A Look At The Fair Value Of American Electric Power Company, Inc. (NASDAQ:AEP)

editorial-team@simplywallst.com (Simply Wall St)

Wed, Nov 22, 2023, 5:00 AM 5 min read

The projected fair value for American Electric Power Company is US$91.44 based on Dividend Discount Model
American Electric Power Company's US$78.04 share price indicates it is trading at similar levels as its fair value estimate
The US$87.47 analyst price target for AEP is 4.3% less than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of American Electric Power Company, Inc. (NASDAQ:AEP) by taking the expected future cash flows and discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. It may sound complicated, but actually it is quite simple!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for American Electric Power Company

The Model

As American Electric Power Company operates in the electric utilities sector, we need to calculate the intrinsic value slightly differently. Instead of using free cash flows, which are hard to estimate and often not reported by analysts in this industry, dividends per share (DPS) payments are used. This often underestimates the value of a stock, but it can still be good as a comparison to competitors. The 'Gordon Growth Model' is used, which simply assumes that dividend payments will continue to increase at a sustainable growth rate forever. The dividend is expected to grow at an annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.2%. We then discount this figure to today's value at a cost of equity of 6.2%. Compared to the current share price of US$78.0, the company appears about fair value at a 15% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

Value Per Share = Expected Dividend Per Share / (Discount Rate - Perpetual Growth Rate)

= US$3.7 / (6.2% – 2.2%)

= US$91.4

dcf — NasdaqGS:AEP Discounted Cash Flow November 22nd 2023

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at American Electric Power Company as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we've used 6.2%, which is based on a levered beta of 0.800. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

SWOT Analysis for American Electric Power Company

Strength

No major strengths identified for AEP.

Weakness

Earnings declined over the past year.

Interest payments on debt are not well covered.

Dividend is low compared to the top 25% of dividend payers in the Electric Utilities market.

Shareholders have been diluted in the past year.

Opportunity

Annual earnings are forecast to grow for the next 3 years.

Good value based on P/E ratio and estimated fair value.

Threat

Debt is not well covered by operating cash flow.

Paying a dividend but company has no free cash flows.

Annual earnings are forecast to grow slower than the American market.

Next Steps:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. For American Electric Power Company, there are three fundamental factors you should consider:

Risks: You should be aware of the 3 warning signs for American Electric Power Company (1 is concerning!) we've uncovered before considering an investment in the company.
Future Earnings: How does AEP's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

PS. Simply Wall St updates its DCF calculation for every American stock every day, so if you want to find the intrinsic value of any other stock just search here.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.