One of the key ways to gauge the financial strength of a utility is to see whether it has an investment-grade credit rating on its bonds. That's similar to a high credit score, suggesting the borrower is at low risk of defaulting on its debts. An investment-grade rating means a company can borrow money at lower interest rates and better terms.
2. A conservative dividend payout ratio
Utilities pay out a significant percentage of their earnings to investors via their dividends (usually around 65%). However, because financial strength is so important, investors should focus on electric utilities with lower-than-average dividend payout ratios. The lower ratios allow companies to retain more cash to finance growth, which enhances their financial strength.
3. Consistent earnings growth
The best utilities can steadily increase their earnings per share by investing in initiatives that earn high returns on investment. For example, utilities can improve their profitability by retiring aging and expensive coal-fired power-generation plants and replacing them with cheaper, cleaner ones powered by natural gas or renewables.
Likewise, they can increase their earnings by taking advantage of tax credits and other incentives to build out renewable energy projects. Investors seeking electric utility stocks to buy should look for these three characteristics.
These strengths should provide a company with the financial flexibility to steadily expand its earnings and its dividend. Those factors help power an attractive total stock return to shareholders -- the combination of a stock's dividend yield and its stock price appreciation.
Why are electric company stocks good investments?
Electric utility companies have several features that make them attractive investments, including:
- Predictable revenue: It costs lots of money to build and maintain electricity-generating plants and electrical distribution systems, so governments give electric utilities a monopoly to operate in a specific region. Government entities then regulate these companies by approving the rates and fees they can charge customers for providing electricity. As a result, electric utilities generate predictable revenue -- a desirable feature for those seeking lower-risk investments.
- Steady growth: Electricity demand tends to be stable and rises steadily. Catalysts such as economic growth, increased digitalization, and the growing adoption of electric vehicles should power steady growth in demand in the coming decades. That should enable electric utilities to continue investing capital to expand their operations, supporting steady earnings growth.
- Attractive dividends: Electric utility stocks also typically pay investors a dividend, which is a cash payment of a portion of the company's profit. Utilities generally offer an above-average dividend yield -- the ratio of a company's annual dividend to its stock price -- because they choose to pay out a larger share of their profit instead of retaining it to expand their operations. The sector's higher dividend yields make these stocks attractive income investments for retirees.
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