In February 2000, Consolidated Edison (ED) traded at $26 per share. If I told you that per share revenues would only grow by 2.5% over the next fifteen years, and over 70 million new shares of stock would be created through executive options and additional stock issuances to avoid piling on more debt to the balance sheet, would you be interested in buying the stock? At the time, the stock was making $2.74 per share and trading at a valuation of 12x earnings.
I would guess that the stock price might expand its P/E ratio a bit, and the utility dividend would be nice, but I’d ultimately pass on the opportunity on the theory that 2.5% revenue growth over the long term just doesn’t seem like the path to building sizable wealth.
And yet, long-term ownership of the stock since February 2000 has produced returns of 10% to 12% annually depending on whether you reinvested over that time frame. Those long-term results far exceeded my expectations of what the stock seemed capable of producing if you knew the relevant growth figures that occurred over the 2000-2015 time period.
Well, as it turns out, people like having electricity in their homes. This results in very steady cash flow streams that manifest themselves in dividends that creep forward over so slightly year after year, though no individual year’s growth seems like anything worthy of getting excited.
I mean, just look at the 2000-2015 year dividend history. You got $2.18 in 2000, $2.20 in 2001, $2.22 in 2002, $2.24 in 2003, $2.26 in 2004, $2.28 in 2005, $2.30 in 2006, $2.32 in 2007, $2.34 in 2008, $2.36 in 2009, $2.38 in 2010, $2.40 in 2011, $2.42 in 2012, $2.46 in 2013, $2.52 in 2014, and $2.60 in 2015. From 2000 until 2012, the quarterly dividend only went up by half a cent! Then, the quarterly dividend started going up a penny per share. That’s about the minimum annual dividend growth that a company can deliver while fitting the truth of the term “dividend growth stock.” The income came to shareholders glacially–it just doesn’t look like a vehicle for creating substantial wealth.
Yet, this glacial dividend growth interacted with one favorable factor: a generally low stock market valuation. This raised the dividend yield of the stock, putting it perpetually in the 4% and 5% range. There was only one year between 2000 and 2015 in which the valuation of Consolidated Edison consistently traded above 16x earnings–and that was the 18x earnings year of 2004.
The stable cash-generating power of this electric utility was beautiful. You collected $37.48 in dividends without any reinvestment, and the share price increased from $26 to $75.25. Your ending wealth value is $112.73. That’s a compound annual growth rate of 10.27%. These figures may be overstated to the extent that it doesn’t include inflation or taxes, may be neutral to the extent it may have been invested in a tax-sheltered account, and may be understated to the extent that it contains an assumption that the dividends just pile up as cash for fifteen years earning no interest.
If you had been reinvesting the dividends into Consolidated Edison for these past fifteen years, then you would have generated $46.78 in income per share that got reinvested at an average price of $52.43 per share over the fifteen-year holding period. In short, each $26 invested into a single Consolidated Edison share grew into 1.89 shares with an ending value of $75.25. The reinvestor ended up with a net wealth amount of $142.22. This works out to a compounding rate of 12% even for fifteen years.
I perform these case studies of utilities largely for selfish reasons, as it is a way of instructing myself with real-world examples that the historical performance of utilities is much better than I would guess by merely taking a look at a stock price chart over time or taking a close look at the debt levels or frequently anemic revenue growth that is inherent in the industry. The consistency of collecting 4% to 5%, and then seeing that figure rise just a bit over time, has a marginal effect when viewed over a short-term time horizon but has a multiplicative effect over a longer time period as the positive income growth compounds upon itself over and over again. The Consolidated Edison dividends that have poured over time basically double your share count every 17 or 18 years, which is remarkable when considering the low growth rate of the asset itself.
Despite these studies, I don’t think the lesson is to run out and buy Consolidated Edison stock right now. I still have some concerns. The valuation of the stock has gone from 12x earnings to 18x earnings over this time frame, and that is something that is almost undeniably related to interest rate levels that sloped downward over time. This is a company whose historical fair value is somewhere around 15x earnings.
What happens if you pay 18x earnings for the asset and it reverts to 15x earnings? What if interest rates end up getting a bit higher than you’d expect a few years down the line, and the comparison period features Consolidated Edison’s valuation shifting from 18x earnings to 12x earnings? This is something that you have to worry about with the slow growing firms that doesn’t affect Visa, Brown Forman, Becton Dickinson, or Disney nearly as much because they have the earnings per share growth rates to countervail high interest rates.
If Consolidated Edison traded at 15x earnings today, the stock would be at $61. Those 1.89 shares for the reinvestor would be worth $115 instead of $142. Now, your compounding has come down from 12% to 10.4%. For someone that didn’t reinvest, the results would be down to 9.28%. And that only answers the question of “What if Consolidated Edison only saw its P/E ratio expand from 12 to 15 over the past fifteen years?”
This current 18.2x earnings valuation is the highest value for the stock in the past thirty years, with the exception of 2004 (and the 2004 figures are a bit distorted because Consolidated Edison suffered earnings impairment of $0.50 per share that year). The dividend, which is almost always in the 4% or 5% range, currently sits at 2.56%. That’s less income to reinvest, and also suggests a very high probability of P/E compression over the holding period.
Even most analysts are only expecting Consolidated Edison’s profits to grow to $4.70 over the next five years. At a P/E ratio of 15, that would suggest Consolidated Edison would be worth $70.50 sometime around 2020. The current price is $75 per share. My approach would be this: Keep tabs on Consolidated Edison, and consider purchasing the stock if it falls to $60 in the next year or two. As time passes, consider purchasing the stock somewhere in the $65-$70 range in 2018, 2019, and 2020.
The dark side is that, from 2004 to 2009, Consolidated Edison compounded at 4.8% annually. That’s the closest thing the stock has recently experienced to a measuring period when the valuation shifted from 18x earnings to 12x earnings. And even this understates the harm because it was more of an accounting reality than an economic reality when Consolidated Edison traded at 18x earnings in 2004
As a class, utility stocks are seriously underrated. Even with anemic growth, the forward slog of dividend growth mixed with dividend reinvestment creates a very strong end result when measured over 15+ year time horizons. But valuation plays an especially strong role in tilting the scales for these slow growth cash cow types of firms. For that reason, I would stick Consolidated Edison in the back pocket for the time being. The lesson is that it belongs in a long-term portfolio in a tax shelter because the income becomes enormous over time, but also that the best results happen when that 3.5% starting yield turns into a 5% starting yield.
Originally posted 2016-03-19 23:53:12.