Utilities are trading at a premium
To be sure, US utilities continued to trade higher throughout 2016, despite some severe corrections, and many investors appear to have stuck with utilities strictly due to attractive yields. But how are these stocks valued at the beginning of 2017?
Overall, US utilities are currently trading at an EV-to-EBITDA (enterprise value to earnings before interest, tax, depreciation, and amortization) of multiple ~10.5x, while they have historically traded at a ratio of between 8x and 9x. The stock rally in 2016 may have been the reason why major US utilities are still fairly expensive.
The EV-to-EBITDA ratio indicates whether the stock is undervalued or overvalued, regardless of its capital structure. Remember, enterprise value refers to the combination of a company’s debt and equity, minus its cash holdings. For this calculation, we’re considering EBITDA for the trailing 12-months.
NextEra Energy (NEE), one of the largest utilities by market capitalization, is trading at an EV-to-EBITDA multiple of 11.5x. Its five-year historical average stands at 11x. NextEra stock continued to trade at the elevated levels throughout 2016. Notably, the valuation multiple of Californian utility giant Sempra Energy (SRE) stands at ~15.5x.
Hybrid utilities such as Exelon (EXC) and FirstEnergy (FE), or even merchant power stocks like NRG Energy (NRG), might appear fairly priced compared to their historical averages. However, their volatile earnings are likely to result in increased volatility in stock movement. From an investor’s perspective, these can be riskier bets than regulated utilities.
US utilities (XLU) have traded at a five-year historical average PE (price-to-earnings) multiple of 15x–17x. But as of December 30, 2016, they were ~19x–20x, trading at fair premiums to their historical averages.
Now let’s discuss US utilities’ yields going forward.