“Electric utility stocks are overstretched.” That’s the way Wall Streeters talk. They mean, “Electric utility stock prices are too high,” which is a polite way of saying that they will go down. Too high compared to what?
Investors measure stock value in comparison to other stock groups, earnings, interest rates, and the stock's market value versus the underlying value of corporate assets. They also look at expected total return: the current dividend rate plus the stock's expected earnings growth rate.
A stock investor's goal, simply stated, is to exceed the return of low risk bonds. In the U.S. low risk bonds typically refers to U.S. Treasuries. The total return here is simply the interest payments expressed as the yield or coupon rate. In our current era of zero to negative interest rates, yield hungry investors have been forced to "reach" for dividend return. This is largely because alternative sources of typical low risk income, like bank CDs, yield almost nothing. (People like that pay more than they should for a stock. Anything seems better than nothing.)
With one year bank CDs offering 0.05 percent versus a typical utility dividend yield of 4 percent, the difference or "spread" is 3.95 percent. That suggests a lot incentive or investor enthusiasm that often leads to price or valuation excesses.
Investors also compare utility dividend yields with 10 year U.S. Treasury bond yields. As low risk/low growth equities, utility stocks should yield somewhat more than bonds. But again, at what "spread'? The U.S. ten year bond yields slightly better than 1.5 percent versus a typical utility yield of 4 percent. That substantial 2.5 percent positive yield spread also induces investors to look at solidly investment grade electric utility securities. Which is why the two yields tend to move in the same direction.
In equity or stock investing there's often a tradeoff. You the investor can have growth or income but not usually at the same time (in the same stock). Investors accept a higher dividend yield while they forego the earnings growth that owning other stocks would provide. Related: Can The Natural Gas Rally Continue?
As seen in Figure 1, utility dividend yields and U.S. bond yields have declined. But utility dividend yields have not declined by as much. A widening of the spread so to speak suggesting valuations are not excessive. However, this does not necessarily imply that electric utility stock investors are getting a better relative return. If the growth component of these stock's total return is getting smaller, as we suspect, valuations can still be quite rich. More on that later.
Figure 1. Baa bond yield vs dividend yield on EEI Index stocks (year-end unless otherwise noted)
Most investors value stocks using the price/earnings ratio. As interest rates fall, utility investors tend to capitalize stocks at higher and higher multiples of earnings. But what constitutes earnings? Over the past decades U.S. electric utilities have reported an uneven stream of net income. Not because the main electric business is unstable, but because of a long record of bad acquisitions and investments with subsequent 'hits" (write downs of earnings) in eight of the fifteen years 2001 to 2015 - about half the time.
Each write down is a one-off event. But these events now occur regularly like the 100 year flood now occurring every other year. Each write off indicates that earnings in previous years have been overstated. Among other things, the company's management did not correctly assess depreciation and amortization of assets. In brief, stuff they thought was going to last a long time didn't.
On the basis of reported earnings, the industry earned a 9 percent return on equity, but excluding extraordinary items it earned 11 percent. Investors, we suspect, look to the future and assume that managers will not repeat the old mistakes, so they pay attention to adjusted earnings that exclude all those pesky “nonrecurring” items. Reported earnings in 2015 (and therefore in the most recent trailing 12 month reports) included some horrific write offs, making the price/earnings ratio look stratospheric. Taking out those items brings the ratio down from nosebleed levels, but still closer to the higher than lower end of the range, as seen in figure 2.
Figure 2. Reported and adjusted price/earnings ratios (year end except when noted otherwise)
Note: Ratios calculated for EEI sample of utilities. 2002 reported CP/E is negative due to loss.
As a final check, we should examine the ratio of stock price to underlying book value, because the regulator sets a return on book value or some number close to it. Theory says that a stock should sell close to book value when the company earns a return close to cost of capital. When return earned exceeds that benchmark, stock price exceeds book value. The differential between bond yields (“risk free” return) and return on equity provides a rough estimate of the equity risk premium, and the higher the number the better the return relative to capital costs. As seen in figure 3, both the market/book ratio and the equity risk premium are at high levels, but not unusually so.
Figure 3. Market/book ratio and equity risk premium (end of year except when noted otherwise)
According to studies made by the legendary Peter Bernstein, stock investors over the centuries earn roughly 2.5-5 percentage points more than bond yields. So let’s approximate total return expected by electricity equity investors at 3.5 percentage points above the Baa bond yield. (For example, if bonds yield 5 percent, and the company grows at 4 percent, equity investors will price stocks to produce a dividend yield of 4.5 percent, because the 4.5 percent yield plus the 4 percent growth will produce the required 8.5 percent total return. Related: The Oil Price Relief Rally Has Begun
We know that the electric industry earned a reported 9 percent return on equity in the past 15 years and paid 70 percent of those earnings in dividends, leaving enough retained earnings to finance an almost 3 percent per year growth rate. Based on adjusted earnings, the industry earned 11 percent on equity and paid roughly 60 percent of that in dividends, meaning it could finance almost a 5 percent growth rate from retained earnings. In the fifteen years, both reported and adjusted earnings grew roughly 4 percent per year, so that might be a good number to use for investor expectations of growth. As table 1 shows, adding 3.5 percentage points to bond yield and then subtracting out the dividend produces a growth rate expectation of roughly 4 percent. In other words, prices seem roughly where they should be based on current circumstances.
Table 1. Growth expectations
Electric utility stocks sell at historically high price/earnings ratios and at historically high relationships to U.S. industrial stocks. This may be irrelevant if the electric group’s profitability has changed dramatically for the better. But it has not. The industry's stock price averages trade at levels suggesting that earnings will continue as before. Industry sales have been declining. Outsiders have begun to nibble away at the very integrity of the franchise. Going "off grid" may be initially expensive but it's no longer impossible.
Regulators could also narrow the current big gap between the utility stock return allowed and their underlying cost of capital. How many companies in these somewhat challenged circumstances can maintain current, seemingly high market valuations? Wall Streeter analysts tend to focus somewhat mechanically on current stock pricing ratios. They might do better to reconsider overoptimistic earnings and growth expectations. When? We are not soothsayers. But when they do, watch out.
by Leonard S. Hyman and William I. Tilles for Oilprice.com
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