With an average analyst rating of buy, American Electric Power Company is clearly an analyst favorite. But the analysts could be wrong. Is AEP overvalued at today's price of $81.55? Let's take a closer look at the fundamentals to find out.
The first step in determining whether a stock is overvalued is to check its price to book (P/B) ratio. This is perhaps the most basic measure of a company's valuation, which is its market value divided by its book value. Book value refers to the sum of all of the company's assets minus its liabilities -- you can also think of it as the company's equity value.
Traditionally, value investors would look for companies with a ratio of less than 1 (meaning that the market value was smaller than the company's book value), but such opportunities are very rare these days. So we tend to look for company's whose valuations are less than their sector and market average. The P/B ratio for American Electric Power Company is 1.77, compared to its sector average of 1.03 and the S&P 500's average P/B of 2.95.
Modernly, the most common metric for valuing a company is its Price to Earnings (P/E) ratio. It's simply today's stock price of 81.55 divided by either its trailing or forward earnings, which for American Electric Power Company are $3.85 and $5.62 respectively. Based on these values, the company's trailing P/E ratio is 21.2 and its forward P/E ratio is 14.5. By way of comparison, the average P/E ratio of the Utilities sector is 22.89 and the average P/E ratio of the S&P 500 is 15.97.
The problem with P/E ratios is that they don't take into account the growth of earnings. This means that a company with a higher than average P/E ratio may still be undervalued if it has extremely high projected earnings growth. Conversely, a company with a low P/E ratio may not present a good value proposition if its projected earnings are stagnant.
When we divide American Electric Power Company's P/E ratio by its projected 5 year earnings growth rate, we obtain its Price to Earnings Growth (PEG) ratio of 3.06. Since a PEG ratio between 0 and 1 may indicate that the company's valuation is proportionate to its growth potential, we see here that AEP is overvalued when we factor growth into the price to earnings calculus. One important caveat here is that PEG ratios are calculated on the basis of future earnings growth estimates, which may turn out to be wrong.
Indebted or mismanaged companies can't sustain shareholder value for long, even if they have strong earnings. For this reason, considering American Electric Power Company's ability to meet its debt obligations is also an important aspect of pinning down its valuation. By adding up its current assets, then subtracting its inventory and prepaid expenses, and then dividing the whole by its current liabilities, we obtain the company's Quick Ratio of 0.236. Since AEP's is lower than 1, it does not have the liquidity necessary to meet its current liabilities.
Investors are undoubtedly attracted by American Electric Power Company's dividend of $3.9%. But can the company keep up these payments? Dividends are paid out from levered free cash flow, which is the money left over after the company has accounted for all expenses and income -- including those unrelated to its core business. In American Electric Power Company's case, the cash flows are negative which calls into question the firm's ability to sustain its dividends.
Analysts are bullish on American Electric Power Company, but we are concerned they may be missing the clouded growth picture, as expressed by the stock's elevated PEG ratio. In addition, many of its valuation metrics point to a stock with an inflated value. We will keep following AEP to see whether the analyst community was right.