Many investors who focus on a low price-to-earnings ratio and high dividend yield in their search for value will have a hard time swallowing the maxim legendary investor Warren Buffett lives by: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”.
Today, I’m considering whether FTSE 100 utility company National Grid (LSE: NG) (NYSE: NGG.US) is a wonderful company, and whether its shares are trading at a fair price.
A wonderful company?
During 2010, Buffett’s Berkshire Hathaway investment group completed its biggest ever acquisition. Berkshire bought the US’s largest rail company, Burlington Northern Santa Fe (BNSF), in a deal valued at $44bn.
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In Berkshire’s annual letter to shareholders, Buffett discusses BNSF alongside another of Berkshire’s major operations, utilities group MidAmerican Energy, in a section headed ‘Regulated, Capital-Intensive Businesses’.
Buffett distinguishes these businesses from Berkshire’s many others: “A key characteristic of both companies is the huge investment they have in very long-lived, regulated assets, with these funded by large amounts of long-term debt”.
Ordinarily, Buffett prefers to invest in companies that have no debt, or modest debt. Regulated businesses, then, are the exception to the rule.
National Grid certainly has plenty of debt: over £21bn at the last balance sheet date of 31 March. But the nominal amount of debt is less important than the company’s ability to service it.
National Grid’s interest cover was 3.9x at the last reckoning, comfortably above management’s target range of 3 to 3.5x. That looks good on the face of it, but how does it compare with Buffett’s MidAmerican group?
MidAmerican has been building its interest cover under Buffett’s ownership: cover rose from 2.3x to 3.9x between 2001 and 2010, and at the latest reckoning stood at 4.6x. MidAmerican says: “Zero dividends paid to Berkshire Hathaway and tax benefits received [from Berkshire] have allowed for an accelerated improvement in credit ratios”.
Be that as it may, there’s not a huge debt-affordability gulf between National Grid and MidAmerican. Indeed, credit rating agencies Moody’s, S&P and Fitch have the two companies on identical ratings.
National Grid and MidAmerican are also closely matched on return on equity (ROE), which is one of Buffett’s preferred measures of what he calls “managerial economic performance”. Due to regulation, utilities will never have the highest ROEs in the market, but National Grid and MidAmerican both manage to deliver ROEs in double figures.
Buffett has said of the utilities companies that make up MidAmerican: “Berkshire’s ever-growing collection of good to great businesses should produce above-average, though certainly not spectacular, returns in the decades ahead”. I’d say National Grid wouldn’t look out of place within that collection.
A fair price?
The relative predictability of regulated businesses makes them suitable for discounted earnings models of valuation — a variation of which Buffett uses. I can tell you that the Motley Fool’s leading analyst not only believes National Grid is a wonderful company, but also has run the discounted earnings numbers and concluded that at 775p the company’s shares are at a 9% discount to fair value.
