I’m taking a look at whether these two dividend favourites have become too expensive after their recent gains?
Not just valuations
Utilities come to mind when I think of defensive dividend investing, and National Grid (LSE: NG) is probably the quintessential defensive stock. Being a natural monopoly in a heavily regulated industry means the company earns “rent-like” profits, which gives it visibility over long-term cash flows.
But following an 11% gain in its share price since the start of the year, and a fall in its dividend yield to 4.1%, has National Grid now become too expensive?
One big thing that’s been attracting investors to the stock is the company’s forthcoming special dividend. Following the sale of its 61% stake in its UK gas distribution business, the company has committed to paying shareholders a £3.2bn special dividend. This equates to a dividend of 84.375p per share, which is worth roughly 8% of its current share price. The stock is due to go ex-dividend on 22 May 2017, meaning new buyers still have time to buy shares in National Grid and be eligible to receive the special payout.
But even after subtracting the value of its forthcoming special dividend from its share price, National Grid trades on a pricey forward P/E ratio of 16 times. Usually, when a stock trades at such multiples on its future earnings, it implies that relatively high levels of growth are on the cards. However, City analysts expect earnings to grow by less than 5% in each of the next three years, with dividend growth of at least RPI inflation only after 11 for 12 share consolidation.
Moreover, it’s not just valuations that investors should be worried about. Government intervention in the energy market, particularly price controls, seems increasingly likely, and this could delay much needed investment in new generation capacity. If this were to happen, this would hurt growth in National Grid’s regulatory asset base and, therefore, earnings growth too.
Weighing up these factors, I reckon National Grid looks too expensive at these levels.
Pension concerns
Another stock which income investors should be wary of is BAE Systems (LSE: BA). The defence company has also enjoyed a significant share price gain over the past year. A former favourite of fund manager Neil Woodford, BAE shares have risen 31% over the past 52-weeks, with an 8% gain since the start of 2017.
That results in the stock now trading on a forward P/E ratio of 14.5 and dividends yielding 3.3% — which doesn’t seem especially expensive against the market. However, its valuations do seem pricey when compared to its historic norms, as its five-year historical forward P/E average is 11.8, with an average trailing dividend yield of 4.6%.
Investors also need to be wary of the BAE’s hefty pension deficit, which was the main reason behind Neil Woodford selling the £160m stake in the company last year. This is because the company may not have much cash left over to fund growth in its dividend payouts as it focuses on increasing pension contributions and reducing its leverage. And this implies that despite expectations of healthy high single-digit earnings growth over the next two years, dividend growth for the stock may languish in low single-digits.
Given the risks involved, I reckon the current yield of 3.3% looks a little disappointing.
