Are utilities overpriced?

Donald Saltz

October 11, 1991|By Donald Saltz

Investors in the shares of utility companies and financial officers of those same companies delight when interest rates move lower. Lower rates mean cheaper borrowing costs -- utilities are almost always large borrowers -- and the dividend payouts become more attractive, thus boosting the share prices.

So, as interest rates have been declining regularly in recent months, utility stock prices have been moving up. Baltimore Gas & Electric, for example, is at its best level in well over a year and near its high for several years. The share price is not due to strong earnings because earnings are weaker; it is a result of the sharp drop in interest rates.

All over the country utility stocks have been climbing in price during a period when industrial stocks are floundering. Even though utilities' dividends are not as secure as they once were -- there have been a number of dividend omissions and cuts by large utility companies -- the group in general is still regarded as the surest place for the best available stock yields and some dividend growth.

Buying demand for utility shares is spurred by money that, normally, would be invested in banks and savings and loans, tucked away for a year or two in a CD, or in money market accounts. Lower interest rates at banks and S&Ls have led a lot of investors to turn to bond investments, but a great number are going with utilities.

The question, however, is whether utilities are worth buying today. Are investors going too far?

Let's take another look at BG&E, selling for more than $32 a share. The company's per-share earnings have deteriorated since 1988, down from $3.47 in '88 to less than $2 currently. In fact, earnings are not quite covering the dividend payout. The dividend is $2.10 a share, providing a yield of about 6 1/2 percent. Insufficient earnings prevent a dividend increase, which is one of the key reasons people buy utility shares. Current utility yields seldom approach bond yields. And when earnings are less than the dividend rate, there is always some chance of a dividend reduction.

BG&E shares are selling for about 17 times latest 12-month earnings. That is a P-E ratio worthy of a growth company, and utilities are not growth companies. While BG&E's 6 1/2 percent yield may be higher than the current returns on many CDs and that of money market accounts, it is not likely to be raised in the foreseeable future and the shares may be overpriced.

Potomac Electric Power Co., whose service area includes parts of Montgomery and Prince George's counties, is also at a high of about $24 a share, yielding about the same as BG&E -- 6 1/2 percent -- but with a 14 P-E, still heavy for a utility. The trend of Pepco's per-share earnings, as BG&E's, has been down. Dividend increases are an annual event for Pepco, but at 4 cents a share this year the increase is more modest than it used to be.

Allegheny Power System is nearly $44 a share, a high for recent years. With earnings flat for years, Allegheny, with a P-E of 12, yields just over 7 percent. Allegheny is the parent of the Potomac Edison Co.

Lower interest rates will tend to raise earnings for the utility companies, but that may well have a negative effect on potential rate increases. Dividend increases are usually so modest, if they're made at all, that it would take years to tack on an extra percent to the yield.

Are utility shares overpriced? A good argument can be made that they are.

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