Why do utility companies have such high valuations?

[ChpBstrd]

Here are the components of the XLU fund, and their PE ratios:

NEE     22
SO      20.4
DUK     20
CEG     24.9
SRE     20.3
AEP     18.8
D       20.9
PEG     21.4
PCG     16.6
VST     26.7

According to State Street, the estimated 3-5 year EPS growth rate for XLU is 8.21%. According to Simply Wall Street, "The industry is trading close to its 3-year average PE ratio of 24.5x." but "Revenues for these companies have grown 6.4% per year."

So why is the slow-growth utility industry trading at a relatively high PE ratio? Prior to about 2012, utilities traded for between 10x and 15x earnings.

What caused their valuation to double in recent times?

Meanwhile similar industries like energy (PE = 15.5) and tobacco (PE = 15.1) are selling at valuations closer to what one would expect from utilities. Small caps and mid caps are at about 17x forward earnings. What's the appeal of paying over 20x for highly regulated, low growth, capital intensive, low margin, high liability industry?

[reeshau]

Datacenters are stressing electric grids, increasing demand.

Datacenter operators are turning to modular nuclear to try and be location independent (from hydro), "green" (not adding to global warming) and controllable.  But that won't do it all, will take time, and is not assured.

[SilentC]

A) that’s trailing EPS, they are slightly more reasonable on forward
B) what @reeshau said
C) most or all of that list is in the S&P 500 so it’s automatically moderately to  significantly overvalued.

Edit - some of those higher multiple names have unregulated fossil assets and those terminal values went up.  Still probably very richly valued. 

[NN6]

Most of their income as utilities should be pretty predictable and regulated so to me it does not make any sense either. My best guess would be generally high valuations across the SP500 which is not to say this can't continue. I personally sold off my NEE and Citi stock recently. So maybe another question is, do you see big bank stock valuations as justified  after their huge runup (even after Trumps election)?

[GilesMM]

Utilities are basically regulated monopolies with stable but modest earnings.  Some pay good dividends.  They are not growth stocks and are not correlated with the rest of the market.  People buy them as a defensive play and for the reliable dividends.   I have plenty in VTI/VTSAX.

[ChpBstrd]

After thinking about this for a while, the best idea I have (which is not even satisfactory to me) is that utilities are so highly valued because they offer more consistent earnings than other companies.

I.e. Suppose regular recessions cause all other companies than utilities to have negative earnings in one out of 10 years. Therefore non-utilities have positive earnings in 9/10 years and utilities have positive earnings in 10/10 years in this simplified world. The present value of 10 years of earnings is higher than the present value of 9 years of earnings.

It's not satisfactory though, because even a modest amount of faster growth or lower valuations would make up such a difference.

[erp]

I think there's also a bet on at least some power utility companies catching a significant part of the potential electrification boom which might come out of climate adaptation. Estimates in sources like the economist or Bill Gate's book were saying numbers on the order of 2-4x expansion in the grid, which could plausibly allow some of these companies to grow a ton.

I think it's priced in and it's by no means certain, but it's a longshot upside.

[MustacheAndaHalf]

Google has a performance graph built in when I search for things like "NEE stock".  It shows the total performance - not the annual average - over a time period.

NEE: +30.82% 5 yr; +32.89% 1 yr ... subtracting gives -2% from 2020-2023
SO: +39.60% 5 yr; +26.26% 1 yr ... subtracting gives +13% from 2020-2023
DUK: +24.28% 5 yr; +22.85% 1 yr ... subtracting gives +1% from 2020-2023

Two stocks have almost all their 5 year performance in the past 12 months.  The lowest was 2/3rds of its 5 year performance in the past 12 months.  These stocks went nowhere for years, and had very impressive 2024 performance.

Besides AI datacenter demand, President Biden passed the Inflation Reduction Act, which included support for EV adoption.  EVs require more electricity, and the U.S. electrical grid has been under-invested in.  So the boost might partly come from AI datacenters (much higher energy demands), and partly from the Inflation Reduction Act.  Congress could repeal parts of that act over the next few years, so it seems risky to rely on that.  I guess we'll know more in 2025.

[ChpBstrd]

I think there's also a bet on at least some power utility companies catching a significant part of the potential electrification boom which might come out of climate adaptation. Estimates in sources like the economist or Bill Gate's book were saying numbers on the order of 2-4x expansion in the grid, which could plausibly allow some of these companies to grow a ton.

I think it's priced in and it's by no means certain, but it's a longshot upside.

