American Electric Power (AEP) is a utility serving several mid-Atlantic and mid-western states. It appears to be a fine core candidate for a dividend-growth (DG) portfolio.
AEP’s Dividend Record
AEP is a solid mid-yield, mid-growth DG stock. Its 3.5% yield is acceptable for most investors, and its 5-6% growth rate per year is fine for a mid-yielding stock.
From the CCC (Dividend Champions) document, we can see that AEP’s dividend increases have been quite consistent for the past decade.
I always like it when a company highlights its dividend growth performance, and AEP does that in its recent investor presentation:
Business Model and Company Quality
American Electric Power Company, founded in 1906 and headquartered in Columbus, OH, is an electric utility holding company.
AEP has seven regulated electrical utilities serving about 5.5 million customers across 11 states (AK, IN, KY, LA, MI, OH, OK, TN, TX, VA, and WV). Most of those states are considered to have constructive regulators.
AEP also operates in competitive (non-regulated) areas):
- AEP Energy is a retail electricity and natural gas supply provider for over half a million residential customers and businesses.
- AEP Energy Partners offers customized wholesale power supply products to wholesale customers for their customers’ electric systems.
- AEP Onsite Partners is a leading provider of “behind-the-meter” solutions that assist customers in saving energy and money.
AEP touts its investment proposition in this slide, illustrating 3% annually from its dividend and 5-7% from annual EPS growth:
As with many utilities nowadays, AEP points to its commitment to renewable energy, with long-range plans for a big drop in energy generation from coal offset by a big jump in generation from renewable sources (hydro-electric, wind, and solar).
Morningstar accords AEP a Narrow moat, which is all a utility can get under its system. The moat is based on AEP’s monopolies in its regulated service areas plus efficient scale advantages.
AEP’s revenues have been basically flat for a decade. But that has not prevented the company from generating healthy earnings increases, as AEP has been diligent in attending to cost savings.
AEP forecasts 5-7% earnings growth for the coming few years.
(Source of all graphics in this section: Simply Safe Dividends)
AEP’s efficiency metrics are OK, a little above the benchmark on ROE but below the benchmark for ROIC.
AEP’s profitability, as reflected in its Operating Margin, has been better than average most years. Per recent research, typical operating margins for S&P 500 Utility companies have been around 14%. AEP’s is well above that rate.
AEP’s debt situation is fine for a utility, which tend to be capital-intensive businesses. As we saw earlier, AEP has a good investment-grade credit rating of A-, so debt is not a problem for the company.
Like most utilities, AEP’s share count grows as it issues new shares to help pay fund its capital needs. AEP’s share-growth rate has been very modest. It has only 3% more shares outstanding now than it did a decade ago.
Here is a summary of AEP’s financials:
I use four models in valuing companies, then average the results. See Dividend Growth Investing Lesson 11: Valuation.
Models #1 and #2: FASTGraphs relative P/Es
The first two models use FASTGraphs charts. Model #1 is a basic estimate of the stock’s fair value based on a general market history, while Model #2 “normalizes” #1 by using the stock’s own past 5-year average valuation rather than the market’s.
The magenta line is Model #1, a default valuation reference line based on a historical “fair” price-to-earnings ratio of 18. The blue line is Model #2, based on AEP’s own average 5-year P/E, which is 18.4. AEP’s current valuation is 18.9.
The black line is AEP’s actual price. AEP’s price is currently very close to both reference lines, indicating that the stock is fairly priced. You can also see that AEP’s price dropped steeply last year because of the pandemic, and that it has not recovered the level it had prior to that crash. That’s good news if you are in accumulation mode.
I compute valuation ratios, which are the ratios of the actual P/E to the fair-value references. Here is the formula for both models:
Valuation Ratio for FASTGraphs = Current P/E divided by Reference P/E
Here are the valuation ratios for AEP:
- Model 1: Based on basic (magenta) line: 18.9 / 18 = 1.05
- Model 2: Based on historical (blue) line: 18.9 / 18.4 = 1.03
Both of these results are within 10% of 1.00, which would represent the stock’s price equally its fair-value price under each model. Thus, both suggest that AEP is fairly valued.
Model #3: Morningstar DCF Valuation. Morningstar uses a discounted cash flow (DCF) model for valuation. The idea behind DCF has been summarized by Warren Buffett has:
Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life. The calculation of intrinsic value, though, is not so simple…. [It] is an estimate rather than a precise figure. (Source)
Morningstar makes what I believe are conservative, logical estimates and performs the necessary calculations. They convert their result into a valuation ratio, just as I did with the first two models.
Morningstar’s valuation ratio is 0.95, suggesting that they see AEP as 5% undervalued.
Model #4: Current Yield vs. Historical Yield. The last model compares the stock’s current yield to its historical yield. The idea is that if a stock’s yield is higher than normal, it suggests that its price is undervalued (and vice-versa).
AEP’s current yield of 3.5% is practically the same as its 5-year average. Once again, I compute a valuation ratio.
Valuation Ratio for Relative Yield = 5-Year Yield divided by Current Yield
The valuation ratio in this case is 3.4% / 3.5% = 0.97, or undervalued by 3%.
This table summarizes the four models:
It is rare to see all four models in such agreement, or for the average valuation ratio to be exactly 1.00, but there it is.
For a high-quality stock such as AEP, I consider any price within +/- 10% of my calculated fair price to be “fair.”
AEP’s recent price is $85. Its calculated fair price is therefore (obviously) $85 / 1.00 = $85. Allowing for the 10% cushion, we get the following outcomes:
AEP’s fair price = $85
AEP’s maximum buy price = $94
Beta measures a stock’s price volatility relative to the S&P 500. I like to own stocks with low volatility, because they are easier to live with.
AEP’s 5-year beta of 0.24 compared to the market as a whole (defined as 1.0) means that its price has moved far less than the market. This is a positive factor.
CFRA’s current report on AEP shows that the average opinion grade of 19 Wall Street analysts is 3.9 on a scale of 0-5. That translates to Buy/Hold. This is a slightly positive factor.
The Bottom Line on AEP
- Mid-yield (3.5%), mid-growth (6% per year) utility. Dividend growth has been steady for several years; overall streak stands at 11 years. Very good dividend safety score (81 /100 from SSD).
- Well-run business, with high business quality ratings from independent analysts.
- Good, well-balanced financials for a utility. Always profitable, with growth projected at 5-7% per year.
- Fairly valued.
I don’t see any significant negatives for AEP.
Conclusion: In my opinion, AEP is a classic utility in terms of how it is likely to behave as an investment. Its dividend is solid, middle of the range in both yield and growth, and very safe. It is fairly valued.
In a couple weeks, when I reinvest dividends in my own Dividend Growth Portfolio, I will consider AEP as a strong candidate to start a new position and shore up my utility coverage.
This is not a recommendation to buy, hold, sell, trim, or add to AEP. Any investment requires your own due diligence. Always be sure to match your stock picks to your personal financial goals.
Other Reading on AEP
Undervalued Dividend Growth Stock of the Week: American Electric Power (AEP) (Jason Fieber, January 2021)
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