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Why Interest Rates Will Be a Key Indicator for Utilities in 2016

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Jan. 11 2016, Updated 10:47 a.m. ET

Interest rates

US utilities (IDU) had a dismal performance in 2015 in part due to the fear of higher interest rates. The Federal Open Market Committee (or FOMC) raised its short-term interest rates by 25 basis points on December 16, 2015. It will be interesting to see how utilities perform if the Fed implements a series of interest rate hikes this year. Thus, interest rates will be the most important indicator for utilities in 2016.

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Valuation

Currently, Public Service Enterprise Group (PEG) is trading at an EV-to-EBITDA (enterprise value to earnings before interest, tax, depreciation, and amortization) multiple of 6.2x. PEG’s historical average EV-to-EBITDA multiple stands near the same level. PEG’s forward EV-to-EBITDA for fiscal year 2015 stands at 6.9x. This indicates expectations of lower EBITDA in 4Q15. PEG’s EV-to-EBITDA multiple is lower than Xcel Energy’s (XEL) 9.7x while the largest American utility, Duke Energy (DUK), has a ratio of 8.6x. EV-to-EBITDA indicates whether the stock is overvalued or undervalued regardless of capital structure.

Price targets

Wall Street analysts estimate Public Service Enterprise’s one-year price target at $42.1. Currently, it is trading at $38.5 as of January 7, 2016. This is a possible upside of ~7% from the current levels. Of the 20 analysts covering PEG, three recommend it as a “buy” while 15 recommend it as a “hold.” Two analysts are recommending PEG a “sell.”

In comparison, peer Pinnacle West (PNW) has an estimated upside of a mere 2% in the next one year with a price target of $65.3. PNW is currently trading at $64. Large-cap peer Exelon (EXC) has a price target of $33.4 against its current price of $28. This comes to a possible robust upside of 19.5% in the next one-year period.

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