NextEra's Valuation Is A Bit Too Rich
Summary
- NextEra is an undisputed leader in utility-scale clean energy.
- The stock's valuation is closer to a big tech firm than a utility.
- The Wall Street analysts are bullish.
- The options market is sending a modestly bearish signal.
- The current stock price is too high for me to be bullish.
Utilities are increasingly seen as a way to participate in clean energy in addition to their more traditional lines of business. NextEra Energy (NYSE:NEE) is a leader among utilities in building out clean energy assets, claiming to be the world’s largest producer of wind and solar energy.
Source: NextEra Energy, Inc.
NEE has been growing its clean energy business line for a long time (including back when it was called Florida Power and Light) and the market has valued these efforts at a premium. The trailing total returns for NEE make it very clear that this is not your garden-variety utility. The fifteen-year annualized total return for NEE, for example, is 14.97%, as compared to 1.96% for the electric utilities sector and 10.06% for the U.S. equity market as a whole.
Trailing total returns for NEE, utilities sector, and total U.S. stock market (Source: Morningstar)
There is something a bit unnerving when a large utility has forward P/E comparable to a large tech firm. As I write this, NEE has a forward P/E of 29.25 and Alphabet (GOOG) (GOOGL) has a forward P/E of 29.46. Even though the market is getting more comfortable with relatively high valuations for utilities, NEE still looks unusually expensive. Seeking Alpha’s quantitative value grade for NEE is an F. It is also notable, however, that NEE has the highest grade among its peers for growth and momentum.
Seeking Alpha Quantitative Factor Grades for NEE and peers (Source: Seeking Alpha)
Wall Street Analyst Consensus Outlook
The view of the Wall Street analysts who follow NEE is consistently bullish, with a twelve-month price target of $91, almost 19% above the current price. Even the lowest analyst price target is slightly above the current price. Remarkably, the most optimistic of the analysts has a price target of $100, more than 30% above the current price.
Wall Street analyst consensus rating and twelve-month price target (Source: eTrade)
The Wall Street consensus constructed by Seeking Alpha has a slightly lower price target of $89.06, but this is still 16% above the current price. Among the twenty Wall Street analysts in Seeking Alpha’s sample, none are bearish or very bearish and thirteen are either bullish or very bullish.
Wall Street analyst consensus rating and price target (Source: Seeking Alpha)
Outlook from the Options Market
Another way to generate an outlook for a stock is to analyze the prices at which options on the stock are trading. The market prices of options provide information about traders’ consensus outlook on the probability of the price going above a certain level (call options) or below a certain level (put options) over some period of time (from today until the expiration date of the options). By aggregating market prices of call and put options with the same expiration date but different payouts (different strike prices), it is possible to employ a mathematical model to calculate the implied probability of all possible future returns.
This strategy is well-established in institutional finance. For some background, see the Minneapolis Fed’s web pages on their implementation. For a review of the literature on how options prices are useful in generating outlooks in general and with examples using my version of this approach, see this presentation.
The option-implied probabilities of expected price returns are charted as a probability distribution. When I chart the option-implied probability distribution for future return, I rotate the negative side of the distribution about the vertical axis so that the relative probabilities of positive and negative returns are easier to see.
The price outlooks derived from options prices are probabilistic rather than a specific forecast of the future price. The options prices may indicate increased or decreased likelihood of gains or losses and this provides insight into the prevailing beliefs of those buying and selling options.
I have analyzed the option expiring on January 21, 2022, to create the option-implied price return outlook from today until that date.
Option-implied price return probabilities to January 21, 2022
The option-implied price return outlook from now until January 21, 2022, is bearish, with the single most-probable price return equal to -9.4%. The probability of a negative price return is higher than that of positive price return of the same magnitude for all but the most extreme returns (the red dashed line is above the blue solid line from 0% to 40% on the horizontal axis). The annualized volatility derived from this distribution is 31.5%.
Percentiles of option-implied price return probabilities to January 21, 2022
It is also useful to look at the results on a percentile chart. The 55th percentile is the crossover point between positive and negative returns, so there is a 55% chance of having a price return less than or equal to zero between now and January 21, 2022. It is more likely that the price return will be negative than positive.
The options market is somewhat bearish on the outlook for NEE over the next 10.7 months (between now and January 21, 2022).
In a recent analysis of Southern Company (SO), I found that it was possible to sell a January 21, 2022 covered call and generate a total income of 9.2% over the next year or so (call option premium plus dividend), in addition to retaining 3.8% of potential price appreciation. The annualized volatility derived from these options was 26%. Investors who are interested in NEE are probably looking for more price appreciation potential than they might expect from a more traditional utility like SO, so let’s analyze selling a call option on NEE expiring on January 21, 2022, with an $85 strike price.
The current bid price for this option is $4.80, which provides 6.3% in income at the current price. Combined with the 2.1% dividend yield, and the covered call strategy will provide about 8.4% in total income over the next year, in addition to providing about 11% of potential price appreciation. If the Wall Street analysts are right, and the stock price goes up 16% or more, you end up with the 11% in price appreciation plus the 8.4% in income, for a total of 19.4% in total return. If the option-implied outlook is correct and stock price declines, you have the 8.4% in income to offset any decline in price.
Summary
NextEra is a leader in building out utility-scale clean energy production and is positioned to continue in this role. The market has recognized NEE’s innovation at scale for years, however, so the stock valuation is already quite high. The Wall Street analysts are bullish, with price targets that imply 16-19% price return, in addition to the 2.1% dividend yield. The options-implied outlook for NEE between now and early 2022 is moderately bearish, with a most-probable price return of -9.4%, albeit with a wide distribution about this value.
The options-implied distribution suggests that a price return less than zero is more likely than a price return greater than zero for this period. The volatility in the option-implied outlook for NEE, at 31%, is quite low. Considering the rich valuation and the contrast between the analyst outlook (bullish) and the option-implied outlook (moderately bearish), my final rating is neutral even though I greatly admire the company. Investing in NEE with a covered call strategy looks like an attractive compromise position.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.
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