Utility stocks are hugely popular with income investors because utility companies tend to earn stable revenues, which enables them to pay steady, reliable dividends to shareholders. During market downturns, such stocks also often outperform the stock market, which make them excellent candidates for a well-diversified dividend portfolio.
Centrica (LSE: CNA) and National Grid (LSE: NG) are both utility stocks, but as always, no two stocks are the same. In this article, I’ll take a look at the differences between these stocks and explain why I prefer Centrica over National Grid right now.
One of the most important measures of value is the price-to-earnings (P/E) ratio — it’s simply calculated by dividing a company’s share price by its earnings per share. A stock that trades at a lower multiple of its profits is therefore seen as cheaper than one that trades at a higher ratio.
With a 2016 estimated P/E of 13.8, Centrica currently trades at a modest discount to National Grid, which has an estimated P/E of 15.1.
Although, in the past, I’ve championed National Grid over Centrica, my position has now changed. National Grid does still benefit from a lower risk profile, but Centrica seems significantly cheaper and trading conditions are finally looking up for the energy supplier.
Better near-term outlook
Centrica seems set to generate much stronger earnings growth than National Grid amid recovering wholesale electricity prices and cost efficiency gains.
While competition in the retail supply market has intensified in recent years with the entry of many smaller outfits such as First Utility and Ovo Energy, the recent collapse of GB Energy highlights the difficult trading conditions smaller suppliers face right now.
The business models of the smaller suppliers are now being tested as wholesale electricity prices have bounced back, due to a recovery in energy prices and sterling weakness. Smaller suppliers tend not to have the hedging capabilities that their larger rivals benefit from, which makes them more vulnerable to rising energy costs.
Meanwhile, larger suppliers, like Centrica, are finally reaping the rewards of their hedging strategies and this now gives them a competitive edge over smaller rivals as wholesale prices have been rising. They can now more effectively compete on prices and protect their profit margins.
Moreover, Centrica is doing a good job on what it can itself control. It has been reducing its exposure to global oil price volatility by moving away from upstream and has made annual cost savings of over £300m as part of the group’s cost efficiency drive.
National Grid, on the contrary, appears to have less upside potential. As the company’s operational performance already appears to be solid, there’s less to be gained from further efficiency gains. Also, as a regulated utility business, revenues are forecast to grow only modestly, in line with its regulated asset base.
Looking forward, Centrica’s superior earnings growth is set to continue — City analysts currently forecast Centrica’s earnings to rise by 14% over the next two years, while National Grid is expected to post much more modest earnings growth of 6%.
Higher dividend yield
Finally, Centrica has a higher dividend yield. Although they’re both worthy dividend picks for their 4%-plus yields, Centrica has a slight edge today. At the time of writing, its shares carry a dividend yield of 5.2%, while National Grid yields 4.6%.
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Jack Tang has no position in any shares mentioned. The Motley Fool UK has recommended Centrica and National Grid. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.