As investors lap up any stock with a dividend, utilities have been a very popular sector but there's more to a dividend yield than the amount it throws off, as Charles Carlson points out in DRIP Investor.

Utility stocks are a favorite investment area for dividend and DRIP investors. Utilities tick off two important boxes for investors:

  • high cash flow/yield
  • moderate volatility.

The popularity of utilities has pushed many utility stocks sharply higher over the last year. This strength in utility stocks begs the question—is the group overvalued?

Providing fodder to the idea that the group is overbought, most utilities have mediocre to just plain lousy scores in our Quadrix stock-rating system. For example, the average Quadrix Overall score for the 54 utilities is just 41 out of a possible 100.

Another potential headwind for the group is the possible change in tax laws regarding qualified dividends. Unless the Bush tax cuts are extended, the tax on qualified dividends jumps from a maximum 15% in 2012 to a taxpayer’s ordinary tax rate, which could be as high as roughly 40% in 2013 depending on income. This “fiscal cliff ” has potentially onerous implications for dividend stocks, such as utilities.

So investors should dump their utilities, right? Not so fast. As is usually the case, it is dangerous to throw the baby out with the bathwater.

Yes, there are utilities that are probably not worth owning, but there are also utilities that should continue to see solid investor support. These are the utilities that should put up decent results and—something that is especially critical to utility investors—ample dividend growth.

Furthermore, the factors driving investors’ demand for utilities—cash flow and stability—are not likely to disappear anytime soon. Don’t be surprised if utility stocks lag during the next rip-roaring bull market (they lagged badly during the market’s strong first quarter of this year), but my guess is that quality utilities will put up solid returns over the long term and continue to merit a place in virtually any investor’s portfolio.

One mistake investors make is blindly buying the highest-yielding utility stocks. The highest-yielding utilities often possess the lowest dividend-growth potential. A better strategy is to buy quality utilities with decent yields, above-industry dividend-growth potential, and reasonable appreciation potential.

Among my favorites, I’m a big fan of NextEra Energy (NEE). The firm’s two principal subsidiaries are Florida Power & Light, the largest rate-regulated utility in Florida and third largest in the nation, serving roughly 4.6 million customer accounts; and NextEra Energy Resources, the largest generator in the US of renewable energy from the wind and sun.

The company's shares trade around their 52-week high, and look poised to move higher. Providing more fuel for the stock is the company’s operating performance.

Per-share profits in the first quarter beat the consensus estimate by 4 cents per share. For 2012, per-share profits should come in around $4.53, up from $4.39. I like the growth potential of NextEra relative to the rest of the utility sector.

And that growth potential should show up in decent dividend growth. Indeed, the firm boosted its dividend 9% earlier this year, a hefty increase for a utility stock. The stock currently yields 3.5%.

Trading at 15 times expected 2012 profits, it’s hard to classify NextEra as a “cheap” stock. Still, with a growing bottom line and dividend, the valuation seems warranted. Investors looking for a quality play in the utility sector, especially one with exposure to “clean” energy, should consider these shares.

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