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...
in such situations, but there is ample data available that ranks political risk in foreign countries.
For some high-risk investments, such as oil exploration or financing with a leveraged buy out, it can prove difficult to arrive at a precise figure for cost of common equity. Managers who can achieve success in these businesses have an innate ability to judge risk, and that will be required in some foreign utility investments.
Payback rates may be worth considering in certain high-risk situations. The payback rate shows the time required to get the capital back from cash flow. Payback rates offer a useful tool for managers to use as a measure of risk, despite objections that payback rates ignore cash flows expected after the payback period ends, and fail to consider the time value of money.
It is easy to see that the faster the recovery of your initial capital outlay, the less time your capital remains at risk. This idea may help evaluate foreign investments, where business and political risk can change quickly. A foreign project that requires a large capital investment and carries a long life will obviously be much riskier than a capital investment with a shorter payback period.
The same problems arise (but to a much lesser degree) with the need to estimate correctly the cost of capital for various services and diversification strategies available in the U.S.
Allocating capital marks just the first step in maximizing shareholder wealth. After that is done, monitoring return on common equity is still necessary, with allowance for all risks. Whether electric utilities can carefully apply these ideas will affect whether they can preserve and maximize shareholder wealth in the industry's great leap forward. t
John F. Childs has spent his career advising companies on corporate financial policies. He is a graduate of Harvard Business School and Fordham Law School, and is a member of the New York Bar. He has held positions as first v.p. at Kidder, Peabody and sr. v.p. and head of the utility, financial consulting, and corporate trust departments at Irving Trust Co. (now Bank of New York). He has also served as a utility director, and is director of the New York Council on Economic Education. His work last appeared in PUBLIC UTILITIES FORTNIGHTLY in a pair of articles that critiqued studies on earned rates of return: "An Examination of NARUC's Stockholder Return Reports," Jan. 1, 1992, p. 21, and "A Review of Electric and Telephone Stockholder Returns from 1972 to 1988," Feb. 15, 1990, p. 50.
Where Value Comes From
To maximize shareholder wealth, a company must earn more than its cost of common equity. How much it can earn will depend upon the nature of the industry and whether the individual firm can develop a competitive edge in its own market.
In the pharmaceutical industry, for example, with its millions spent on research and development, firms can patent their products, earnings a high return. By contrast, airlines carry a large, long-lasting capital investment. Price wars, until recently, cut into profits from air travel.
Similarly, power generation requires