Research Articles

Readers’ Choice Calculating Fair Value on Transalta, Southern Company and Exelon

Chuck Carnevale - Tuesday, July 24, 2012

This blog post is presented in response to questions and comments on recent articles I published.  Therefore, I offer this following post to clarify certain confusions that readers had.

My articles were dealing with valuation discussions about dividend growth stocks to include utilities. Three utility companies were discussed where I felt there was some confusion regarding their current valuations.  Therefore, I offer this blog post through the lens of FAST Graphs the fundamentals analyzer software tool to hopefully cast a light upon the darkness.

FAST Graphs are a “tool to think with” and as such, have no agenda of their own.  Instead, they are designed to provide “essential fundamentals at a glance” and allow the user to interpret the data according to their own philosophies, strategies and beliefs.  In this context, FAST Graphs are the deliverer or reporter of important information.

Essentially, the FAST Graphs stock research tool provides investors many benefits, but there are four things they do especially well.

  • 1. FAST Graphs provide a historical review and instantaneous perspective of how well the business behind the stock has historically performed.
  • 2.  FAST Graphs provide an instantaneous perspective of how the market has historically capitalized or priced the company’s operating results or business performance.
  • 3.  FAST Graphs provide a consensus estimate of leading analysts near term earnings expectations for a company’s current fiscal year and next fiscal year followed by a five year consensus estimate.
  • 4.  FAST Graphs provide the opportunity to override and therefore input the user’s own estimates or expectations of the company’s future prospects.

This Blog post will primarily look at valuation through the lens of FAST Graphs.  I consider this powerful graphing tool an essential first step when attempting to determine both fair value and the potential return that a common stock offers me.  However, they are not the final step. Instead, they provide a very efficient mechanism that allows me to determine whether I want to embark on a more comprehensive research effort or not. Consequently, they can save me (and you) from wasting a lot of my time and effort towards a lost cause.

In addition to providing some short commentary on each of the companies covered with this blog post, the reader will be provided live working FAST Graphs on each selection. 

(Follow this link to free, live, and fully functioning F.A.S.T. Graphs™ on the companies discussed in this blog post. Run this "tool to think with" through its paces. Draw graphs displaying 2 to 20 years of history. Discover how this tool dynamically re-evaluates valuation based on the company's earnings and price relationship.)

In order to get the maximum benefit from this powerful stock research tool, it’s imperative that multiple graphs covering various time frames are drawn. To be clear, when I use this stock research tool, I start with the 15-year default and then I will expand out to the 20-year, followed by a 10-year, followed by a 5-year, and finally a 2-year graph.  This allows me to see the dynamic of the company’s growth rates as they change.  I suggest that all subscribers run multiple charts on any company they are examining.   

 FAST Graphs are a dynamic tool that calculates the company’s changing growth rates each time a different time period is selected. Therefore, the user can determine such things as whether the company’s earnings growth rates are accelerating, decelerating or staying the same, and see major inflection points, if any, in a company’s business vividly revealed. This is a major component of the “tools to think with” aspect of this fundamental research tool.

To summarize and clarify, the following commentary on each of the three companies covered in this blog post is offered as a valuation preview prior to a more comprehensive research effort. Stated more clearly, what follows is an earnings and price correlated view of each company based solely on the “fundamentals at a glance” provided by this powerful stock research tool.

Transalta (TAC) Undervalued Historically But Future Returns Questionable

A quick snapshot from the company’s website:

Beginning as a small, local power company in 1909, we have transformed over the last century to become an experienced and well respected power generator and wholesale marketer of electricity. With approximately $3 billion in annual revenue, more than $9 billion in assets, and power plants in Canada, the United States and Australia, we've proven our worth as a power generator, as a community member, and as a solid investment.”

Let’s examine Transalta (TAC), utilizing the four primary features that FAST Graphs provide.

1. FAST Graphs provide a historical review and instantaneous perspective of how well the business behind the stock has historically performed.

Looking at the 12-year earnings and price correlated FAST Graphs shows that Transalta has averaged 7% earnings growth since going public in July of 2001.  However, note the cyclical nature of the company’s earnings change per year highlighted in yellow at the bottom of the graph. The orange line plots the company’s earnings per share and represents a fair value PE of 15.

