How Are Merchant Stocks Valued?
On January 11, 2017, NRG Energy (NRG) was trading at an EV-to-EBITDA (enterprise value to earnings before interest, tax, depreciation, and amortization) valuation multiple of 9x. The average multiple of US merchant power utilities stands just above 8x. NRG’s five-year historical average EV-to-EBITDA ratio comes to 11x.
By comparison, Dynegy (DYN) is trading at a valuation multiple of 11x while Calpine (CPN) is at 10x. Merchant power stocks seem to be trading at a relatively fairer valuation compared to broader utilities (XLU), which are trading at an average multiple of 10.5x. Their downward stock movement in 2H16 might have resulted in a comparatively discounted valuation.
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The EV-to-EBITDA ratio indicates whether a stock is undervalued or overvalued, regardless of the capital structure of the company. EV (enterprise value) is the combination of a company’s debt and market capitalization minus its cash holdings.
Broader utilities like NextEra Energy (NEE) or Southern Company (SO) are currently trading at an EV-to-EBITDA valuation multiple of 12x. Most utilities continued to trade at elevated valuations throughout last year.
Merchant stocks may appear at attractive pricing compared to broader utilities. However, the latter tend to offer a much better risk and reward proposition compared to the prior despite being pricey. Investors should note that merchant stocks could be tremendously volatile, which may lead to capital erosion. On the other hand, utilities, at large, have stable stock movements along with stable dividend income.
Read Which utility pays the highest dividends? for more information.