Investing in Top Utility Stocks

Updated: June 24, 2020, 4:01 p.m.

Utility stocks provide essential services such as electricity, natural gas, and water and wastewater to residential and commercial customers.

The steady demand for these services has helped utility stocks historically generate relatively stable earnings. Meanwhile, the rates they charge for delivering these services are either regulated (i.e., approved by a government entity) or contractually guaranteed (nonregulated). Utilities’ reliable earnings enable these companies to pay dividends with above-average yields. That combination of predictable profitability and income generation makes utility stocks lower-risk options for investors.

However, not all utility stocks deliver competitive investment returns. The best utilities share additional noteworthy characteristics that give them the power to outperform.

What are the top utility stocks to buy?

The best investments in a utilities company boast a top-notch financial profile and visible growth prospects. Each of the below companies meets those criteria, and has the potential to produce above-average total stock returns -- its dividend yield plus its stock price appreciation.

Here is a list of stand-out companies, followed by our assessment of each investment:

1. American Water Works

American Water Works (NYSE:AWK) is the largest publicly traded water and wastewater utility in the U.S. It makes most of its money by providing regulated water and wastewater services, with the rest coming from less predictable market-based activities, including services provided to homeowners and the military. American Water Works expects to grow its earnings per share at a compound annual rate of 7% to 10% between 2020 and 2024, which would make it one of the fastest-growing utilities in the country. The main driver of its outlook is a multibillion-dollar investment to expand its regulated operations. The water utility has the financial flexibility to support its expansion plan thanks to its top-tier financial profile. It's one of the three utilities rated highest by credit rating agency S&P Global (NYSE:SPGI). Meanwhile, it has a very conservative dividend payout ratio (it has targeted an average of around 55% of its adjusted EPS). That strong financial profile leads American Water Works to foresee dividend growth of 7% to 10% per year through 2024 while maintaining a conservative payout ratio target range of 50% to 60% of its earnings.

2. Brookfield Infrastructure Partners

Brookfield Infrastructure Partners (NYSE:BIP) owns a diversified portfolio of infrastructure businesses, including:

  • Regulated utilities: Regulated electric and natural gas transmission and distribution businesses and a port terminal.
  • Transport: Railroads, toll roads, and ports supported by long-term contracts or regulated rates.
  • Energy: Natural gas midstream and distributed energy operations backed by long-term contracts or regulated rates.
  • Data infrastructure: Data centers, cell towers, and fiber-optic cables supported by long-term contracts with customers.

Brookfield Infrastructure operates several utilities and utility-like businesses that generate predictable cash flow. It expects this portfolio to deliver high-single-digit annual earnings-per-share growth over the long term. It also anticipates acquiring new utility-like infrastructure businesses, which should provide an additional earnings boost. Supporting Brookfield Infrastructure's outlook is its top-notch financial profile. It has historically targeted a payout ratio of 60% to 70% of its cash flow. Further, it has a high credit rating for a company in the utility sector. Because of those factors, the company believes it can grow its dividend by an annual rate in the mid-to-high single digits over the long term.

3. NextEra Energy

NextEra Energy (NYSE:NEE) operates regulated electric utilities in Florida. It also owns a non-regulated competitive energy business that operates natural gas pipelines and renewable energy projects that generate predictable income backed by long-term, fixed-rate contracts. NextEra expects these businesses to grow its EPS at a 6% to 8% compound annual rate through 2022. That’s faster than the mid-to-mid single-digit EPS growth rate projections of its largest peers in the electric utilities sector. Powering that growth is NextEra’s ability to fund high-return expansion opportunities thanks to its strong financial profile. That profile includes one of the highest credit ratings among the large, rate-regulated electric utility companies, and a dividend payout ratio that’s historically been below the sector average. Because of its lower payout ratio, NextEra plans to grow its dividend by roughly 10% per year through at least 2022.

Multicolored interconnected outdoor water pipes.

Image source: Getty Images

What makes a good utility stock investment?

Utility infrastructure is costly to build and maintain. Because of that, a utility needs a strong financial profile to invest in maintaining and expanding its infrastructure while also paying an attractive dividend. Three metrics can help you gauge utilities’ financial strength.

An investment-grade bond rating

A bond rating or credit rating for a company is like a credit score for an individual. Companies with higher, “investment-grade” bond ratings can borrow money at lower rates and on easier terms. That's important for utilities, since they routinely need to borrow money to help fund maintenance and expansion projects. So investors should seek out companies with high bond ratings, since they can more easily finance their operations, which helps them grow their earnings and dividends.

Low leverage metrics

Utilities need to borrow money to finance maintenance and expansion projects. But having too much debt limits their ability to grow. Because of that, investors should look for utilities with conservative leverage metrics for the sector. Two notable ones are the debt-to-EBITDA ratio (i.e., debt in relation to income) and debt to total capital (i.e, debt in relation to total value). Good targets for the sector are a debt-to-EBITDA ratio of less than 4.5 times and a debt-to-capital value of less than 60%.

A conservative dividend payout ratio

A dividend payout ratio is the percentage of a company's profits that it pays out to investors via its dividends. Utilities traditionally have a higher dividend payout ratio than other companies; averages of 65% for the sector in 2019 vs. 36% for the average company in the S&P 500, but utilities with below-average payout ratios for the sector retain more cash to reinvest in expansion projects. As a result, they don't need to borrow as much money (which would lower their credit rating) or issue as many new shares (which would dilute existing investors’ shares of their profits) to finance growth.

Utilities with stronger financial profiles have the flexibility to invest in expansion projects and make acquisitions that grow their earnings at an above-average rate. The extra fiscal strength also gives them more power to increase their dividends.

Related topics

The best utility stocks offer above-average growth for less risk

These utility companies all have top-tier financial profiles. Because of that, they have the flexibility to invest in expanding their operations while also growing their dividends. Those dual growth drivers should give these utilities the power to produce attractive total returns for investors over the long term.

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