Utilities Companies' Defensive Characteristics Make Them Worth Knowing About – Here's How To Analyze The Industry And Pick Winning Stocks

Reda Farran, CFA

17 mins

Utilities Companies' Defensive Characteristics Make Them Worth Knowing About – Here's How To Analyze The Industry And Pick Winning Stocks

Utilities stocks are famously “defensive”. Utility companies provide essential everyday services like electricity and water; and while that means revenues and profits don’t always grow rapidly, they do remain resilient during economic downturns. That’s why utilities stocks tend to be less volatile than the overall stock market – and why their prices typically outperform when the rest of the market falls.

Having utilities stocks in your portfolio can therefore be a good way to increase diversification and protect against rough patches. And because they tend to pay investors a steadily growing dividend, utilities stocks can also provide you with a reliable income stream. But it’s not all about defense and income: today, there are some fast-growing utilities out there benefiting from big thematic trends like renewable energy and electric vehicles.

In this Pack we’ll be looking at those trends and more. We’re also going to explain the basic principles of the sector, what to look for when investing in individual utilities stocks – and how to value them. But before we get into all that, it’s worth first taking a step back to set out how the industry is split up.

There are three main types of utility, characterized by what they provide customers: electricity, gas, or water. Electric utilities do two things: electricity generation, and electricity transmission and distribution (T&D). Generation is pretty self-explanatory: think power plants. T&D, meanwhile, is the process of getting that generated ‘tricity to customers’ homes or businesses. An electric utility company may do one or both of these things; the latter are known as “vertically integrated utilities” because they control the entire value chain – from spark to socket, as it were.

Vertically integrated utilities

Gas utilities, on the other hand, are always T&D operations. They don’t drill and process natural gas themselves – instead they buy it in from specialists and focus purely on getting the gas safely to customers.

Some large companies own both electric and gas utilities, such as Dominion Energy in the US or SSE in the UK. But they’re unlikely to also dabble in the third category: water utilities, which deal in the transportation of clean H20 to customers – and the less glamorous business of carrying wastewater away from customers to treatment facilities…

Regardless of the type of utility (electric, gas, or water), the T&D trade is a natural monopoly. In other words, a single T&D utility typically owns and operates the sole infrastructure in any given area, with few concerns about competitors encroaching on its territory. That’s because it makes little sense to have multiple expensive water and gas mains running alongside each other. (Note that third-party energy “suppliers”, to whom you may pay your bills, are a different thing – these companies themselves pay the actual generation and T&D utilities for use of their infrastructure.)

But precisely because utilities often have the exclusive right to operate in a particular area, they’re generally heavily regulated to make sure customers get fair pricing and a suitable service. This regulation is actually one of the most important principles of the utilities industry – and one we’ll explore further. Stay tuned!

The takeaway: The utilities industry includes electricity, gas, and water utilities. Many businesses are natural monopolies and are therefore heavily regulated. Investing in utilities stocks can help diversify your portfolio and secure a regular income stream.

The Utility Principle

As a natural monopoly, the utilities industry is highly regulated. Government authorities typically have the final say on what companies can spend, what they can charge customers, and therefore what returns they can make – among other things.️

The precise nature of this regulation differs from one country to another. In the US, it even differs between states. But one thing that’s common across most geographies is the concept of “rate base”, or “regulatory asset base (RAB)” in Europe. It’s one of the most important metrics for utilities companies – and therefore their investors.

Rate base is essentially the value of all a utility’s investments – in power plants, pipelines, water treatment facilities and so on. The rate base rises whenever the utility spends money on new or improved infrastructure, but it also goes down every year due to depreciation: as things grow older and wear out, their accounting value declines.

Let’s say a new utility company, Finiflow – nice name – spends $100 million building a power plant with a 10-year useful lifespan. The utility’s rate base will be $100 million in year 1 and, assuming it invests in nothing else, that rate base will decline by $10 million every year as the plant’s future usefulness erodes. (In reality there are a few more nuances involved, but you get the idea.)

