How to Find the Best Utility Stocks

The types of utility stocks

The first step toward understanding a stock in the utility sector is to identify the different types of businesses out there. This will help to identify which model fits best in your portfolio. 

Utilities are one of the 11 major groupings of the Global Industry Classification Standard (GICS) that divides the universe of publicly traded stocks. However, within that parent group of "utility stocks" are five GICS subgroups that include:

• Electric utilities
• Gas utilities
• Multi-utilities
• Water utilities
• Independent power and renewable electricity producers

As with other sectors, two companies classified as a "utility stock" at a high level can be very different. For instance, some electric utilities own and operate their own power generation facilities to local customers. But a deregulated electricity market in parts of the U.S allows energy traders and independent firms to potentially service customers on the other side of the nation by "renting" third-party transmission infrastructure.

Success metrics for utility stocks vary based on the nature of the underlying business – whether the utility is vertically integrated, whether it uses natural gas or nuclear or renewable power sources, and many other factors. So make sure you start by understanding the business to ensure you're comparing apples to apples.

Understanding key financial metrics for utility stocks

There is no guaranteed way to find the best utility stocks – or the best stocks for that matter. But a careful analysis of financial metrics can help give investors a better chance of success.

A few key numbers to explore with utilities include:

Long-term share price performance: Utility stocks are generally sleepy in nature, and historically underperform dynamic and growth-oriented companies like small tech stocks. But by comparing one utility to relevant peers, you can still get a sense for which one generally delivers better returns.

Dividend yield: Dividend yield is a commonly understood metric, where investors divide a stock's current share price by its annual dividend. That gives you the percentage of your initial investment you get back each year – and, obviously, the higher the better. Utilities are known for being some of the best dividend stocks.

Dividend payout ratio: Payout ratios are also important because they show a dividend's sustainability. If a company is paying $2 in dividends per share but only makes $1 per share in total profits, that's not a good sign. The best utility stocks typically pay out only about two-thirds of total earnings per share in annual dividends, or about 66 cents for every $1 in earnings per share. That provides enough cushion to maintain operations in tough times, as well as the dividend.

Total customers: Generally speaking, utility stocks are hamstrung by the capital intensive nature of building out distribution networks and power generation. In some cases, they also can be limited by local regulations. This means growing an existing customer base is a very slow exercise, so you may be better served by relying on utility stocks that already operate at scale with 1 million or more total customers. This provides a strong foundation for the company as well as a bigger impact on any potential rate increases or gains in efficiencies over the long run. 

Key risks for utility stocks

The green energy transition presents many challenges for the global economy in general, and utility stocks in particular. That means it's important to understand the long-term plans for any investment you may make in the sector, and how it will transition away from "dirty" energy sources like coal and toward green energy alternatives. 

If the utility doesn't move fast enough, there is a risk that regulation may render some of its capacity unusable.

Speaking of regulation, the utility sector is one of the most highly regulated areas on Wall Street. A complex network of federal regulations as well as statewide utility laws create a web of rules to navigate. In many jurisdictions, a utility must ask permission before it is allowed to make any major changes to its rates or power plants. That means paying attention to both state and federal trends that could impact your investments.

Last but not least, it's important to pay attention to the news. In the wake of deadly wildfires that were blamed on utility stock PG&E (PCG), California ordered a record $2 billion in damages to be paid as restitution. 

You may think that utilities are relatively uncontroversial, but like all investments there is a chance of the unexpected headline wreaking havoc on shares. Make sure you stay in the loop to avoid potential pitfalls in this sector, as with others.

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