MW in the Carolinas.

Duke has invested approximately $7 billion in four key fleet modernization projects with approximately 2,700MW. The company's 620MW Eden plant is expected to begin operations by the end of this year. That power plant alone will replace three of the retired coal plants. Post merger, Duke has decided to focus on energy efficiency programs, which will more than double the potential customer savings in the next decade. The company's collaboration with Cisco also aims to reduce energy consumption by 20% until 2016.

Summary

Duke Energy is a strong company with its sights firmly set toward the future. The company has the ability to finance its debt while ensuring growth in the energy market. Duke Energy is taking full advantage of its transition towards gas and nuclear power plants by ensuring optimal efficiency.

Based on my FED+ valuation, Duke Energy is clearly trading within its fair valuation range. Higher efficiency will promote higher margins for this energy giant. Duke Energy's ambitious plans have positioned the company to lead the industry in the coming years.

Source: Duke Energy: Primed For A Leap