So why does rate base matter? Because it’s a key factor in calculating a utility’s possible profit as rate base is what regulators allow utilities to earn a return on. Back to our previous example, if the regulator allows utilities to earn a 5% rate of return each year, then Finiflow’s profit in year 1 will be $100 million x 0.05 = $5 million. Of course, there’ll likely be other factors affecting the utility’s precise profit; we hear those hard-working Finiflow employees are due a pay rise…

All of this leads to three interesting takeaways. First, a utility’s profit growth is mainly determined by rate base growth: the allowed rate of return won’t change much from year to year, but a utility’s rate base can. Second, utility companies have a perverse incentive to spend as much as possible.That’s why regulators have powers to permit only sensible and necessary projects. Otherwise you’d have profit-hungry utilities building dozens of nuclear power plants that no one really needed!

Third, rate base means utilities’ profits are predicted in precisely the opposite way to normal companies’. Instead of forecasting revenue and expenses and then adding the two together, regulators first determine a utility’s permitted profit and then add allowed expenses to arrive at a revenue figure. By dividing revenue by the expected amount of electricity, gas, or water the utility will sell, the regulator can specify how much it’s allowed to charge per unit.

Does the rate base formula mean utilities’ profits can be predicted precisely? No: reality can come in quite different to initial forecasts. For example, a gas utility might experience lower sales than predicted if the region it serves experiences a warmer winter than normal.

That’s why the quality of regulation is crucial. In our gas utility example, some jurisdictions may have mechanisms that automatically adjust a utility’s revenue upwards if it ends up selling less gas than expected, essentially removing “volume risk”. Another quite obvious example of “good” regulation (for investors, at least) involves allowing higher rates of return, with the same rate base leading to higher profit.

Next, we’ll go over some of the biggest trends the utility industry is currently experiencing – and look at how some of those are providing great opportunities for utilities to grow their rate bases…

The takeaway: The value of rate-base investments is crucial in calculating a utility’s permitted profits, with the role – and quality – of the regulator another key factor.

Powerful Industry Trend

One of the biggest trends taking place in the utilities industry right now is the transition away from traditional fossil-fuel power generation (like coal) towards renewable energy (like wind and solar). Renewable energy is the fastest-growing source of power at present, with costs rapidly falling thanks to greater innovation and scale as more governments set legally binding renewables targets to combat climate change.

Electric utilities are obviously at the forefront of this transition – so how is it affecting them financially? Remember, utilities earn a return on rate base. By investing in new wind and solar farms, they’re increasing their rate bases and profits. And because older power plants have already depreciated in value, the negative effect of their shutdown is more than outweighed.

The energy transition helps utilities in another way too. Coal and nuclear plants are more expensive to operate and, in the case of the former, you have to constantly spend money buying fresh fuel. Wind and solar farms are cheap to run and have zero fuel costs – bringing down utilities’ overall expenses. This also helps lower customer bills, which keeps the regulators happy; as a result, they’re more willing to let utilities invest in increasing their rate bases further.

All this renewable energy is occasioning another big trend in the utilities industry: battery storage. Massive power cells the size of parking lots charge up when there’s excess renewable generation – for example, when the sun shines all morning – and they can then be used to compensate for any dips in supply when things cloud up in the afternoon. The more a country relies on renewable energy generation, the more battery storage it needs as a backstop.

Utilities are increasingly investing in both battery storage alongside renewable energy generation – meaning even bigger rate bases and higher profits. Plus, since battery storage allows utilities to better balance electricity supply and demand, they should see lower costs and lower customer bills – which means even happier regulators.

Of course, utilities can also lower customer bills through higher volumes of electricity, gas, or water sales. (Remember, regulators divide permitted revenue by sales volume to work out per-unit charges). If a utility sells more electricity, then the customer cost per unit naturally goes down. And that brings us to another big trend in the utilities sector: electric vehicles (EVs). As more people switch to EVs, electricity demand will rise. That should allow utilities to make other investments and increase their rate bases without greatly increasing customer bills. EVs also, incidentally, provide utilities with an opportunity to build the charging infrastructure needed to enable mass adoption.

It ain’t all gravy, though. One which may lower utilities’ sales volumes is rooftop solar. People who install personal panels on their roof will purchase less electricity or gas from their utility – and if the trend gets big enough, the cost per unit for remaining customers could rise. In a vicious cycle, they may themselves then switch to cheaper rooftop solar. So far, however, this “death spiral” remains a hypothetical threat; utilities building large solar farms is a much more cost-effective way of meeting renewable targets.

