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/(RG)
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.
No comments:
Post a Comment