If we look at a five-year share-price chart for National Grid (LSE: NG) (NYSE: NGG.US), the gas and electricity transmission system operator, we see an almost perfect two-o’clock rise over the period, of the sort usually associated with a steady growth company that is increasing its earnings and cash flow year on year.
A flat business
Despite the impression given by its share price, National Grid’s business has been trading flat over the period, as we can see from the record:
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2010 |
2011 |
2012 |
2013 |
2014 |
|
Net cash from operations (£m) |
4,516 |
4,858 |
4,228 |
3,750 |
4,019 |
|
Operating profit (£m) |
3293 |
3745 |
3539 |
3749 |
3735 |
Valuation-expansion drives the share-price rise, and the momentum will surely end unless profits and cash flow rise to support the upward movement.
Investors prize defensive companies such as National Grid because steady demand leads to consistent cash flow, but what’s that worth? At today’s share price of 900p, the forward P/E rating is over 15 for year to March 2016. That strikes me as rich for a firm that City analysts expect to grow earnings by just 5%, and that after a 17% earnings’ decline during year to March 2015.
But isn’t it about the dividend?
It’s true that National Grid keeps its dividend rising. The forward yield is running at almost 5%, which seems attractive on the surface.
However, remember those flat profits — the dividend keeps rising at the expense of cover from earnings. 2016’s payout will only be covered about 1.3 times by forecast earnings. That’s thin-looking cover that can’t keep getting thinner indefinitely. Sooner or later, the forward dividend progression will need to halt, or earnings rise, or both.
If we notionally adjust the payout to achieve a more comfortable two-times cover from earnings, the forward yield would be about 3.2% and I think that’s a better yield-perspective measure of valuation for National Grid.
What now?
Demand for National Grid’s services might be steady and its cash flow constant, but the industry has its challenges. Fierce regulation adds a measure of uncertainty, and the capital-intensive nature of operations keeps the firm reliant on high gearing from its debt-load.
The firm is no growth-star and deserves to be on a lower rating given the risks that its activities carry. The yield should be higher and better covered from earnings in my view.
Whichever way I look at National Grid, the shares seem expensive — so I’m keeping away.
