Investing in Electric Utility Stocks

Updated: Aug. 25, 2020, 11:43 a.m.

Electric utility stocks are companies that:

  • Generate a meaningful portion of their income from regulated electric utilities.
  • Trade publicly on a stock market exchange (e.g., Nasdaq or New York Stock Exchange).

What is an electric utility?

A utility company maintains infrastructure for public service. Utilities stocks include companies that distribute electricity and natural gas, as well as those that provide water and wastewater services.

An electric utility company's main objective is to provide reliable power to its customers. It does so by performing three functions:

  1. Generate or purchase electricity from power generation facilities.
  2. Distribute this power to end users like homes and businesses through an interconnected grid system.
  3. Maintain and expand its electrical infrastructure to ensure reliability.

What makes electric utilities good investments?

It costs lots of money to build and maintain electricity-generating plants and electrical distribution systems. Because of that, governments give electric utilities a monopoly to operate in a specific region, meaning they're the only company allowed to operate a power distribution system. Government entities then regulate these companies by approving the rates and fees they can charge customers for providing them with electricity. As a result, electric utilities generate predictable revenue -- a desirable feature for those seeking lower-risk investments.

Electric utility stocks also typically pay a dividend, which is a cash payment of a portion of the company's profit, to their investors. Utilities generally offer an above-average dividend yield -- the ratio of a company's annual dividend to its stock price. That's 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 investments for retirees.

What are the best electric utility stocks?

Several publicly traded companies operate electric utilities, giving investors lots of options in this sector. Below, find three stocks -- Duke Energy (NYSE:DUK), NextEra Energy (NYSE:NEE), and Xcel Energy (NASDAQ:XEL) -- that stand out and what makes them such solid investments.

Duke Energy

Duke Energy (NYSE:DUK) is one of the largest energy holding companies in the country. It operates three business segments:

Duke Energy’s portfolio of utilities generates steady rate-regulated revenue. Meanwhile, its non-regulated renewable energy business produces stable cash because it sells the power produced under long-term, fixed-rate power purchase agreements (PPAs) to other utilities and end users.

Duke Energy stands above many other utilities because it complements its steady revenue-generating ability with a strong financial profile (including an investment-grade credit rating) and a conservative dividend payout ratio, giving it the flexibility to invest in cleaner energy. Those expansion-related investments position Duke Energy to grow its earnings per share at a 4% to 6% annual rate through 2024. Add that steady growth to Duke’s dividend, and investors could enjoy attractive total returns.

NextEra Energy

NextEra Energy (NYSE:NEE) is one of the largest electric utilities in the country, owning two separate companies in Florida that serve roughly 5.5 million people. It also operates a competitive energy business that generates and sells electricity under long-term PPAs. This business is the world's largest generator of renewable energy from the wind and sun.

NextEra Energy has all the qualities an investor would want in a utility. It routinely has one of the highest credit ratings among large, rate-regulated electric utilities. It also typically has a lower-than-average dividend payout ratio. That gives NextEra the financial flexibility to invest in making its utilities cleaner while building more renewable power projects.

Those investments should expand NextEra’s earnings 6% to 8% annually through 2022, while growing its dividend by 10% per year during that time frame. That’s above-average growth for the sector, which could help NextEra generate sector-leading total stock returns.

Xcel Energy

Xcel Energy (NASDAQ:XEL) operates four electric and gas utilities across eight states in the central U.S., serving 3.6 million electric customers and 2 million natural gas customers. Those businesses generate predictable rate-regulated revenue.

Xcel Energy’s excellent qualities include an investment-grade balance sheet and a conservative dividend payout ratio. Its strong financial profile gives it the flexibility to invest in high-return expansion opportunities, such as replacing coal-fired power plants with wind power. The company believes these investments to transform itself into a cleaner electric utility can grow its earnings per share 5% to 7% through 2024. That steady growth, combined with Xcel’s dividend, could produce attractive total shareholder returns.

How to find the best electric utility stocks

Investors need to understand how to analyze electric utility businesses in order to find companies with the potential to generate attractive total returns. Three main factors have contributed to outperformance in the sector over the years:

1. Financial strength

Having a strong financial profile is vital for an electric utility, because it needs to fund the maintenance and expansion of its infrastructure while also paying an attractive dividend to its shareholders. 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 a low risk of defaulting on its debt by failing to make payments. 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 dividend (usually more than 65%). However, because financial strength is so important, investors should focus on electric utilities with lower-than-average dividend payout ratios. That allows utilities to retain more cash to finance growth, which enhances their financial strength.

3. Consistent earnings growth

The best utilities can steadily grow their earnings per share by investing in initiatives that earn high returns on investment. For example, utilities can increase their profitability by retiring aging and expensive coal-fired power generation plants and replacing them with cheaper, cleaner ones powered by natural gas. Likewise, they can expand 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 the company with the financial flexibility to steadily grow its earnings and its dividend. And those two factors help power an attractive total stock return to shareholders -- the combination of a dividend stock's yield and its stock price appreciation.

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