Are National Grid shares a buy?

National Grid PLC is the company that owns and operates the electricity and gas transmission networks in England and Wales.  It’s listed on the FTSE 100, has a market cap of around £28 billion and has paid a consistently growing dividend for many years – but does that make it a good buy with today’s share price at 746p?

As well as owning and operating transmission networks, National Grid also owns energy generation facilities in the US, operates (but doesn’t own) the Scottish transmission network, and is involved in various other activities that relate to getting energy to consumers and businesses.

Choosing your investment criteria

How you value shares depends on what you’re after.  If you’re after triple-digit gains in a year and are willing to risk a total loss, then a speculative mining company may have a certain value for you.  If, on the other hand, you are after a steady dividend income, then the value of a speculative mining company is essentially zero.

I’m a defensive value investor, which to me means aiming for steady growth of income and capital by investing in quality companies at attractively low prices.  Specifically, I want to invest in companies that have:

• Consistent, above-average records of growth
• Strong balance sheets
• Relatively large, preferably international operations
• High dividend and earnings yields
• Good future prospects

Let’s see how National Grid stacks up under those criteria.

Past financial performance

In the chart below, you can see how the company has done in recent years.

It’s easy to see that the company has had some pretty solid results, especially given the unexciting and perhaps even dull industry in which it operates.

Consistently high historic growth rates

Growth has averaged around 7.5%, with dividends growing at closer to 9%.  Despite somewhat volatile earnings, the general upward trend is clear and relatively consistent.

Strong balance sheet

This is an area where National Grid stumbles to some extent.  As a heavily regulated monopoly operator in the utility industry, it is virtually guaranteed revenue, profits, cash and growth.  On that basis, it may be acceptable for the company to carry more debt than would be prudent for a company that was not a monopoly.

In this case National Grid carries something like £28 billion in debt.  That is a lot by almost anybody’s definition.  Interest payments are covered only four times over by current earnings, which means around 25% of the company’s earnings are being used to pay the interest on its colossal debts.

For most companies, that would be a huge bankruptcy risk.  In a recession or downturn, the interest payments may not be kept up, and the end would be nigh.  For a heavily regulated monopoly, that’s unlikely to happen, although the debt is still a drag on returns to shareholders.  Every penny that goes to creditors is a penny that isn’t being productively reinvested or paid as a dividend to shareholders.

Large, international operations

National Grid is nothing if not large, with a market cap of almost £28 billion.  The company is perhaps surprisingly international too.  Although not widely diversified across many different countries, it does generate about 55% of its revenues outside the UK, principally in the US.

Given a choice, I would always prefer to spread risks internationally rather than being dependent on any single country.

Good future prospects

It’s one thing to look at the past, but as investors, we also need to think about the future.  Are past growth rates sustainable going forwards?  Is the regulatory environment going to remain stable?

These questions are the lifeblood of most investment analysts, which is a shame because, for the most part, the answers are almost entirely unpredictable.  However, we do know that the past dividend growth rate of around 9% is unlikely to be sustained due to regulatory changes.

National Grid recently announced a new dividend growth policy, which is to target dividend growth in line with RPI for the foreseeable future.  In practice, this will mean something between one and two percent above CPI inflation, which should still be enough to keep many income investors happy.

Is National Grid, the company, a worthy investment?

Although a much more detailed investment review should be carried out before investing, this brief overview shows that National Grid is a large, international, successful business which is consistently profitable and pays a progressive dividend.  I think it is likely to have an equally steady and consistent future.

All of those are features that I look for as a defensive value investor.  However, huge debts are a problem, and each investor must make up their own mind as to whether or not those debts are too much of a risk or not, given the regulated monopoly status of the company.

Are National Grid shares a good buy?

Assuming that the relatively high debt levels haven’t put you off, the next step is to move from looking at the company to looking at the price we’re being asked to pay for it.

As of 11^th September 2013, the shares stand at 746p each.

At that price, the shares have a dividend yield of 5.5%, while the FTSE 100, at 6,590, has a dividend yield of 3.5%.  So from day one, you will get a cash income which is some 57% higher from National Grid than you would from a FTSE 100 index tracker (income in both cases is, of course, variable and not guaranteed).

In terms of earnings, National Grid’s share price is 14.2 times its average earnings from the past decade.  The FTSE 100, in comparison, is priced at an almost identical 14.3 times its average earnings.

Combined with National Grid’s expected dividend growth rate (matching RPI inflation), the current 5.5% dividend yield looks very attractive compared to the market average.

On the UKVI Stock Screen, National Grid currently comes in at position 32 out of more than 200 consistently dividend-paying companies.  That’s more than high enough to make it into the model portfolio, but so far, those high debt levels have kept it out.  Your opinion on the debts may be different to mine.

If your opinion is different, then a 5.5% dividend growing at something like three to five percent a year may well produce between eight and ten percent total returns in the longer term (with some share price volatility along the way, of course).  That may not get you excited, but real investing isn’t about excitement; it’s about achieving your desired financial outcomes over the long term.

Disclosure: I do not own any shares in National Grid.