The key to value investing is finding a company with rising profits that trades at a reasonable price and can pay dividends well into the future. But searching for undervalued energy utilities in the present market environment has been difficult.

For one, the era of historically low interest rates has forced many retail investors, who in the past would have largely depended upon fixed-income investments, to pile into dividend stocks, particularly utilities. Consequently, these income-hungry investors have bid up the entire sector, focusing on dividends instead of earnings quality.

Further, the challenge of discovering undervalued utilities has been compounded by the fact that earnings quality at some companies is being affected by cheap natural gas and new technological disruption. Once-reliable dividend payers such as Atlantic Power Corp (NYSE: AT), Exelon Corp (NYSE: EXC) and FirstEnergy Corp (NYSE: FE) stunned investors over the past year when they cut their payouts due to these changing market dynamics.

In response to these developments, we’ve augmented Utility Forecaster’s Safety Rating System by incorporating an additional layer of security into our approach through the DuPont Hybrid Model. This model helps us deconstruct a company’s return on equity (ROE) into its individual components, which allows for greater ease in analyzing what’s actually driving growth.

We first unveiled this new model in the feature article of our November issue, and we’ve spent the intervening months rigorously testing this proprietary system in preparation for its official debut as part of our investment process. And in the forthcoming issue of Utility Forecaster, we offer subscribers a detailed look at the system and insights into some of our top picks gleaned from this analysis.

While we originally developed this system to alert investors to potential problems at a company that could lead to a dividend cut, the model’s focus on ROE has had the added benefit of identifying undervalued utility investments (See Chart A).

Chart A: Some of the Utilities with the Strongest ROEs Are Undervalued 

Created with YCharts 

One of Warren Buffett’s Favorite Metrics

The original DuPont model was developed in 1919 by a finance executive at EI du Pont de Nemours and Co, and it was subsequently employed by numerous other companies to evaluate the critical components that contribute to ROE and hence shareholder value. ROE is still considered a key metric when comparing companies against their peers and is used by many of the world’s top investors, including Warren Buffett.

According to a study conducted by Charles Schwab, ROE also appears closely correlated with the safety and sustainability of a company’s payout. Schwab reviewed the characteristics of dividend payers among the top 3,200 stocks by market capitalization, over the period from 1990 through February 2009, and found that companies that have higher ROEs were less likely to have cut their dividend.

In 2005, your correspondent, as the executive editor of the utility journal Public Utilities Fortnightly, developed with Jean Reaves Rollins, managing partner at The C Three Group, the DuPont Hybrid Model to evaluate the financial performance of US utilities. We have since further honed this model by adding additional steps to the process to not only show which aspects of growth are driving ROE, but also whether ROE is being driven by something other than growth.

The three-step DuPont Model shows whether a company is boosting its ROE by improving profitability, using assets more efficiently, or taking on additional leverage. Then by incorporating the five-step model into our analysis, we can examine two peer companies that have differing ROEs and learn whether the discrepancy exists due to factors such as credit risk and the attendant interest expense, poor deployment of capital, an unwieldy debt burden, or higher operating costs.

Of course, the DuPont Hybrid Model also has its limitations. While it’s well-suited to evaluating the performance of companies in large established industries such as electric, water and telecommunications utilities, the model is less effective when analyzing firms with highly volatile earnings, such as energy exploration and production companies. The system also shouldn’t be applied to companies that typically distribute all their earnings, such as master limited partnerships (MLP).

Furthermore, many utilities’ cash flows are cyclical in nature, as they’re highly sensitive to weather-related events. A precipitous, short-term drop in ROE in one quarter may not necessarily indicate that a company’s financials are unraveling. As such, our new early-warning system will evaluate trends in ROE across multiple quarters prior to recommending any action with regard to an existing holding or a new opportunity.

Even so, the rapidly changing operating environment means that we’ll be giving companies a shorter leash than in the past. After all, the failure of corporate management in the last few years to give investors fair warning when instituting dividend cuts, or properly communicating earnings challenges, has led to the destruction of shareholder value, and thus the need for greater scrutiny by investors than ever before.