Why Utility Stocks’ Upside Looks Capped from Here

While the S&P 500 has fallen more than 5% from its peak last month, utility stocks have continued to make all-time highs. So far this year, the Utilities Select Sector SPDR ETF (XLU) has surged more than 18%, outperforming equities at large.

This year, investors keep turning to these bond proxies amid broader market volatility fueled by trade disputes. However, the scenario has largely made utility stocks too expensive. Concerns are growing about whether these defensives will serve their purpose at such record valuations.

Why Utility Stocks’ Upside Looks Capped from Here

Utility stocks look overvalued

NextEra Energy (NEE), the biggest of all utilities by market cap, is trading at 25 times its estimated earnings for the next 12 months. In historical terms, NextEra Energy’s average valuation comes in at around 20x. Thus, the stock seems to have come a long way from a historical valuation standpoint.

NextEra Energy stock has indeed had a great run in the last few years. Its superior earnings and dividend growth largely influenced its market performance in the period. It’s up about 30% so far this year.

Broader utilities are trading at an average forward PE valuation of 19x, which makes NextEra Energy stock way too expensive. It’s XLU’s biggest constituent with a weight of around 13%.

Southern Company

Top-rallying stock Southern Company (SO) also looks to be trading at a premium valuation. The stock is up more than 30% this year and is trading at a valuation of 19x. Its five-year average PE is around 17x. Southern Company’s Vogtle-related developments have impressed investors this year. Its superior dividend yield could also have attracted investors amid increasing trade tensions. Southern Company stock makes up 7.2% of XLU.

XLU, the representative of the biggest utility stocks in the country, currently offers a dividend yield of 3%, higher than the broader markets and the benchmark Treasury yields.

Although utilities offer premium yields, it doesn’t justify their premium valuation. Many of these utilities have been paying stable dividends for decades, but paying close to 20 times for earnings growth of around 4% seems unwarranted. Utilities have been trading at bloated valuations for months. In comparison, broader markets on average are growing at much higher rates—around 17 times their forward earnings.

Utilities are perceived as relatively safe because they focus on domestic operations, which aren’t related to economic cycles. Their stable operations usually enable stable earnings and regular dividends.

The second-biggest utility stock by market cap, Duke Energy (DUK), is up about a mere 6% YTD (year-to-date). It’s currently trading at 18 times its forward earnings, marginally higher than its five-year historical average valuation. Duke Energy stock reported a new 52-week high last week. The utility has grown around 4% per year in the last few years and is expected to continue to grow at similar levels. Thus, the stock seems to be trading at an unattractive valuation.

The only bright spot

The only stock among the top utilities that looks to be trading at a discount is Dominion Energy (D). It’s currently trading at around 18 times its forward earnings compared to its five-year historical average of 23x.

Dominion Energy has significantly underperformed its peers in the last few years. However, contributions from Cove Point and SCANA will likely nab Dominion Energy higher earnings growth than its peers in the next few years. It yields close to 5%, higher than the above-mentioned players. Thus, Dominion Energy stock looks attractive among top utilities.

To learn more about the dividend profiles of these utilities, read Finding the Top Dividend Stock among Utilities.

Why utility stocks look attractive

Despite utilities’ concerning valuations, many factors support them. Trade tensions between the US and China could fuel the unrest in the broader markets. Similar uncertainty has driven defensives this year. Lower interest rates could also boost bond substitutes.

According to CME Group’s FedWatch tool, traders expect almost 100% probability of a quarter-point rate cut at the Fed’s September meeting. Utility stocks generally trade inversely to interest rates. Moreover, the yield curve’s inversion has already spurred recession fears in the broader markets. Defensives could continue to see inflows amid growing worries. Thus, utilities continue to look attractive from a dividend perspective, but their upside might be capped in the short to medium term.