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Most utility stocks are purchased with dividends as the primary investment consideration. Indeed, as of October 26, 2010, the average yield of the electric utility equities that Value Line covers was 4.4%, more than twice the 2.0% median yield of all dividend-paying stocks under our coverage. Most investors would also like to receive annual dividend increases. But there is a trade-off. The highest yielding utility issues typically provide little or no dividend growth, and the utilities with the best prospects for dividend growth usually have a high valuation (i.e., a below-average yield).

This is understandable. Nonutility companies that are growing the fastest usually command high price/earnings ratios, because investors are willing to pay a premium for the company’s growth potential. For a utility, the equivalent of a high p/e ratio is a low yield. Imagine a scenario in which two utilities are each paying a $1.00-a-share annual dividend. One hasn’t raised the dividend in many years and isn’t likely to do so anytime soon, and the other is expected to continue its pattern of annual dividend growth. All else being equal, why wouldn’t an investor pay more for the latter utility? As the stock price goes up, the yield goes down.

There are several examples of utility stocks that have high yields but little or no dividend growth potential or low yields but good dividend growth potential.  (All yields are as of October 26, 2010.)  Wisconsin Energy (WEC) has a yield of just 2.9%, one of the lowest of any electric utility equity, but the dividend is being boosted rapidly in order to raise the payout ratio, which is low for a utility. It helps that earnings are rising fast, too.  Another fast grower with a low yield is Northeast Utilities (NU). If the company’s proposed merger with NSTAR (NST) is approved by shareholders and regulators, NU shareholders will also benefit from a step-up in the dividend (to NSTAR’s level) when the merger closes.  On the other hand, Empire District Electric (EDE), FirstEnergy (FE), and UIL Holdings (UIL) have yields of 6.0% or higher.  None of these companies has raised their dividend in 2010, and we aren’t expecting an increase from any of these companies later this year or in 2011.

Some companies have above-average yields and dividend growth potential, but their yields are usually less than one percentage point above the utility mean. For example, Southern Company (SO) has a yield of 4.9% and a track record of dividend growth. One exception is Duke Energy (DUK), where the stock has a yield of 5.5%, Duke also provides historical dividend growth. The company’s dividend growth rate has slowed, however, due to a high payout ratio.  Progress Energy (PGN) also has a 5.5% yield, but, for the first time in many years, the board of directors did not raise the dividend in 2010.  For now, we look for a dividend hike next year.

Other things besides dividend growth potential influence a stock’s yield. Financial strength, regulatory or operating risks, and the prospects of nonutility subsidiaries (if any) also play a part, and investors need to consider these factors, too.There is no right answer to the question of which is more important — the current yield or dividend growth potential. Investors with a short-term focus ought to consider stocks with a high yield (as long as the dividend does not appear to be at risk of a cut), while those with a longer investment horizon might well fare better with stocks that offer good dividend growth potential.

 

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.