Does Severn Trent Plc Pass My Triple Yield Test?

2013 bid target Severn Trent Plc (LON:SVT) continues to trade at a premium to its peers. Roland Head asks whether the firm’s likely returns can justify its rich valuation.

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Like most private investors, I drip feed money from my earnings into my investment account each month. To stay fully invested, I need to make regular purchases, regardless of the market’s latest gyrations.

However, the FTSE 100 is up 75% on its March 2009 low, and the wider market is no longer cheap — it’s getting harder to find shares that meet my criteria for affordability.

In this article, I’m going to run my investing eye over water utility Severn Trent (LSE: SVT) to see if it might fit the bill.

The triple yield test

Today’s low interest rates mean that shares have become some of the most attractive income-bearing investments available.

To gauge the affordability of a share for my portfolio, I like to look at three key trailing yield figures — the dividend, earnings and free cash flow yields. I call this my triple yield test:

Seven Trent Value
Current share price 1,793p
Dividend yield 4.3%
Earnings yield 5.6%
Free cash flow yield 1.4%
FTSE 100 average dividend yield 2.9%
FTSE 100 earnings yield 5.8%
Instant access cash savings rate 1.5%
UK 10yr govt bond yield 2.8%

A share’s earnings yield is simply the inverse of its P/E ratio. Severn Trent’s earnings yield of 5.6% equates to a pricey P/E of 17.9, which is clearly based solely on the firm’s 4.3% dividend yield — providing water to the UK population is hardly a growth business, after all.

Severn Trent’s free cash flow yield for the last twelve months is just 1.4%, which doesn’t cover its dividend yield, and suggests that the majority of the dividend comes from reserves or borrowings — not ideal, given that Severn Trent’s net gearing is a massive 400%. This is very high, even by the standards of UK utilities.

Is Severn Trent a buy?

Personally, I wouldn’t touch Severn Trent shares. The firm’s sky-high debt, high valuation and poor free cash flow cover all put me off, and I believe that Severn Trent’s less indebted and cheaper peer, United Utilities, looks much better value.

What’s more, I think that Severn Trent’s management were being greedy when they rejected last year’s 2,200p takeover bid on the grounds that it didn’t reflect the firm’s long-term value. Since the bid was made, Ofwat has cut its guidance for the average return water companies should expect from during the 2015-20 regulatory period from 4.3% to 3.85%, reducing the potential long-term gains for water utility investors.

Severn Trent is a strong sell, in my view. Last year’s bid provided a golden opportunity to get out, but there’s no reason I can see to expect another bid this year.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

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

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