Are Utility Stocks Priced for Perfection?

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Utilities are the classic “widow-and-orphan” stocks—meaning they are slow and steady providers of dependable income.  While earnings per share growth isn’t going to take anyone’s breath away, utilities operate in a highly regulated industry and thus aren’t likely to collapse.  These companies provide electricity, and are therefore critical to the prosperity and security of the nation.  Even in a dire economy, utilities provide investors the certainty of reliable earnings and dividends.  Lately, these stocks have been anything but slow and steady.  Many stocks in the sector have enjoyed huge run-ups in price over the last few years.  Therefore, the question posed to investors now is, are these utility stocks still good investments?  Or, conversely, are they priced for perfection and too risky to buy?

The Cost of Peace of Mind

As previously mentioned, utility stocks help investors sleep at night.  Investors don’t need to worry if these stocks will keep pumping out quarterly dividends.  The cost of this, however, is extremely slow growth.  Utilities can offer investors moderate earnings per share and dividend growth as a result of the occasional rate increases they are able to pass on to consumers, and that’s about it.  Utility stocks such as Southern Corporation (NYSE: SO), Duke Energy (NYSE: DUK) and Consolidated Edison (NYSE: ED) pass on annual dividend increases in the low to mid-single digit range.  In fact, five-year compound annual growth in dividends for Southern, Duke Energy, and Consolidated Edison is 3.98%, 3%, and 0.8%, respectively.

A few years ago, the lack of strong dividend growth wasn’t a deterrent to investing in utilities because these stocks offered huge yields for new investors.  In February 2010, ConEd was yielding north of 5.5%.  In just three years, its shares have climbed more than 50 percent.  The stock’s slow dividend growth meant the yield didn’t keep up, and with shares trading as high as $65, the stock was yielding less than 4 percent.

Southern Corporation finds itself in a similar position.  While Southern has passed on decent dividend increases in the mid-single digits, thereby keeping the yield comfortably above 4 percent, its shares are trading at a trailing price-to-earnings ratio of 17.  The S&P 500 price-to-earnings ratio sits at 15, according to Morningstar.  Investors should be wary of the prospect of buying a stock for a greater multiple and lower growth than the market.

The same caution should be applied to Duke Energy: the company has seen its market value surpass $46 billion and its trailing P/E ratio exceed 20.  Duke was trading in the low $50’s two years ago, and then began an uninterrupted 30% rise to $70 before settling back to its current level of $66.  Its price-to-earnings growth (PEG) ratio is over 5, meaning investors are currently paying a high price for very little earnings growth.

The Bottom Line

In a zero-interest rate investing environment, it’s understandable that investors would pile into stocks with high dividend yields.  Utility stocks offer the combination of reliable earnings and regular dividend payments.  But even profitable companies can be poor investments if an investor pays too high a price for those earnings and dividends.  Prospective buyers would be wise to wait for a more attractive entry point (and higher yield) before jumping in to any of these three utility stocks.

rciura has no position in any stocks mentioned. The Motley Fool recommends Southern Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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