Finding utility companies that are benefiting from these trends is one sensible approach to investing in the sector. Next, however, we’ll show you what else you should be looking out for…

The takeaway: Renewable energy, battery storage, and electric vehicles provide great opportunities for utilities to grow their rate bases while keeping regulators (and customers) happy.

Investing In Utilities Stocks

Before you scrutinize individual investments, it may be worth considering the macroeconomic factors affecting utilities stocks as a whole. That’s because utilities’ stock prices often move in tandem, experiencing shared periods of over- or under-performance relative to the market.

The biggest such factor is bond yields. Because utilities stocks pay out a large portion of their profits in dividends, investors sometimes think of them as similar to income-paying bonds. Utilities stocks therefore tend to perform better when yields on corporate and government bonds are falling – and worse when bond yields rise and make their dividends look less attractive.

In the US, you can keep an eye on this relationship by comparing the dividend yield of the XLU exchange-traded fund (ETF) of utilities stocks to the 10-year Treasury bond yield. If it’s much higher than normal, that could indicate an attractive time to start buying utilities stocks. The same holds true for other regional equivalents.

The other key environment where utilities stocks tend to outperform the market is during periods of investor panic and stock-market sell-offs – especially if fears of an economic recession are rising. Remember, utility companies provide essential services, and their profits are resilient. When recession fears rise, investors tend to rotate their money out of growth-sensitive sectors and into utilities – and you may want to do so too.

But how do you invest in utility stocks in the first place? One easy option is to buy a utilities sector ETF like XLU mentioned above. The other way involves picking your own utility stocks. If going down this path, remember that one of the most important metrics for a utility company is its rate base – and the most attractive utilities tend to be those that can grow this at above-average levels. Consistency also matters; utilities benefiting from the sort of trends we talked about in the previous session are likely to keep growing their rate bases.

Another consideration is the quality or riskiness of rate-base growth. A utility growing this through lots of small and necessary projects – such as water or gas pipeline upgrades – is less risky than a utility relying on two new nuclear power plants. Not only is rate-base growth uneven in the latter case, but such mega-projects are prone to delays and cost overruns.

Other risks exist. Utilities’ infrastructure is heavily exposed to natural disasters, and these are growing more common. Rolling wildfires in California over 2017 and 2018 pushed one giant state utility into bankruptcy: its equipment sparked the blaze and it was thus liable for the subsequent damage. You can mitigate such risks by investing in utilities that operate across multiple geographies – or by investing in a portfolio of utilities across different areas.

Accidents are also important. Negligent utilities may be on the hook not only for damages but for fines from the regulator – or even a reduction in their allowed rate of return. Digging into utilities' safety records and relationships with regulators by looking at documents from companies and authorities alike is important.

You’ve now got a good overview of what to look for before investing in utilities stocks. Finally, we’ll show you have to value ‘em.

The takeaway: Utilities stocks tend to move inversely to bond yields and outperform other sectors during market sell-offs. The best grow rate bases smoothly, strongly, and consistently – but you also need to be aware of the risks.

Valuing Utilities Stocks

The most common way of valuing US utilities stocks uses price-to-earnings (P/E) ratios: a company’s market value compared to next year’s projected profit. This method is straightforward; the “earnings” part can be forecast to a high degree of accuracy thanks to the regulated return on rate base we discussed earlier.

You can try to forecast future earnings yourself using the rate base and allowed rate of return (with some adjustments). An even more straightforward approach involves adopting investment bank analysts’ average forecast, which you can find under the “analysis” tab of the stock’s Yahoo Finance page. You then multiply this earnings estimate by an appropriate P/E ratio to arrive at a “justified” stock price – one at which you might want to buy.

But what ratio should you use? Some advocate taking the average P/E ratio of similar utility companies and then adjusting it upwards (also called “applying a premium”) or downwards (also called “applying a discount”) depending on the circumstances. Imagine a utility with an average earnings-per-share forecast for next year of $2. If similar utility companies trade at an average P/E of 20x and you think this particular utility justifies a 10% premium, then you’d value it at $2 x 20 x (1 + 0.1) = $44 per share.

