Capital Investment Drives Utilities' Growth, but Valuations Are Rich

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Morningstar, Inc.

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Thematic (Sector/Industry)

United states Utilities / Thematic (Sector/Industry)

<div class="content-highlight"><h2>Growth is hip, but valuations are a drag.</h2></div><hr><h2>Utilities Fundamentally Attractive, but Valuations Still Rich</h2><p>Halfway through 2019, utilities continue to impress with good growth prospects, secure dividends, and sound balance sheets. That's good for investors, who could realize 5%-7% annual dividend and earnings growth from many high-quality utilities with narrow moats and 3% yields.</p><p>But those strong fundamentals come at a high price. U.S. utilities in our coverage universe trade at a 14% premium to our fair value estimates on a median basis as of mid-June. That means investors' long-term capital gains are at risk even if utilities make good on their earnings and dividend growth potential.</p><p>Utilities' rich valuations also lessen their attractiveness as defensive investments in a market downturn. During the last two major U.S. bear markets—2007-09 and 2000-02—utilities' valuations going into the downturn had a big impact on the sector's outperformance relative to the market.</p><p>Investors should be selective as they pick utilities in this market, focusing on those with the best growth plans or cheap relative valuations to offset a valuation pullback we think is coming.</p><hr><h2>Key Takeaways</h2><ul>
<li>Utilities' long-term growth opportunities are abundant based on our discussions with utilities executives at the recent American Gas Association Financial Forum. We think renewable energy and distribution growth projects are the most attractive. Our May 20 report, <a href="https://www.smartkarma.com/insights/capital-investment-drives-utilities-growth-but-valuations-are-rich" target="_blank" data-smartkarma-citation="insights:29917">Capital Investment Drives Utilities' Growth, but Valuations Are Rich</a>, has more detail on utilities' growth plans.</li>
<li>Utilities are 14% overvalued as of mid-June based on our fair value estimates, the richest they have been since 2017. Regulated utilities are particularly expensive with median 22 P/E and 2.1 P/B—both multi-decade highs.</li>
<li>Utilities with large, attractive investment plans include <a href="https://www.smartkarma.com/entities/nextera-energy-inc" target="_blank" data-smartkarma-citation="entities:7402:1">Nextera Energy (NEE US)</a>, <a href="https://www.smartkarma.com/entities/edison-international" target="_blank" data-smartkarma-citation="entities:16455:1">Edison International (EIX US)</a>, <a href="https://www.smartkarma.com/entities/dominion-energy-inc" target="_blank" data-smartkarma-citation="entities:5937:1">Dominion Energy Inc (D US)</a>, <a href="https://www.smartkarma.com/entities/xcel-energy-inc" target="_blank" data-smartkarma-citation="entities:6402:1">Xcel Energy Inc (XEL US)</a>, <a href="https://www.smartkarma.com/entities/new-jersey-resources-corp" target="_blank" data-smartkarma-citation="entities:19030:1">New Jersey Resources (NJR US)</a>, <a href="https://www.smartkarma.com/entities/cms-energy-corp" target="_blank" data-smartkarma-citation="entities:3143:1">Cms Energy Corp (CMS US)</a>, <a href="https://www.smartkarma.com/entities/sempra-energy" target="_blank" data-smartkarma-citation="entities:1796:1">Sempra Energy (SRE US)</a>, and <a href="https://www.smartkarma.com/entities/atmos-energy-corp" target="_blank" data-smartkarma-citation="entities:13170:1">Atmos Energy (ATO US)</a>. Although many of these are expensive, their growth should cushion returns if valuations compress.</li>
<li>Utilities' rich valuations limit their defensiveness. Utilities entered the 2007-09 bear market with a 19 P/E and outperformed the S&amp;P 500 by 11 percentage points, their worst bear-market performance in 35 years. Bear-market returns improved when utilities had more modest valuations.</li>
<li>Although utilities look rich on absolute valuation measures, the sector's 3.4% average dividend yield remains attractive relative to the 2.1% 10-year U.S. Treasury yield. Historically, utilities have outperformed bonds when their dividend yields are this much higher than interest rates.</li>
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Growth is hip, but valuations are a drag.Utilities Fundamentally Attractive, but Valuations Still RichHalfway through 2019, utilities continue to impress with good growth prospects, secure dividends, and sound balance sheets. That's good for investors, who could realize 5%-7% annual dividend and earnings growth from many high-quality utilities with narrow moats and 3% yields.But those strong fundamentals come at a high price. U.S. utilities in our coverage universe trade at a 14% premium to our fair value estimates on a median basis as of mid-June. That means investors' long-term capital gains are at risk even if utilities make good on their earnings and dividend growth potential.Utilities' rich valuations also lessen their attractiveness as defensive investments in a market downturn. During the last two major U.S. bear markets—2007-09 and 2000-02—utilities' valuations going into the downturn had a big impact on the sector's outperformance relative to the market.Investors should be selective as they pick utilities in this market, focusing on those with the best growth plans or cheap relative valuations to offset a valuation pullback we think is coming.Key Takeaways
Utilities' long-term growth opportunities are abundant based on our discussions with utilities executives at the recent American Gas Association Financial Forum. We think renewable energy and distribution growth projects are the most attractive. Our May 20 report, Capital Investment Drives Utilities' Growth, but Valuations Are Rich, has more detail on utilities' growth plans.
Utilities are 14% overvalued as of mid-June based on our fair value estimates, the richest they have been since 2017. Regulated utilities are particularly expensive with median 22 P/E and 2.1 P/B—both multi-decade highs.
Utilities with large, attractive investment plans include Nextera Energy (NEE US), Edison International (EIX US), Dominion Energy Inc (D US), Xcel Energy Inc (XEL US), New Jersey Resources (NJR US), Cms Energy Corp (CMS US), Sempra Energy (SRE US), and Atmos Energy (ATO US). Although many of these are expensive, their growth should cushion returns if valuations compress.
Utilities' rich valuations limit their defensiveness. Utilities entered the 2007-09 bear market with a 19 P/E and outperformed the S&amp;P 500 by 11 percentage points, their worst bear-market performance in 35 years. Bear-market returns improved when utilities had more modest valuations.
Although utilities look rich on absolute valuation measures, the sector's 3.4% average dividend yield remains attractive relative to the 2.1% 10-year U.S. Treasury yield. Historically, utilities have outperformed bonds when their dividend yields are this much higher than interest rates.


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