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Are Utilities Ripe for Correction after Their Epic Ascent?

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Duke Energy: Market performance

Duke Energy (DUK) has been able to gain nearly 10% so far this year. Utilities gained ~10%, rallying on the soft approach of the Federal Reserve over interest rate hikes and better 4Q15 earnings. NextEra Energy (NEE) has risen by ~12% since the beginning of 2016.

The recent climb of utilities resulted in relatively less attractive return potential from them despite their strong fundamentals and growth prospects. The chart below shows Duke Energy’s normalized stock price movement compared to the Utilities Select Sector SPDR ETF (XLU) as well as the broader equities (SPY).

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Valuation

The valuations of almost all the utilities surged last quarter due to their sharp ascent. Currently, Duke Energy (DUK) is trading at an EV-to-EBITDA multiple of 10.1x. Its five-year historical average EV-to-EBITDA[1. enterprise value to earnings before interest, tax, depreciation, and amortization] multiple stands at 10.4x. The industry average is at the same levels of ~10.4x. The EV-to-EBITDA multiple is a valuation metric used to indicate whether a stock is overvalued or undervalued, regardless of capital structure.

By comparison, Southern Company (SO) has a multiple at 10.5x while NextEra Energy’s (NEE) multiple is slightly on the higher side at 10.7x. American Electric Power (AEP) has a multiple lower than these peers at 9.5x. Edison International (EIX) has a ratio at 8x.

Duke Energy’s (DUK) forward EV-to-EBITDA multiple is around 9.7x. The fact that its forward multiple is lower than its current multiple indicates expectations of a higher EBITDA in 2016. Almost all the utilities (PUI) have lower forward EV-to-EBITDA multiples than their current multiples. This suggests expectations of better earnings this year.

In the final part of this series, we’ll look at analysts’ recommendations for Duke Energy ahead of its 1Q16 earnings release.

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