What would justify a premium valuation over other utilities? Anything that fundamentally makes your stock better. Here’s a list, by no means exhaustive:

1) Utilities with higher allowed rates of return 2) Utilities that earn more than their allowed rates of return (remember, the regulator uses expected company expenses to determine customer prices; if the utility manages its costs well enough, it’s often allowed to keep part of the difference) 3) Utilities that can grow rate base at above-average levels over long periods of time 4) Utilities that can fund rate base growth with very little equity issuance. When a company issues equity (i.e. sells more shares) to fund growth, it can dilute existing shares’ value 5) Utilities operating in regions with sympathetic regulation, e.g. lower volume risk (as mentioned previously) 6) Less risky utilities, e.g. those geographically diversified 7) Utilities with good environmental, social, and governance (ESG) ratings.

The most common way utilities stocks are valued in Europe uses a multiple of regulated asset base (RAB). RAB is just the European term for rate base: the value of investments it’s allowed to earn a return on. Say, for example, a utility has an RAB of $100 million and similar utilities have stock market values equivalent to 1.5x RAB. Our utility in this case would be valued as $100 million x 1.5 = $150 million. As with the P/E method, we can also apply a premium or a discount to peers’ average RAB multiple depending on our utility’s individual characteristics.

Lastly, because utilities tend to pay a steadily growing dividend, we can value them using a dividend discount model (DDM) – a technique that aims to calculate how much a stock is worth today based on how much its regular dividends will pay out over time. One particular variant our analysts favor is the H-Model.

The H-Model is a two-stage DDM that assumes a faster dividend growth rate for an initial period while the utility is still experiencing high rate base growth. The model then assumes a slower constant dividend growth rate for the remaining life of the utility (i.e. forever). The clever part of the H-Model is that it doesn’t assume that the initial fast growth rate suddenly drops straight down to the long-term growth rate, instead accounting for a gradual shift. Here’s the formula:

H-model valuation

Where: H = length in years of the high-growth phase D = current dividend per share ghigh = high growth rate during the initial H phase gLT = long-term growth rate r = “discount rate” – i.e. shareholders’ required rate of return, given the stock’s riskiness

Other than D (the current dividend per share), you have to make assumptions about the variables. ghigh can be set to the utility’s current dividend growth rate, considering most utilities provide medium-term guidance on this. H should be based on your view of how long the utility will experience above-average rate base growth. gLT is usually set between 2-3%, in line with the long-term growth rate of the overall economy. Lastly, r can be calculated using the Capital Asset Pricing Model (CAPM) – read our Pack on How To Value Stocks to find out how to do this.

Alternatively, you can look at the yields of long-term bonds issued by the utility – the other way of investing in companies – and add a “risk premium”. The idea is that stocks, which are riskier than bonds (as bondholders get paid back first in the event of the company collapsing) should deliver suitably higher returns than the bonds’ average. Working out that premium, however, will depend on lots of factors both macroeconomic and company-specific.

So there you have it: three different ways to value utility stocks. You can use the one you find most logical, or else try out some combination of the three. Along with understanding how the utilities industry works, its biggest trends, and what to look for when investing in stocks, valuation is the last tool you need in your arsenal before taking the plunge. Good luck!

In this Pack, you’ve learned:

🔹 The utilities industry includes electricity, gas, and water utilities. Many businesses are natural monopolies and are therefore heavily regulated. Investing in utilities stocks can help diversify your portfolio and secure a regular income stream.

🔹 The value of rate-base investments is crucial in calculating a utility’s permitted profits, with the role – and quality – of the regulator another key factor.

🔹 Renewable energy, battery storage, and electric vehicles provide great opportunities for utilities to grow their rate bases while keeping regulators (and customers) happy.

🔹 Utilities stocks tend to move inversely to bond yields and outperform other sectors during market sell-offs. The best grow rate bases smoothly, strongly, and consistently – but you also need to be aware of the risks.

🔹 You can use price-to-earnings ratios, multiples of rate bases, and dividend discount models to value utilities stocks. The first two involve looking at what ratios peers are trading at and applying a premium or a discount; the third is a bit trickier.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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