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This P/E Suggests National Grid plc is a Buy

The FTSE 100 has risen by more than 85% since it hit rock bottom in 2009, and bargains are getting harder to find.

I’m on the hunt for companies that still look cheap, based on their long-term earnings potential. To help me hunt down these bargains, I’m using a special version of the price to earnings ratio called the PE10, which is one of my favourite tools for value investing.

The PE10 compares the current share price with average earnings per share for the last ten years. This lets you see whether a company looks cheap compared to its long-term earnings.

Today, I’m going to take a look at the PE10 of dividend favourite National Grid (LSE: NG) (NYSE: NGG.US).

High yield, low price?

National Grid currently offers a 5.2% dividend yield and has committed to increase its dividend in-line with RPI inflation for the ‘foreseeable future’. As a result, it’s a firm favourite with income investors — but has this popularity pumped up National Grid’s valuation, or does it still look cheap?

Let’s take a look at National Grid’s current price-to-earnings ratio, and its PE10:

  Trailing
P/E
PE10
National Grid 13.9 12.2

National Grid’s trailing P/E of 13.9 is significantly lower than the FTSE 100 average of 16, although it’s worth remembering that utilities are low-growth businesses, and that National Grid’s current 780p share price is quite close to its all-time highs.

More encouraging is the firm’s PE10, which shows that National Grid is currently trading on just 12.2 times its average earnings from the last ten years. Although not quite in bargain basement territory, this is a fairly undemanding valuation.

Is National Grid a buy?

National Grid’s key attraction for investors is its income, and in the current market, the firm’s prospective yield of 5.4% — backed by regulated income, and increased in-line with RPI inflation each year — is very competitive.

An additional attraction of National Grid is its geographic diversity. Its US business accounts for nearly half of its profits, and should help to lessen the impact of exceptional events and regulatory changes.

National Grid’s current regulatory price controls came into force in April, and will run for eight years. If the firm’s management has done its sums correctly, National Grid should be able to maintain its inflation-linked dividend payments until at least 2021, making the firm’s shares a clear buy, in my opinion.

Can you beat the market?

If you already own shares in National Grid, then I’d strongly recommend that you take a look at this special Motley Fool report. Newly updated for 2013, it contains details of top UK fund manager Neil Woodford’s eight largest holdings.

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> Roland does not own shares in any of the companies mentioned in this article.