The National Grid dividend yield is 5.7%! Here’s why I’m not tempted

The National Grid dividend yield is 5.7%! Here’s why I’m not tempted

A lot of income investors like the dividend potential of utility companies. Take power distribution network National Grid (LSE: NG) as an example. At the moment, the National Grid dividend yield is 5.7%. Not only that, the FTSE 100 company increased its annual dividend last year. And the year before that. And the year before that. And the year before that.

In fact, the company has been raising its ordinary dividend annually for many years.

So, why do I have no interest in buying the shares for my portfolio and hoping for a growing passive income thanks to the National Grid dividend?

Attractive business model or not?

In a word: debt.

I will give a more detailed explanation below. But before I do that, I think it is fair to acknowledge that the National Grid investment case has a lot going for it. That helps explain why it has an army of small shareholders: over half a million investors held 500 or fewer shares at the time of the most recent annual accounts.

The reason utilities are popular with many investors is because they often have the economic characteristics of a monopoly. That implies significant pricing power, although regulation can put a cap on that – and does, in the case of National Grid.

Demand for power generation is likely to be resilient, for decades. Indeed, due to population growth and changed energy consumption patterns, it may increase.

Building a distribution network to rival National Grid’s would be prohibitively expensive, if not downright impossible. What rival would bother even trying?

Why I’m bearish

But what I see as the source of National Grid’s pricing power – its unique network – it also the reason I am bearish on its business model and investment case.

Building and maintaining a distribution network would not only be expensive for competitors. It is already expensive for National Grid.

The steadily rising National Grid dividend could theoretically keep growing forever – if the company has enough free cash flow. But it has to spend a lot of capital maintaining the network. It is currently in the midst of a £40bn five-year investment programme. That eats into free cash flows heavily.

On that basis, it is perhaps unsurprisingly that the company’s balance sheet has shown sizeable growth in net debt over the long term. Last year it fell 4%, but still weighed in at £41bn. That is more than the company’s entire market capitalisation of £37bn.

Looking elsewhere

Share ownership is not just about dividends. The National Grid dividend has been growing – and so has its share price. It is up 19% in five years.

But if there is a nasty surprise on the dividend front I think the share price could fall too. Utilities do sometimes cut dividends and such cuts can be brutal: just ask anyone who owns shares in SSE.

I am concerned about the long-term outlook for the National Grid dividend given the company’s debt pile. I therefore have no plans to buy the shares despite the juicy yield.

Like buying £1 for 51p

This seems ridiculous, but we almost never see shares looking this cheap. Yet this recent ‘Best Buy Now’ has a price/book ratio of 0.51. In plain English, this means that investors effectively get in on a business that holds £1 of assets for every 51p they invest!

Of course, this is the stock market where money is always at risk — these valuations can change and there are no guarantees. But some risks are a LOT more interesting than others, and at The Motley Fool we believe this company is amongst them.

What’s more, it currently boasts a stellar dividend yield of around 8.5%, and right now it’s possible for investors to jump aboard at near-historic lows. Want to get the name for yourself?

See the full investment case

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C Ruane has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.