THE POWER PLANTS OF AT LEAST FIVE UTILITIES IN NEW England and California get swapped this year for more than $5.3 billion. And happily, those holding bonds on the plants will be given cash for...
Which matters most: Cost? Price? Sales? Regulation?
Many investors no longer think of electric utility stocks primarily as dividend-rich, income-oriented investments. Instead, they have begun to consider new criteria in evaluating utility stocks (em criteria that might help explain some of the variations in equity price performance now seen among various utility companies. Such criteria might include changes in state regulation, or company-specific data that track competitive indicators such as production costs, asset mix, price advantage, or customer profile.
How well do these new criteria predict utility stock performance, as measured by market-to-book ratio (M/B, or equity share price divided by book value)?
As we have found in our most recent study, at least three-fourths of the variance in M/B ratios observed in June 1996 across 73 utilities can now be explained by differences in regulation and certain competitive indicators: 1) return on equity (ROE), 2) industrial prices, 3) embedded cost of generation capacity, and 4) the relative progress achieved by state regulators toward industry restructuring. This level of explanation (75 percent) marks an improvement over our previous study, conducted last year and published in PUBLIC UTILITIES FORTNIGHTLY, %n1%n in which we found we could use ROE and stranded-cost estimates by bond credit rating agencies to explain 51-55 percent of the variance in year-end 1995 M/B ratios across 69 utilities.
Stranded Costs: Still Significant
In our previous study we relied on three different calculations of stranded costs in the electric generating sector, taken from reports by Moody's %n2%n and Standard & Poor's (S&P). %n3%n The Moody's report measured stranded generation plant investment (as a percent of equity); the S&P report looked at the potential utility revenue loss from retail competition (as a percent of total revenues) and gave two estimates, positing both "reasonable" and "severe" cases. An econometric analysis of M/B ratios for 69 utilities for which Moody's and S&P stranded cost estimates were both available revealed that a combination of ROE and one of the stranded-cost estimates explained 51-55 percent of total variance.
Here, however, we have chosen an expanded sample of 73 utilities. In the first phase we tested each of the three stranded-cost estimates from the earlier study in combination with ROE for year-end 1995, and then again for the end of June 1996, to see if there had been any significant change in the explanatory power of the stranded-cost estimates prepared by the rating agencies. Using the expanded sample of 73 companies, we found that the explanatory power of the stranded cost estimates has increased substantially by the end of June 1996, as compared to year-end 1995. Investors appear to have further factored stranded-cost exposure into their investment decisions (see Table 1). The explanatory power of the Moody's and the S&P "reasonable" case estimates appears to have increased by one-half during the past six months (em from 6 and 11 percent of variance to 9 and 17 percent, respectively. The variance explained by the S&P "severe" case has nearly doubled (em from 10 percent to 19 percent. At the same time, however, the explanatory power of ROE has