With the high degree of uncertainty in the investing world today, investors naturally gravitate to investments perceived as low risk. Whether bidding up the prices of U.S. Treasury Bonds, or parking money in low volatility stocks with predictable earnings streams like utility stocks, investors seem happy to place money in these asset classes without regard to the prospect of future returns.
The future returns of Treasury bonds are easy to calculate. It only takes a minute for a high-schooler to be able to figure out the future return of the 10 year Treasury bond. Calculating the future return of a utility stock gets a little more complicated. It’s not rocket science mind you, but it does take a little more knowledge to get to a satisfactory conclusion.
Case in Point: Consolidated Edison (NYSE:ED)
According to Morningstar, for the month ending May 31st, 2012, the 1, 3, and 5 year total returns for Con Ed including dividends are 23.85%, 23.42% and 9.62% respectively. Everyone will agree that this is a batch of very healthy returns especially considering the difficulty of the period represented.
Historic rates of return are good to know but they tell us nothing about the future and after all, that’s all that matters in the world of investing. There are numerous ways to attempt to calculate a company’s future return but I would like to highlight a simple and yet effective way to make a decent projection. This idea is put forth by Mary Buffett and David Clark in their recent book: The Warren Buffett Stock Portfolio, Warren Buffett Stock Picks: Why and When He is investing in Them. (You can also hear my interview with Mary and David on my radio show: http://www.onthemoneyradio.org/guests/uploads/784.mp3
Here is how the calculation goes.
First we gather a couple of basic inputs; 1) The annual earnings per share 10 years ago and 2) the most recent EPS. 3) The current dividend rate, 4) the current price and 5) the lowest price to earnings ratio in the previous 10 years. The idea is to capture a long enough time frame to smooth out the business cycle and the authors feel 10 years is sufficient.
You will also need a CAGR (Compound Annual Growth) calculator (available on line) or as I have done, create a spreadsheet using IRR formulas to do the work for you.
Here is a table with the inputs for Con Ed.
Earnings in 2001
Earnings latest year
Dividend at today's rate
Current Price 6/14/12
Lowest PE- last 10 years
These inputs create the following calculations:
EPS Growth last 10 years: 1.71%
Earnings per share in 10 years at 1.71% CAGR: $4.25
Future Price Estimate (Future EPS X Lowest PE): $32.33
10 years of dividend earnings at $2.42 per year: $24.20
Total value at the end of 10 years: $56.53
Future Estimated Rate of Return at the Current Price: -.92%
Perhaps using the lowest PE is too stringent. Using a rough estimate of the average PE over the last 10 years of 15.2, the future CAGR rises to only 3.66% which is less than the current dividend yield.
Some may argue there are better measures than earnings per share for capital intensive companies. EBITDA and Free Cash Flow are often cited as superior yardsticks. Con Ed fails in these measures as well. According to Gurufocus.com, the 10 year growth of EBITDA and Free Cash Flow has been 1.7% and 0%, respectively. These numbers do not help the case for an investment in Con Ed.
At the current price, call it a bubble or just a crowded trade, the bottom line remains that in spite of the high dividend and perceived element of safety, Con Ed, in my opinion, is anything BUT safe. Always remember that you can buy a terrific company with the best balance sheet, the cleanest financials and most wonderful prospects for the future (Con Ed would NOT be included in this list) yet make the most serious mistake of all; the mistake of paying too much.
Hopefully, this exercise will help you to avoid that mistake. It is a good time to take profits and look elsewhere.