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Higher Interest Rates Could Be Detrimental to Utilities

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Market performance

Shares of American Electric Power (AEP) ended the day with a gain of 2% after the company reported quarterly earnings on January 28. Utilities had a dismal performance in 2015 and corrected 8% on average throughout the year. Investors dumped utilities in 2015, fearing that interest rates would soon go up. American Electric Power corrected by 2% during the year.

The above chart displays the stock price movement of American Electric Power (AEP), Southern Company (SO), and the Utilities SPDR ETF (XLU).

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Valuation

American Electric Power is currently trading at an EV-to-EBITDA (enterprise value to earnings before interest, tax, depreciation, and amortization) multiple of 8.7x. Its average five-year EV-to-EBITDA stands at the same level. The utility sector’s (VPU) average EV-to-EBITDA is 9.9x. Southern Company (SO) has a ratio of 10.3x while Pinnacle West Capital (PNW) comes in at 8x.

The EV-to-EBITDA multiple is a valuation metric that indicates whether a stock is overvalued or undervalued, regardless of the company’s capital structure.

Interest rates

American Electric Power’s $15 billion capital spending plan for the next five years may increase its debt levels. It had a total debt of $20 billion on December 31, 2015.

Over the past five years, utilities (XLU) have significantly increased their leverage. In fact, this is one of the industries that benefitted from near-zero interest rates. The recent hike of 25 basis points may not have such a huge impact on their performances. The sector continues to be attractive due to the expected slow pace of interest rate hikes.

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