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How Safe Is Your Money In National Grid plc?

Investors have pushed the share price of National Grid (LSE: NG) (NYSE: NGG.US) up to record highs recently, cutting its forecast dividend yield to less than 5%.

national gridDividend growth will be scaled back, too: National Grid’s new deal with regulator Ofgem will not reward shareholders as generously as in the past. Whereas recent years have seen dividend growth averaging around 8%, National Grid’s dividends will now grow in-line with RPI inflation — meaning shareholders should expect annual dividend growth of around 3% for the foreseeable future.

All of which means that new investors are accepting lower returns from National Grid than in the past — so they must be pretty certain that the grid operator is a safer bet than high-yielding utility peers such as SSE, which currently offers a prospective yield of 5.7%.

I reckon investors are right to trust National Grid for their income — here’s why.

1. Interest cover

What we’re looking for here is a ratio of at least 2, to show that National Grid’s earnings cover its interest payments with room to spare:

Operating profits/net interest paid = interest cover

£3,735m / £901m = 4.1 times interest cover

As a regulated utility, National Grid benefits from predictable revenues and low debt costs. Against this backdrop, the firm’s interest cover of 4.1 times is ample, and should ensure that National Grid’s dividend isn’t threatened in the near future.

2. Gearing

Gearing is simply the ratio of debt to shareholder equity, or book value. I tend to use net debt, as companies often maintain large cash balances that can be used to reduce debt if necessary.

Utilities normally have high levels of gearing, and National Grid is no exception. According to the firm’s 2013/14 accounts, National Grid has net debt of £21.2bn, and equity of £11.9bn, giving net gearing of 178%.

Although this would be alarmingly high for most businesses, it shouldn’t be a problem for National Grid — although investors should be aware of the risk that future regulatory price increases in the UK and US may be less generous than in the past, which could trigger a change to National Grid’s inflation-linked dividend policy.

3. Operating margin

Last year, National Grid reported an operating margin of 25%. This is impressive by any measure, and emphasises the firm’s near-monopoly status as the UK’s main electricity and gas grid operator.

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> Roland owns shares in SSE, but does not own shares in National Grid.