The problem is that utilities may not be able to grow profitably. Consider the following stats for Return on Assets for the 3 companies @MustacheAndaHalf mentioned above.

NEE: 3.05%
SO: 3.48%
DUK: 2.66%

Now imagine each of these utilities needs to raise cash to build new capacity. Their cheapest source of capital is probably the bond market (ignore the fact that all these utilities are already leveraged up to their necks, and additional debt might result in downgrades / higher cost of capital). They can probably borrow at around a 5% interest rate.

So they'll borrow at 5% to buy assets earning ... 3%?

The US electrical grid has been under-invested in, and the reason for that still exists today. This does not seem to be a market where investment and growing revenues leads to higher earnings.

[MustacheAndaHalf]

NEE: 3.05%
SO: 3.48%
DUK: 2.66%
(ignore the fact that all these utilities are already leveraged up to their necks, and additional debt might result in downgrades / higher cost of capital).

Sorry, I can't ignore that tidbit, and I wanted to clarify your meaning of "leveraged up to their necks", so I looked up their valuations on morningstar.

NEE: 1.65 debt/equity
SO: 1.95 debt/equity
DUK: 1.77 debt/equity
https://www.morningstar.com/stocks/xnys/nee/valuation
https://www.morningstar.com/stocks/xnys/so/valuation
https://www.morningstar.com/stocks/xnys/duk/valuation

Berkshire Hathaway has 0.20 debt/equity and over $300 billion in cash.  Personally, I think Buffet sees no deals in this overvalued market, and is waiting for better prices (aka a crash).  Others believe he is storing up cash so the company can buy out his stock when he is no longer at the company.

Speaking of Buffet, he has reduced his stake in $AAPL stock by 60% since the start of this year.  I think Apple's 1.87 debt/equity ratio might be a factor, especially with valuations so high.

[ChpBstrd]

NEE: 3.05%
SO: 3.48%
DUK: 2.66%
(ignore the fact that all these utilities are already leveraged up to their necks, and additional debt might result in downgrades / higher cost of capital).

Sorry, I can't ignore that tidbit, and I wanted to clarify your meaning of "leveraged up to their necks", so I looked up their valuations on morningstar.

NEE: 1.65 debt/equity
SO: 1.95 debt/equity
DUK: 1.77 debt/equity
https://www.morningstar.com/stocks/xnys/nee/valuation
https://www.morningstar.com/stocks/xnys/so/valuation
https://www.morningstar.com/stocks/xnys/duk/valuation

Berkshire Hathaway has 0.20 debt/equity and over $300 billion in cash.  Personally, I think Buffet sees no deals in this overvalued market, and is waiting for better prices (aka a crash).  Others believe he is storing up cash so the company can buy out his stock when he is no longer at the company.

Speaking of Buffet, he has reduced his stake in $AAPL stock by 60% since the start of this year.  I think Apple's 1.87 debt/equity ratio might be a factor, especially with valuations so high.

Yea it's unrealistic to think these utilities will only issue bonds to buy more power plants and upgrade the grid. They're already at their optimal levels of leverage to maximize ROE. My example of them selling bonds to finance expansion is unrealistic because doing so would raise their leverage, which could lead to downgrades and a higher cost of capital. I.e. they can sell bonds today at 5% yields, but if they increased their leverage even more that might become 6% or 7%! Companies that over-leverage pay a price for it when their earnings take a hit from having to pay higher interest rates on their debt.

Yet 100% debt financing at today's rates is the most conservative estimate for their cost of capital. Dilution through the sale of preferred stock or common stock has a higher implied cost of capital to shareholder than the debt. Realistically, these utilities would have to issue both debt and equity to maintain their pre-existing and presumably optimal D/E ratios.

Maybe that will happen, but the point is that when your cost of capital greatly exceeds the return on the assets you buy with that capital (i.e. ROA) it's a value-destroying transaction. I used 100% debt financing to prove this point because that's the lowest cost capital they could possibly acquire, and therefore if it doesn't pencil out with 100% debt financing it certainly won't pencil out with the more expensive and more realistic debt + equity financing.

[SilentC]

I think there are some really interesting names in utilities right now which I can’t discuss for some period of time/work related.  Hint, they are not in the S&P. They do have a lot of duration and so the returns do look quite poor on a 3 or 5 year basis, and some of the ones that had too much leverage going in but a path to dealing with it should do well.  Also, if there is a lost decade in US stocks based on starting point values these will be stellar performers.