Id find it hard to buy National Grid (LSE: NG) (NYSE: NGG.US) right now.
Dont get me wrong, I can see that buying the firms shares at just about any point over the last 15years has worked out well for investors that held on until today the share-price chart is a perfect advertisement for buy-and-hold investing.
Its just that the valuation seems to be stretching, and that makes me feel uneasy.
Valuation up, business flat
Take 2010, for example. Back then, the shares valued the firm at a P/E rating somewhere around 10 and the dividend yield was knocking on the door of about 7%. Today, the forward P/E rating is running at 15 or so, and the yield is down to about 5%.
The shares are more expensive than they were, but maybe thats okay as long as earnings keep growing in a smooth, defensive sort of way. The trouble is that they arent. City forecasters predict an earnings decline of 17% this year followed by a 5% recovery the year after. Thats not growth, its shrinkage.
Over the four-year period that National Grids valuation has increased by 50%, the firms actual business has been flat:
|
Year to March |
2010 |
2011 |
2012 |
2013 |
2014 |
|
Net cash from operations (m) |
4,516 |
4,858 |
4,228 |
3,750 |
4,019 |
|
Operating profit (m) |
3293 |
3745 |
3539 |
3749 |
3735 |
Whichever way I look at that table it nets out the same way: valuation up, business flat. Surely, thats not supposed to happen. However, it has happened and, I reckon, thats the main reason that City analysts ratings cluster around neutral right now Im not the only observer concerned about forward total-return outcomes for investors from here.
The paradox of the defensives
We might think that with uncertain economic times just about all share valuations would contract. Yet theres a tendency for defensive-type firms to do well on the stock market when investors are running scared.
Piling into firms with steady, predictable cash flows is appealing, and that effect seems magnified by the lousy returns savers get from holding cash. National Grids dividend yield still seems attractive at around 5%.
Yet, adjusted forward earnings cover the payout less than 1.3 times. Earnings and cash flow need to grow if dividend progression is to continue. Any whiff of a halt on dividend raising, or worse, a cut in the payout, and the firms valuation could start to contract, causing capital attrition to wipe out perhaps years worth of dividend gains for investors.
The higher the valuation goes, the higher the stakes. Maybe an interest-rate rise could send the valuation-cycle lurching into the other direction down.
Five years from now anyone reading this article may be tittering into their hand as National Grid sits on a share price of 12 with P/E rating of 20 and a yield of 3%. Then again, perhaps the cyclical effect of valuations will kick in driving down the P/E rating and pushing up the dividend yield as investors abandon the defensives in favour of more appealing stock market opportunities in a benign macro-economic environment.
What next?
Its the uncertainty that keeps me away from National Grid. To me, its best to buy the shares when they seem out of favour and when the valuation is modest. Although National Grids shares have done well lately, Im not too keen.
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Kevin Godbold has no position in any shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
