This P/E Suggests SSE Is a Buy

LONDON -- The FTSE 100 has risen by 25% over the last year, and many top shares are beginning to look quite expensive.

I'm on the hunt for companies that still look cheap, based on their long-term earnings potential. To help me hunt down these bargains, I'm using a special version of the price to earnings ratio called the PE10, which is one of my favorite tools for value investing.

The PE10 compares the current share price with average earnings per share for the last 10 years. This lets you see whether a company looks cheap, compared to its long-term earnings.

Today, I'm going to take a look at the PE10 for the U.K. utility firm SSE  (LSE: SSE  ) (NASDAQOTH: SSEZY  ) .

Is SSE a buy?
SSE's share price has fallen by 9.6% since it peaked in May, as the yield demanded by investors from utility shares has risen, to reflect rising bond yields. As a result, SSE's yield has now risen above 5.5% once more.

Does this mean that the U.K.'s third-largest utility is now cheap? Let's take a look at SSE's current price-to-earnings ratio, and its PE10:

 

Trailing
P/E

PE10

SSE

12.8

19.9

At its current price of 1,515 pence, SSE shares currently change hands at 12.8 times the firm's 2013 adjusted earnings. That compares to a PE10 of 19.9, which highlights how widely SSE's earnings van vary from year to year, due to the investment demands of its business.

That's not cheap, but when you consider that SSE offers a fairly safe dividend yield of 5.6%, it doesn't seem so unreasonable.

Utilities play by different rules
P/E is not always a very useful ratio with utilities, because their regulated incomes and profit margins mean that they play by different rules to regular businesses.

In essence, regulated U.K. utilities are guaranteed a certain profit margin on top of the cost of their debt, as long as the borrowed money is invested in its regulated assets.

Since their growth potential is fairly limited, it's natural for utilities to reward their shareholders with generous dividends. This is an area in which SSE excels, having delivered above-inflation dividend increases every year since 1999.

For all of these reasons, I think that SSE's PE10 of 19.9 is largely irrelevant, and continue to rate the shares a buy -- with the caveat that May's fall could be the start of a larger correction, if bond markets continue to weaken and push up yields.

Can you beat the market?
If you already own shares in SSE, then I'd strongly recommend that you take a look at this special Motley Fool report. Newly updated for 2013, it contains details of top U.K. fund manager Neil Woodford's eight largest holdings.

Mr. Woodford's track record is impressive: if you'd invested £10,000 into his High Income fund in 1988, it would have been worth £193,000 at the end of 2012 -- a 1,830% increase!

This special report is completely free, but availability is limited, so click here to download your copy immediately.

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