Are Utilities Overvalued?

Don’t look now, but utilities are looking expensive, and it has little to do with whether yields are rising are falling, says ISI Group’s Greg Gordon and team.

Now don’t misunderstand. Gordon isn’t telling investors to avoid all regulated utilities. He has some favorites, including American Electric Power (AEP), Dominion Resources (D), ITC Holdings (ITC), Pinnacle West Capital (PNW) and Westar Energy (WR).

Still, utilities are yield plays. They benefit when interest rates are low and safe yield in bonds are virtually nonexistent, and get hurt when interest rates rise, as safer yield becomes more readily available.

Now forget for a minute whether yields are rising are falling–I’ll leave that to my colleague Michael Aneiro–and consider whether utilities are expensive or cheap to where yields are right now. ISI Group’s Greg Gordon and team explain:

On 9/16/13 we pointed out that [utilities were] more or less at fair value to the bond market and we said that if Treasury yields were to stabilize and corporate yields were to come back in a bit, the group could grind higher, with every 25 basis point move in corporate bond yields worth more than a half a turn in P/E…

Now Regulated Utilities are a turn higher on P/E, trading at 15.9x '14 EPS vs. 15X on 9/16/13. 10-Year Treasury yields have dropped from 2.87% to 2.71% and the Moody's BAA corporate bond yield average has declined from 5.56% to 5.41%. Utilities look at least half a turn overvalued to the bond market. Perhaps Yellen's dovish commentary has had something to do with that.

You can worry about the direction of bond yields later.

American Electric Power has dropped 0.5% to $48.08 at 3:22 pm. today, Dominion Resources has dipped 0.1% to $67.71, ITC Holdings has fallen 1% to $91.10, Pinnacle West Capital has declined 1.4% to $54.64 and Westar Energy is off 0.1% at $32.22.