When investors begin to worry about how the economy is likely to perform, especially on the back of negative headlines, they will generally make haste for safe, defensive investments. Among such investments are utility stocks like Duke Energy (DUK), and the rush into such stocks inevitably bids the share price up beyond fair value.
Duke Energy is currently trading in the low-$100 range. Chart generated from FinViz.
Currently, Duke Energy trades at a price of $102.43 per share with a price-to-earnings ratio of 20.10 and a dividend yield of 3.69%. The current P/E is slightly lower than the five-year average P/E of 20.88, but the current dividend yield is a good bit lower than the five-year average dividend yield of 4.22%. Given this somewhat mixed picture, it is essential to establish what fair value for Duke Energy is.
To determine fair value, I will first divide the current P/E by the historical market average of 15 to get a valuation ratio of 1.34 (20.10 / 15 = 1.34) and divide the current share price by this valuation ratio to get a first estimate for fair value of $76.44 (102.43 / 1.34 = 76.44). Then I will divide the current P/E by the five-year average P/E to get a valuation ratio of 0.96 (20.10 / 20.88 = 0.96) and divide the current share price by this valuation ratio to get a second estimate for fair value of $106.70 (102.43 / 0.96 = 106.70).
Next, I will divide the five-year average dividend yield by the current dividend yield to get a valuation ratio of 1.14 (4.22 / 3.69 = 1.14) and divide the current share price by this valuation ratio to get a third estimate for fair value of $89.85 (102.43 / 1.14 = 89.85). Finally, I will average out these three estimates to get a final estimate for fair value of $91.00 (76.44 + 106.70 + 89.85 / 3 = 91.00). On the basis of this estimate, the stock is currently overvalued by 13%.
In the context of the present situation, it is not really a surprise that Duke Energy is trading at a premium valuation. The coronavirus epidemic, with its consequent adverse impact on the Chinese economy and in turn the world economy, has investors looking to safe havens for their money that can generate a decent return. In a world where low interest rates remain the rule, utility stocks are an ideal choice.
The recent coronavirus epidemic has given Duke Energy’s stock a charge in its valuation. Image provided by the Upstate Business Journal.
Utilities are government regulated businesses which are geographically entrenched. The level of government regulation surrounding utilities makes it very difficult for competitors to encroach on existing providers’ turf, as does the expense involved in constructing power plants. This provides utilities with a virtual monopoly within the geographic area they operate in, and leaves customers with the options of either sticking with the existing provider, or making the cost-prohibitive decision to switch their electrical provider. However, customers are protected from price gouging by the same government regulation which makes their existing provider the only viable option.
Duke Energy is no exception to the description outlined in the previous paragraph. Based in Charlotte, North Carolina, it is an electrical utility that serves 7.7 million customers in six states in the southeast and Midwestern United States. It also operates a gas utilities segment which serves 1.6 million customers in five states. The steady profitability of its operations can be gleaned from the revenue and net income figures reported over the past five years.
|Net Income ($)
Figures collated from annual reports and 10-K reports available on Duke Energy’s investor relations page.
The profitability of Duke Energy is attested to by its 22.75% operating margin, and its shareholder-friendliness is attested to by its 8.36% return on equity. Moreover, Duke Energy have rewarded shareholders with dividend payments for 94 years – further underlying its status as a dependable income investment. These payments have been raised annually for the past nine years, and while the payout ratio of 72.96% is quite high, it does not rule out the prospect of further dividend hikes.
Going forward, Duke Energy intends to continue pursuing its $37.5 billion capital expenditure plan which runs into 2023, and is also a 47% partner in the delayed Atlantic Coast Pipeline project – the remaining 53% partner is Dominion Energy (D). In undertaking these plans, Duke Energy’s balance sheet is less ideal than one would like – long-term debt of $56.42 billion offsets a net worth of $47.95 billion, and total current liabilities of $14.75 billion slightly edge out total current assets of $9.16 billion, cash-on-hand worth $311 million, and total accounts receivable of $3.06 billion.
However, in addition to the plans that Duke Energy is immersed in, the capital-intensive nature of the utility business in general must be borne in mind. It costs money to maintain a grid and the relevant infrastructure, so utilities invariably do have high debt loads. Duke Energy’s steady profitability means that it should be able to service its debt payments and meet its other obligations, but it does put a cap on growth – earnings-per-share over the next five years is projected to be only 4.12%. This means that prospective investors require a discount to fair value before parking money here, not a 13% premium.
That Duke Energy is trading at a 13% premium is evidence that a jittery Mr. Market views it as the steady, reliable, income-providing utility investment that it has been and will likely continue to be going forward. However, no investment should be bought at any price, and no utility stock should be bought at a 13% premium – a premium can only be justified in the event that the stock is a high-growth one, and that just is not the case here. Duke Energy, at its current valuation, is a hold but not a buy.
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.