Monday, November 24, 2014

Gordon Growth model and the value of four utilities.

Question:   What does the Gordon Growth model assert is the proper valuation of electric utilities in November 2014?  How does the actual stock price for these firms differ from the projection provided by the Gordon growth model?


Background:   The Gordon Dividend Growth Model treats the value of a stock as the discounted value of all future dividends.

The formula for the value of the stock can be written as

P=D/(R-G)


P is the value of the stock,
D is the annual dividend,
R is the required cost of equity,
G is the growth rate of dividends.

Note that based on the above one can get R as function of D, P, and G.

R= (D+PG)/P

This value of r is the required rate of equity consistent with the current value of the stock price.


Valuation Calculations for Four Utilities:

Below I present the Gordon Growth Calculations for four different utilities.


Dividend Growth Model and Stock Prices for Four Utilities
Current Stock Price
Annual Dividend
Dividend Growth Rate
Stock Price when r=0.08
Stock Price when r=0.12
r consistent with current stock price
AEP
57
$2.12
0.0424
$56.3
$27.3
7.96%
DUK
79.4
$3.18
0.0519
$113.1
$46.7
9.19%
PEG
40.72
1.48
0.0301
$29.7
$16.5
6.65%
D
73
2.4
0.0608
$125.0
$40.5
9.37%


Observations: 

At r=0.08 AEP is a hold, DUK and D are undervalued and PEG is overvalued.

At r=0.12 all four utilities are overvalued.

Caveats:   The Gordon Growth Model cannot be used for all utilities.   It is best used when dividends are really stable.    Using this model is as much art as science and the results presented here are based on my subjective assessment of the dividend growth rate. 

Concluding Thoughts:  The main risk in investing in the utility sector right now is the possibility of a large increase in interest rates that would lead to a higher cost of equity, which would decrease stock prices.  

Companies have unsystematic risk that could interrupt dividends.   A safer play for investors in the utility sector might be through an ETF.

The publication below has some ratings for utility ETFs.






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