A 5%+ yield but down 11%! National Grid’s share price looks cheap to me

National Grid’s share price looks undervalued against its peers, reflecting neither its monopoly nor its ability to weather changing economic times.

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National Grid’s (LSE: NG) share price doesn’t fully reflect its monopoly status or its significantly recession-resistant business, in my view.

A monopoly business

Households and businesses will always need electricity, whether from fossil or non-fossil fuels.

So, National Grid’s position as owner and operator of the electricity transmission system in England and Wales should generate good business even in economic downturns.

It is also the owner and operator of the two nations’ gas transmission systems. However, it’s in the process of selling off parts of this to focus on electricity.

This seems sensible to me for two reasons. First, gas usage is due to be dramatically wound down in the ongoing transition to clean energy.

Second, the proceeds of these sales can offset the major expense of maintaining and updating the electricity network. 

Its debt-to-EBITDA ratio of 7.6 reflects a relatively high debt resulting mainly from these obligations. I would like to see this start to trend lower over the next three years.

More positively though, its cover of 2.8 times should allow it to service this debt without too many difficulties.

Able to withstand a recession?

Its H1 2023/24 results covered the period when the UK’s cost-of-living crisis was near its peak. Although down 15% on the same period the previous year, the company still made an underlying profit of nearly £1.8bn.

It also continued to pay a good dividend, and it did so during the peak years of Covid as well.

Working back from 2023, the dividends yielded 5.3%, 4.3%, 5.7%, 5.1%, and 5.6%, respectively. This compares to the average FTSE 100 yield from 2019-2023 of around 3.7%.

As part of these results released on 9 November 2023, the firm maintained its five-year financial targets for 2020/21 to 2025/26.

These include an assets’ compound annual growth rate (CAGR) of 8%-10%, and an earnings per share (EPS) CAGR of 6%-8%.

Does the share price reflect this?

To ascertain whether National Grid’s business is fully reflected in its share price, I used the key price-to-earnings (P/E) ratio.

It trades at a P/E of 15.1, against a peer group average of 16.6 — suggesting it is very good value.

A discounted cash flow analysis shows its shares to be around 25% undervalued at their present price of £10.45. 

Therefore, a fair value would be about £13.93, although they may never reach that price, of course.

Dividend looks set to rise

For its full-year 2022/23 (running from 1 April 2022 to 31 March 2023), it paid 55.44p in dividends. This gives a 5.3% yield on the current share price.

Looking ahead, it increased its interim dividend in its half-year results by 9%. If this were applied to the full-year dividend, then the payout this year would be 60.43p.

Based on the present share price, this would give a dividend yield of 5.8%.

I don’t currently own an out-and-out defensive stock – one whose performance doesn’t change much in economic good times or bad. So, I am seriously considering buying this one for three key reasons.

First, its strong monopoly business. Second, the demonstrated undervaluation of its share price against those of its peers. And third, a good yield that compares very favourably to the 3.9% current average return of the FTSE 100.

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.

Simon Watkins has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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