[BETA] Fortnightly

Do electric utilities understand how to earn profits for shareholders in a competitive market?

Here's one way to look at the problem. Gather a group of financial experts and ask this question: If a company's long-term bonds are rated AA, and yield 8 percent, what minimum return would you require from dividend yield and price appreciation to induce you to buy that company's stock?

The typical expert will say 12 percent, indicating a 4-percent premium (or spread) above AA bond yields. This figure approximates the rates of return on common equity (about 3.4 percent above yields on AA-rated bonds) that regulators have allowed for electric utilities from 1986 to 1996, as compiled by Regulatory Research Associates. For companies with lower-rated debt, the spread would obviously be higher.

Today, with the advent of competition, the dam has burst. With the grass looking greener on the other side of the fence, utility managers are considering expansion. Some companies are sending other products over their existing lines and adding special related services. Others are concentrating on generation and power contracting. Still, companies can see more by spreading their wings with large investments in foreign utilities. All are caught up in a compelling rush to grow.

Unfortunately, the grass may not be any greener.

From 1981 to 1993, returns on common book value for unregulated businesses hovered at 4 percent above AA-rated bond rates, based on the

Standard & Poor's index of 400 industrial common stocks. (Since 1995, the spread has climbed above 12 percent, however.)

Utility diversification strategies are nothing new. In the not-so-recent past, utilities got into everything from

insurance to banking to real estate (em but largely with poor results. In the future, however, competition will raise the bar. To diversify successfully in a competitive arena will require a new understanding of maximizing shareholder wealth.

So What's Wrong With Earning

Your Cost of Capital?

Technically speaking, there is nothing wrong if a company earns its cost of capital. That means it is breaking even; consumers are sufficiently interested in the product to pay all costs. In fact, an unwillingness to pay all costs (including cost of capital), would indicate that capital was misdirected and wasted.

In this break-even example, the company's stock will sell in the long run at a price-earnings ratio equal to the reciprocal of the common cost and at book value. Such performance falls short of what is needed to maximize shareholder wealth. To do that, utility management must do two things: 1) earn a return above the cost of common equity, and 2) put more capital to work at that higher return.

High earnings without growth can improve shareholder wealth, but will not alone materially raise stock prices. Earnings above cost of common equity turns the company into a cash cow. It is the ability to put more capital to work at a higher return that really maximizes shareholder wealth.

Let Investors Take a Different View if They Want,

I Don't Care

Investors today tend to follow earnings per share. It is appropriate for them to do so because