2.  FAST Graphs provide an instantaneous perspective of how the market has historically capitalized or priced the company’s operating results or business performance.

In this example, we see that the market has normally applied a premium valuation represented by the blue normal PE ratio line.  The calculated normal PE ratio has been 23.2.  By visually looking at the graph you can see that this stock has traded at the 23.2 PE quite often.  However, you can also see periods of time where the price has been above and below this normal valuation.  Moreover, the current blended PE of 13.3 appears to represent very attractive valuation from the historical perspective.

When reviewing the performance table below, the reader should note that high beginning valuation based on the normal PE to today’s low valuation has diminished performance.  The dividend component remained strong based on the company’s operating earnings growth.  However, capital appreciation was hurt by high valuation, but nevertheless has remained positive.

 

3.  FAST Graphs provide a consensus estimate of leading analysts near term earnings expectations for a company’s current fiscal year and next fiscal year followed by a five year consensus estimate.

Unfortunately, there are no analysts currently providing estimates for Transalta’s near or longer-term earnings growth. Consequently, FAST Graphs automatically default to calculating the company’s historical EPS growth since 2007, which has only averaged 1% per annum (note that when analyst estimates are not available, FAST Graphs™ are programmed to find the most relevant average historical earnings results of five years or longer). On this basis, the majority of future return would be based on the company’s current dividend yield and modest growth expectations.  Therefore, although this company may be fairly valued, future returns appear relatively weak based on earnings growth.

 

4.  FAST Graphs provide the opportunity to override and therefore input the user’s own estimates or expectations of the company’s future prospects.

The following screenshot represents a spot of the FAST Graphs navigation bar that allows subscribers to check consensus estimates from Zacks.  The user can check these numbers against the Capital IQ data provided on the graph, and if different, input the Zacks’ data as an override.  Or another common method that many investors use for forecasting is to run the company’s five-year historical earnings growth as a proxy for the next five years estimate (note that this is currently the estimate provided since Capital IQ offers no estimates at this time).

The following is a screenshot of the excerpt of the report that subscribers can use by clicking on the yellow link above.  Note that consistent with Capital IQ, Zacks does not provide long-term estimates on this company either.  However, they do provide a rather onerous estimate for this fiscal year with only a minor recovery for the 2013 fiscal year.

 

Southern Company (SO) A Classic Picture of Current Overvaluation

A quick snapshot from the company’s website:

“Based in Atlanta, Southern Company is one of the largest generators of electricity in the nation, serving both regulated and competitive markets across the southeastern United States. We participate in all phases of the electric utility business with more than 42,000 megawatts of electric generating capacity and a grid of transmission and distribution lines that would more than circle the earth. Southern Company and its subsidiaries have been serving the Southeast for more than 100 years.”

Let’s examine Southern Company (SO) utilizing the four primary features that FAST Graphs provide.

1. FAST Graphs provide a historical review and instantaneous perspective of how well the business behind the stock has historically performed.

Southern Company has been only capable of growing earnings at an average rate of 3.5%, however, they achieved this growth rather consistently. Consequently, Southern Company represents a quintessential example of a highly correlated earnings and price relationship.  Note how the monthly closing stock price (the black line) consistently tracks the company’s orange earnings justified valuation line representing a fair value PE of 15. This correlation is so high that the blue normal PE ratio line calculating a normal historical PE of 16 closely correlates to the earnings line.  The only reason the normal PE is higher is because the current overvaluation has slightly separated the lines.

2.  FAST Graphs provide an instantaneous perspective of how the market has historically capitalized or priced the company’s operating results or business performance.

Now here is the critical point that I ask the reader to accept. Regardless of how these lines have been calculated, I ask the reader to note how accurately they reflect fair valuation.  Clearly, in every case on Southern Company’s graphs where the black price line deviates from the orange line, it very quickly moves back into alignment. These are simple facts that the FAST Graphs is simply reporting. Consequently, the current price that has risen above both the orange and blue line vividly illustrates overvaluation from a historical perspective.

When looking at performance, note that the only reason that the annual rate of return (closing annualized ROR) has been higher than the company’s earnings growth rate is because of today’s overvaluation.  In contrast, dividend growth has closely tracked the company’s operating earnings growth rate, and only deviates due to rounding.

