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.
