Electric utility stocks seem to have tapered off, after all the hoopla about how demand from AI would transform the business turned into concern that demand from AI would raise prices to consumers and rile the politicians who set the rates. Maybe it is time to reassess what investors expect.

First, understand that Wall Street focuses most on one number in utility financial valuation nowadays, the growth of rate base, because regulators set earnings as a percentage of rate base. The bigger the rate base, the more the utility’s income. We calculate that the US utility rate base will grow at a 9% rate over the coming five years. You may wonder why, when few expect sales to grow more than 3% per year, and, secondarily, how the industry can afford to support that increase in rate base, given the discrepancy between rate base and sales growth. To the first question, we can provide a number of explanations, but the simplest is to note that the average industry plant in place is at least 30 years old, and that a new plant, as a result of inflation, costs substantially more (maybe 2-3x more per unit of capacity). There is a simpler answer to the second question. You, the consumer, will pay more for electricity. Wall Street takes it for granted that you will do so.

For our calculations, we will use the same numbers as everyone else, defining the industry as all the members of the Edison Electric Institute, the industry’s trade association. Start with the utility’s rate base in 2024, approximated by the net plant of $1,573 billion. Add on projected five-year capital spending (industry estimates boosted by us because industry numbers are invariably too low, especially in the last two years) of $1,350 billion, and then subtract out estimated depreciation in the period. That new number is rate-based in 2029, or $2,513 billion, a 60% increase over five years.

How to raise $1,350 billion? Internal sources (mainly depreciation and retained earnings) could provide $550 billion. To keep the same capitalization ratios as in 2024, the industry will have to sell $553 billion of debt and $247 billion of equity. Hold on, you say, that equity offering will boost stockholder equity by 40%, and the increased shares will surely dilute earnings per share growth down to next to nothing. Not so, because utility shares now sell at about 175% of their book value, and in the peculiar world of utility finance, selling shares above book value actually raises the earnings per share of the old shares. At current prices, the utilities would have to increase the number of shares by 23% to raise the required money. So, if net income for stockholders goes up in line with the increase in the equity account (60%) and the share number rises 23%, that means that earnings per share over the period will rise 30%, or about 5.5% per year. Many brokers believe that earnings per share can grow 8-9% over the coming three years, so we might be on the low side.

What about customers? Will they pay more? Assume sales growth of 3% per year and the rate of inflation at 3%. Then divide expenses plus capital costs into two categories: those that will increase with sales and the rate of inflation (40%), and those that will move up with the investment base (60%). That calculation produces a 7.8% per year increase in revenue requirements, or 4.7% per KWH. Deflate that number by the rate of inflation to get the real price increase per KWH of 1.6% per year. Don’t get hung up on anything beyond the decimal point because this is a one significant figure calculation, but the message is clear. Prices of electricity will rise faster than the rate of inflation over the five year time period and could rise even faster in areas hosting AI centers.

The worksheet for the calculations (Table 1) follows:

The average utility stock, then, could show 6% (or more) growth annually in earnings per share, and that same stock now pays out a dividend that yields 3-4%, so, barring a major change in capital market conditions, investors might expect a total return (growth plus dividend) of at least 9%. As an alternative, they could get close to a 6% yield from an investment-grade corporate bond and over 4% from a ten-year Treasury. The present differential return over bonds is in line with historical norms. However, in the past, utilities tended to provide dividend yields no lower than two percentage points below bond yields, or three-quarters of the bond yield, and the average utility stock does not make that hurdle rate.

More than any other measure, investors check out the price/earnings ratio, which at 18-20x earnings looks expensive. A sign of overvaluation? Well, the stock market sells at 31x earnings, an extraordinarily high valuation, but utilities have historically sold at a price/earnings ratio roughly two-thirds that of the market, which is where they are now. However, that comparison may be misleading, because of the unusually high valuation of the Magnificent Seven AI-related stocks, which sell at high price/earnings ratios and make up over one third of the market’s value. Taking out those stocks, the rest of the market probably sells at closer to 22x, and in comparison, utilities would look less attractive. In other words, utility stocks sell where you might expect them to on a relative basis, only if you accept Magnificent Seven valuations as permanent. Before you dismiss this analysis by saying this time is different, remember the Nifty Fifty, the stocks like IBM that would never go out of fashion (but did), and the days when electricity sales were destined to rise forever. It has happened before.

In short, utility stocks don’t seem cheap relative to the market, although not notably overvalued either, so the big question for utility investors should be: where will the market go? Because, given that utilities don’t look like bargains, that is the direction we see them taking.

By Leonard Hyman and William Tilles for Oilprice.com

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