3.  FAST Graphs provide a consensus estimate of leading analysts near term earnings expectations for a company’s current fiscal year and next fiscal year followed by a five year consensus estimate.

The 21 analysts reporting to Capital IQ expect Southern Company to have slightly below-average earnings growth this fiscal year and above-average growth for next fiscal year followed by a 5.9% five-year estimate (the numbers on the graph are rounded).

Therefore, on the basis of earnings forecasts, Southern Company would not be considered overvalued per se, but instead fully valued (price sits at the upper end of the valuation corridor represented by the five orange lines). However, the user should validate whether or not this above-average estimated growth rate is believable or not.

4.  FAST Graphs provide the opportunity to override and therefore input the user’s own estimates or expectations of the company’s future prospects.

A cross-check with Zacks provides similar, but not identical estimates with Capital IQ. Therefore, this might suggest that analysts across the board have a reason to believe that Southern Company’s earnings growth is due to accelerate above its 3.5% historical average.

On the other hand, if we run Southern Company’s historical five-year earnings growth rate, we discover that it is slightly below their longer-term average only coming in at 3%. Once again, it’s up to the users to evaluate this data and draw their own conclusions. FAST Graphs merely reports the information, but never attempts to dictate to the user.

Exelon Corp. (EXC) A Tale of Failing Earnings

A quick snapshot from the company’s website:

“As the leading U.S. competitive power generator, Exelon owns approximately 35,000 megawatts of power generation, including the nation’s largest nuclear fleet of more than 19,000 megawatts. Our customer-facing retail and wholesale energy business will allow us to grow in the energy products we offer to our customers in 46 states. In addition, the new company is the nation’s second-largest regulated distributor of electricity and gas, with more than 6.6 million customers in Maryland, Illinois and Pennsylvania. The three Exelon utilities – BGE, ComEd and PECO – remain headquartered in Baltimore, Chicago and Philadelphia, respectively, and are focused on safety, customer service, reliability and continued infrastructure investment in their service areas. Exelon remains headquartered in Chicago and trades on the NYSE under the ticker symbol EXC.”

Let’s examine Exelon Corp. utilizing the four primary features that FAST Graphs provide.

1. FAST Graphs provide a historical review and instantaneous perspective of how well the business behind the stock has historically performed.

When we examine the historical operating results of Exelon Corp. we see a record of very strong earnings growth up through the great recession of 2008, followed by three consecutive years of falling earnings.  Clearly, something has dramatically changed with this business, and FAST Graphs has alerted us to want to discover what and why.

2.  FAST Graphs provide an instantaneous perspective of how the market has historically capitalized or priced the company’s operating results or business performance.

From the historical earnings and price correlated graph we also see how the market rewarded Exelon Corp. when earnings growth was strong, and conversely, how it punished the company when earnings faltered. The importance of earnings driving stock prices is vividly revealed.

Moreover, when looked at from the perspective of the past five years only, we get an even clearer portrayal of the company’s earnings and price relationship. Here we discover that price has very closely followed earnings after reverting to the mean during the latter half of 2008. Since the mean reversion occurred, price has tracked earnings very closely.

Exelon Corp. also provides a classic example of the dangers of overvaluation as depicted in the following performance report.  The company’s stock price had clearly become overvalued going into the summer of 2008, thereby making it very vulnerable to weakening operating results.  Once the earnings began to falter, stock price collapsed and existing shareholders received devastating performance.

3.  FAST Graphs provide a consensus estimate of leading analysts near term earnings expectations for a company’s current fiscal year and next fiscal year followed by a five year consensus estimate.

Here we learn that the consensus of 20 analysts reporting to Capital IQ have very low expectations for Exelon Corp.’s future growth.  Consensus expects a large drop in earnings growth this fiscal year, followed by no growth for the next five years which would indicate that the company is overvalued based on future expectations. Consequently, Exelon Corp. is very overvalued based on future earnings estimates (the price is above the highest future orange earnings line).  Therefore, the total expected five-year total return calculates the only three tenths of one percent per annum (.03) which includes dividends but alas a decrease in capital value.

4.  FAST Graphs provide the opportunity to override and therefore input the user’s own estimates or expectations of the company’s future prospects.

