Does Centrica PLC Pass My Triple-Yield Test?

centrica / sse

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 68% on its March 2009 low, and the wider market is no longer cheap, so 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 Centrica (LSE: CNA) (NASDAQOTH: CPYYY.US), 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 income 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:

Centrica Value
Current share price 314p
Dividend yield 5.3%
Earnings yield 8.7%
Free cash flow yield 7.4%
FTSE 100 average dividend yield 3.0%
FTSE 100 earnings yield 6.0%
Instant access cash savings rate 1.5%
UK 10yr govt bond yield 2.7%

A share’s earnings yield is simply the inverse of its P/E ratio, and makes it easier to compare a company’s earnings with its dividend yield.

Centrica’s earnings yield of 8.7% reflects the low valuations currently prevailing in the utility sector, thanks to political uncertainty about future pricing and renewable subsidies, and the threat of a price freeze if Labour wins the next general election.

Despite this risk, Centrica’s shares do look attractively valued at the moment. A dividend of 5.3% is amply covered by the shares’ free cash flow yield of 7.4%, which shows that Centrica generated more surplus cash over the last 12 months than it paid out in dividends.

Is Centrica a buy?

On a current financial basis, Centrica looks like a strong buy, with a well-covered yield that’s nearly twice the FTSE average, and an undemanding forward P/E of 11.7.

However, the flipside of the high yield provided by utility shares is that they are subject to a greater degree of political risk than most other firms. Centrica’s results show that gas and electricity volumes per household have fallen since 2008, and it has relied on price increases to maintain its profits.

With 12 million residential customers, British Gas is unlikely to grow much larger, leaving Centrica highly vulnerable to a politically-motivated price cap, which could come as soon as next summer.

If I was an existing Centrica shareholder, I’d continue to hold, but new buyers might want to remain on the sidelines for a little longer.

An alternative to Centrica?

Although I believe that political interference could lead to a dividend cut for Centrica shareholders, there is one utility that I reckon provides a far safer way to play the UK market.

I can't reveal the name here, but I can say that the Motley Fool's expert analysts agree with my choice, and recently selected the company for their exclusive special report, "5 Shares To Retire On".

The five companies included in the report currently offer an average prospective yield of 4.3%. For instant access to your free copy of this report, just click here.

> Roland does not own shares in Centrica.