Safe drinking water is just a small step below clean air on the list of must-haves for human life, which is one of the reasons to like utility American Water Works (AWK 0.47%). But it's not the only reason by any stretch of the imagination. Here's why this company has such strong prospects and a look at whether or not this good news is enough to justify buying the stock today.
Bad news is good news
It's no secret that the U.S. has an infrastructure system that is in need of investment. Indeed, the American Society of Civil Engines just gave the U.S. a C grade in its most recent infrastructure report card, a wide-ranging look at the state of the country's physical assets. That's not a very good grade, with drinking water infrastructure getting the same mark on an individual basis. The upshot is that a lot of money will need to be spent upgrading water systems in the years ahead.
That may sound bad, but for American Water Works it is actually an opportunity. Effectively, the company buys water systems from towns and cities and runs them under government regulation. If the price to upgrade a system is high, it is more likely to be sold, passing the effort and cost of upgrading on to someone else. American Water Works has long benefited from this situation to grow via acquisition.
But as a regulated utility, American Water Works also grows its revenue by investing in the systems it acquires. That's because it essentially passes on the cost of upgrades to customers via rate increases. Those rate hikes have to be approved by regulators, but that's not a tough sell given the state of many U.S. water systems and the vital importance of safe drinking water.
All in, American Water Works is a very reliable business. To put a number on that, the water utility has increased its dividend every year since it went public in 2008. That's no small feat, putting the company into the Dividend Achiever space. And the rate of dividend growth, at over 12% on an annualized basis over the past decade, is quite impressive. The long-term target for dividend growth is between 7% and 10% with a payout ratio of between 50% and 60%. The most recent hike was 9.5%. This is a solid option for dividend growth investors with plenty of room for growth ahead, given the state of the U.S. water system.
But is it worth buying?
So American Water Works looks pretty attractive as a business, but that's only half the story. Indeed, even great companies can be bad investments if you pay too much for them, as investment legend Benjamin Graham explained in The Intelligent Investor. For those who don't know this book or Graham's name, he helped to train Warren Buffett. The problem with American Water Works is that investors appear well aware of how rosy its prospects are.
For example, the stock's dividend yield is a scant 1.3%. That is, literally, the lowest level over the past decade. What's interesting here, however, is that the yield trended lower and lower over the span as the stock traded higher and higher. This is a much-loved stock.
Yield, however, is a rough gauge of valuation. So it pays to back up this measure with other numbers. For example, American Water Works' price-to-sales ratio is around 8.6 times today compared to a five-year average of 5.6 times. Its price-to-earnings ratio is a huge 44 times compared to an average of 35, which is itself a pretty big number that you would expect from a tech company and not, perhaps, from a utility. Its price-to-cash flow is currently around 23.6 times compared to a five-year average of 14.5 times. And its price-to-book value rounds things out, coming in at nearly five times versus a longer-term average of 3.3 times. American Water Works looks expensive just about any way you slice it.
Know what you are buying
American Water Works has a good business with ample room for growth. It is the type of company that a dividend growth investor would be happy to own. However, given the stock's elevated price today, it probably isn't a stock that most investors should be buying right now, especially if you have even the slightest of value biases. That said, if you are willing to pay up for dividend growth, then perhaps American Water Works could be of interest. Just go in knowing that a lot of good news is priced in here.