I mentioned in class recently that utility stocks are in some respects like bonds. Which prompted the question, do you value them like bonds then? No. Utility shares are still equities and must be valued as such, but they are on one end of a spectrum that makes bonds a useful point of reference.
A stereotypical utility is a monopoly company with steady, regulated profits. It is low risk (no competitors, little risk of technological obsolesence, low cyclicality), low growth (in mature economies the demand for electricity and water doesn’t grow much, but neither does it fall in recessions) and for much of the time doesn’t require much investment (in mature economic regions at least, the assets last a long time and capacity growth is small). So a company like this would have high leverage and a high payout ratio (low retention of profits for re-investment). It would offer investors a steady but low return, mainly delivered through the dividend yield. It still has equity risk but a pure utility would have a very low beta (0.6 is quite possible for a pure electricity transmission company).
So on the scale of investments from bonds to equities, utilities are quite close to bonds. Historically, US electricity stocks (there are relatively few water companies in the US) were valued on their dividend yields and the sector yield moved broadly in line with municipal bond yields. The utility dividend yield was lower, because there is some growth in utilities, unlike bonds, so some of the total return comes from share price rises. These stocks appealed to income investors and to the “widows and orphans” who seek very low risk.
But not all “utilities” are like this story. Many European utilities have some areas of growth potential, and require more investment. The growth may be from unregulated earnings, which are more risky. The investment, in replacing ageing plant and in expansion, limits their leverage. And there is some regulatory and political risk – just look at the impact on German utilities of the government’s decisions to close their nuclear plants early, then extend their lives, then close them early again. Also, the huge growth in low carbon energy investment needed across Europe creates more opportunity for growth than in most of the US.
And the risk, even for traditional US utilities, is never zero. Historically US utilities have faced some severe risks from their flawed investments in nuclear power, including regulators’ refusal to compensate them for cost over-runs, which on occasions has bankrupted them.
In the UK, only the true natural monopoly businesses (transmission and distribution of electricity and gas, water and sewerage services) are regulated. Profits from these activities are very low risk indeed because there is a legal burden on the regulators to ensure that the utilities can finance their activities. So unless they recklessly over-leverage, this part of the business can be regarded as not far off an index linked government bond (index linked because in the UK regulated prices are linked to the retail price index). They obviously have a bit more credit risk than the government. So I once tried to value UK utilities by splitting their value into a safe part, priced off index linked gilts, and an equity part, priced more conventionally on P/E and DCF and benchmarked against non-utility businesses. I didn’t get very far in practice but I think the idea is sound in principle.
With government bond yields now very low for countries regarded as credit worthy but probably stuck with low growth (US, UK) I suspect that the pure utility returns are under-valued. Infrastructure funds are reportedly still looking for 10-14% returns, even for safe investments with no construction risk. Such returns are very high for the world we now live in. It’s not surprising that Li Ka Shing has been buying British utility assets so enthusiastically.
Interesting post – too bad it didn’t work in practice.
While generation assets, should certainly be DCFed, I’m not sure if it is wise to value utility stocks like a bond.
Best to use points of exception to elaborate – Not all energy suppliers are monopolies in G7 countries. Competition rules in the UK allow new entrants to take on the big 6. These companies have revenue growth projections based on customer acquisition (e.g. Ovo Energy, Good Energy, Spark Energy e.t.c).
DCF analysis on a company like Ovo using public company comparables for the beta would give a very low cost of capital, and potentially push the valuation into the bns. It wouldn’t be clear what premia needs to be tagged onto the (Risk Free + Beta x Mkt Risk Premium) to deal with the stage that it is at in it’s life cycle. Current valuation for Ovo (at £200m) suggests a cost of capital so high that CAPM becomes almost irrelevant.
I’m not sure if anyone can credibly put forward a valuation without reference to a comp .