For added perspective and consideration, the consensus of analysts reporting to Zacks estimate even worse future results than the analysts at Capital IQ. If Zacks is correct, then Exelon Corp. would be even more overvalued than the FAST Graphs estimated earnings and return calculator depicts. The important message here is that even though the current PE ratio of only 12 would indicate that Exelon Corp. is undervalued, from the perspective of future earnings growth the graph tells a different story altogether.  On the basis of future earnings, Exelon Corp. is overvalued and maybe even dangerously so.

 

Summary and Conclusions

The core idea behind this blog post is that numbers, spreadsheets and other mere data points can be misleading if taken out of context.  At first glance, looking solely at the numbers alone, Exelon Corp. and Transalta would appear to be undervalued opportunities.  However, when looked at from the perspective of past present and future fundamentals, the picture does not appear to be so rosy.  Of course, in reality it all depends on what actually happens in the future.  In contrast, Southern Company is vividly shown as currently being priced in excess of fundamentals and historical norms.

At the end of the day, it is the responsibility of each investor to do their due diligence. The idea behind FAST Graphs has been to make that job just a little easier and perhaps more efficient. But most importantly of all, the objective of this powerful stock research tool is to provide a clear picture of how a company has performed as a business, how it might perform in the future and how the market has and/or might treat the company’s stock in the future.

Disclosure:  No positions at the time of writing.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation. 

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“I appreciate your work, Chuck. As a subscriber to FAST Graphs™, I use the tool to decide on whether to purchase additional shares of what I currently hold or to add a new holding. Your articles help me make full use of the tool and give other readers valuable information, if they take the time to learn. One of the biggest enhancements that I use is the FFO data added for MLPs and REITs.”


“When FAST Graphs™ were unavailable because of Hurricane Sandy, I realized how much I need them in order to make investment decisions.

(Wish I could be) Long FAST Graphs!!!”


“One more vote for the value of FAST Graphs™; just started a subscription to Chuck's great service (premium), and am having a ball analyzing so many stocks quickly.”


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“Yesterday, I signed up for your F.A.S.T. Graphs™. It's a really amazing, valuable tool for checking over/undervaluation of stocks. Wish I had it years and years ago!!”


“Love the F.A.S.T. Graphs™: One glance and you know a whole lot.”


“About Chuck's F.A.S.T. Graphs™: They are invaluable to me in making decisions about the stocks I own (in addition to what you are saying about doing other research) and the ones I hope to own in the future.”


"Chuck -- Your proprietary F.A.S.T. Graphs™ are a VERY impressive tool!"


“If there were an Investor Hall of Fame for people who have helped others with their investing, and sharing valuable information, you and your F.A.S.T. Graphs™ would get one of my selections.”


“I love Chuck's F.A.S.T. Graphs™! Well worth the price of admission for what he gives you.”


"Chuck - Thank you for your well thought out articles. I tend to be a visual type of person so I really appreciate the F.A.S.T. Graphs™ approach."


"Great article, as always! I always look forward to your articles, and am especially eagerly awaiting your next in this series. I find the F.A.S.T. Graphs™ extremely helpful."


“Your F.A.S.T. Graphs™ put all of this in a single artful picture and the accompanying spreadsheets hammer home the point.”


“I use the F.A.S.T. Graphs™ method to evaluate all of my ideas. I recommend it for individual investors, since it helps them focus on data and get past the many emotional arguments.”


“I recently subscribed to the F.A.S.T. Graphs™, and these articles are helping me learn how to better use them. They really do give you a good quick look at the valuations picture. A much needed tool!”


“I also always appreciate the clear-cut information provided through your F.A.S.T. Graphs™ and articles.”


“Thanks, Chuck, for your F.A.S.T. Graphs™. Each of these graphs is worth 1,000 words in describing a company's growth, consistency and valuation. Thanks for sharing your graphs.”


“Thanks, Chuck. Love the F.A.S.T. Graphs™! It makes investing so much more clear.”


“Chuck's F.A.S.T. Graphs™: They are invaluable to me in making decisions about the stocks I own (in addition to what you are saying about doing other research) and the ones I hope to own in the future.”


”I am amazed at the usefulness of your F.A.S.T. Graphs™ and I plan on using them for a long time to come.”


“Chuck's F.A.S.T. Graphs™ will give you a tool to find those well chosen stocks...”


“Thanks for the F.A.S.T. Graphs™, Chuck. They are the best tool I've used.”