Is National Grid plc A Promising Capital-Growth Investment?

Some firms’ growth is more sustainable than others. What about National Grid plc (LON: NG)?

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nationalgrid1I’d find it hard to buy National Grid (LSE: NG) (NYSE: NGG.US) right now.

Don’t get me wrong, I can see that buying the firm’s shares at just about any point over the last 15 years has worked out well for investors that held on until today — the share-price chart is a perfect advertisement for buy-and-hold investing.

It’s just that the valuation seems to be stretching, and that makes me feel uneasy.

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Valuation up, business flat

Take 2010, for example. Back then, the shares valued the firm at a P/E rating somewhere around 10 and the dividend yield was knocking on the door of about 7%.  Today, the forward P/E rating is running at 15 or so, and the yield is down to about 5%.

The shares are more expensive than they were, but maybe that’s okay as long as earnings keep growing in a smooth, defensive sort of way. The trouble is that they aren’t. City forecasters predict an earnings’ decline of 17% this year followed by a 5% recovery the year after.  That’s not growth, it’s shrinkage.

Over the four-year period that National Grid’s valuation has increased by 50%, the firm’s actual business has been flat:

Year to March

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

Whichever way I look at that table it nets out the same way: valuation up, business flat. Surely, that’s not supposed to happen. However, it has happened and, I reckon, that’s the main reason that City analysts’ ratings cluster around neutral right now — I’m not the only observer concerned about forward total-return outcomes for investors from here.

The paradox of the ‘defensives’

We might think that with uncertain economic times just about all share valuations would contract. Yet there’s a tendency for defensive-type firms to do well on the stock market when investors are running scared.

Piling into firms with steady, predictable cash flows is appealing, and that effect seems magnified by the lousy returns savers get from holding cash. National Grid’s dividend yield still seems attractive at around 5%.

Yet, adjusted forward earnings cover the payout less than 1.3 times. Earnings and cash flow need to grow if dividend progression is to continue. Any whiff of a halt on dividend raising, or worse, a cut in the payout, and the firm’s valuation could start to contract, causing capital attrition to wipe out perhaps years’ worth of dividend gains for investors.

The higher the valuation goes, the higher the stakes. Maybe an interest-rate rise could send the valuation-cycle lurching into the other direction — down.

Five years from now anyone reading this article may be tittering into their hand as National Grid sits on a share price of £12 with P/E rating of 20 and a yield of 3%. Then again, perhaps the cyclical effect of valuations will kick in driving down the P/E rating and pushing up the dividend yield as investors abandon the defensives in favour of more appealing stock market opportunities in a benign macro-economic environment.

What next?

It’s the uncertainty that keeps me away from National Grid. To me, it’s best to buy the shares when they seem out of favour and when the valuation is modest. Although National Grid’s shares have done well lately, I’m not too keen.

Our analysis has uncovered an incredible value play!

This seems ridiculous, but we almost never see shares looking this cheap. Yet this Share Advisor pick has a price/book ratio of 0.31. In plain English, this means that investors effectively get in on a business that holds £1 of assets for every 31p they invest!

Of course, this is the stock market where money is always at risk — these valuations can change and there are no guarantees. But some risks are a LOT more interesting than others, and at The Motley Fool we believe this company is amongst them.

What’s more, it currently boasts a stellar dividend yield of around 10%, and right now it’s possible for investors to jump aboard at near-historic lows. Want to get the name for yourself?

See the full investment case

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Kevin Godbold has no position in any shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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