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Utility stocks are known for their generous dividend yields. As of December 6, 2011, the average yield of electric utility equities under Value Line coverage was about 4.1%. At that time, 12 electric utility issues were yielding 4.8% or higher. So, why would an investor consider a low-yielding utility stock?

The yield of a utility stock is a key measure of its valuation, much as a price-to-earnings ratio is an important measure of valuation of nonutility equities. Thus, a utility stock with a low yield (by utility standards) can be thought of in the way that an investor looks at a nonutility stock with a high P/E ratio. Sometimes, a stock is attractive, despite its high valuation. Other times, it is merely overpriced.

Why do some utility stocks have much lower yields than most others in its industry? Dividend growth prospects have a lot to do with this. In general, lower yielding stocks offer above-average dividend growth potential. Other factors, such as a company’s financial strength or operating issues (e.g., nuclear plant troubles), can also affect the yield of its stock.

Wisconsin Energy (WEC) is an example of a low-yielding utility stock that is worthy of consideration by utility investors. As of December 6, 2011, its yield was 3.6%. This was well above the 2.3% median for all dividend-paying stocks under our coverage, but well below the 4.1% average for the electric utility industry. Even so, its dividend growth potential is excellent, considering that the company wants to raise its payout ratio (now below 50%) to 60%. In fact, Wisconsin Energy has announced its intention to boost the quarterly disbursement from $0.26 a share to $0.30 a share in the first period of 2012 (subject to board authorization). Over time, dividend growth should make up for the modest income sacrifice that investors are making initially.

ITC Holdings (ITC) is unique as the sole transmission-only publicly traded utility. Its earnings growth potential far exceeds that of the typical utility, and this is reflected in the valuation of its stock. Accordingly, it is not just a dividend play. As of December 6, 2011, its yield was 2.0%. That’s respectable, but a cut below the aforementioned median of 2.3%.

Not every low-yielding utility issue is similarly appealing. Cleco Corporation (CNL) was yielding 3.5% as of December 6, 2011. However, with the stock price already near the midpoint of our 2014-2016 Target Price Range, total return potential over that time is unimpressive, despite Cleco’s good dividend growth prospects. Note, too, that the usual rules of thumb about utility stock yields don’t always apply. IDACORP (IDA) had a yield of just 2.9% as of December 6, 2011, despite the fact that the board of directors hasn’t raised the dividend since it was cut in 2003. And we aren’t looking for an increase in 2012.

As of December 6, 2011, the gas utility industry had a lower average yield, at 3.6%, than the electric utility industry. This is due primarily to the lower risk that is inherent in the gas utility industry. The most conservative utility investors can choose from four gas utility stocks that carry our top rank for Safety, and most other equities in this group are ranked Above Average for Safety. So, this is another example of how low-yielding utility stocks can appeal to certain kinds of utility investors.

Looking at the yield of a utility stock is just the first step in evaluating its appeal. Utility investors shouldn’t automatically shun an equity with a relatively low yield. Dividend growth potential, a top-notch Safety rank, or unusual characteristics can make such a stock appealing, even if investors must forgo some current income. On the other hand, some low-yielding utility issues are simply overvalued.

 

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.