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...
they have liquidity. Regardless of how a corporation might attempt to boost earnings per share, even if by too much leverage, investors need not be concerned, because if earnings are expected to turn down, investors can always sell.
But, even if investors behave in a rational manner from their own perspective, that does not mean utility managers can design corporate strategy on that basis.
Of course, the corporation must remain sensi-tive to earnings per share, because of the way stockholders act. In the long run, however, a strategy of chasing after earnings per share offers an unsound basis for management decision making. Many strategies for boosting earnings per share turn out to be unsound when properly tested against return on investment.
Common equity does not show up on the income statement with a specific cost, as occurs with debt, but it carries a real cost nonetheless. That cost denotes the minimum return that investors require to induce them to place their capital at risk, given their expectations for dividends and market appreciation. One can calculate that cost using various methods, such as the capital asset pricing model or the dividend discount model (also known as the "discounted cash-flow model"), but these techniques pose problems. For one thing, they depend on a "rational" market.
Utility managers who believe the stock market is rational should consider asking themselves the following questions about the way the market really operates:
• Does the stock market tend to take a short-run view (one to two years), an intermediate view (three to four years) or a long-run view (five years or more)?
• Does the market swing widely between excess optimism and too much pessimism (yes or no)?
• On a scale from one to ten, how do you rate the investment decisions of (a) the average individual investor, (b) institutional investors, and (c) brokers who advise investors.
To be successful, a company must thoroughly understand cost of capital and apply it correctly. That is the basic idea in allocating capital and monitoring the results to maximize shareholder wealth. In fact, it seems that of all industries, the electric utility industry would have an in-depth knowledge of the subject. Cost of capital has long formed the basis for traditional utility regulation. But the way that utilities have handled their recent forays at diversification would appear to give some reason for doubt.
Beware the Lure of High Risk
Many utilities are now putting capital abroad. What rate of return should they earn on overseas investment?
If asked, our group of financial experts might say that a company with all assets located in Western Europe should earn a return that includes a premium of about 7 percent more than the yield on AA-rated bonds. Of course, the exact figure depends on where in Europe the investment is located, but it does suggest the need to consider a possible increase in return on foreign investment even in a good location. In less-developed nations with political instability the premium would have to be substantially higher. It requires very astute management to judge the return required