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The Fortnightly 100 Revisited: Do Utility Stock Prices Reflect Operational Efficiency?

Fortnightly Magazine - February 15 1999

incorporates both quantitative metrics such as financial ratios and qualitative and subjective business indicators related to prospects for growth, stability, decline and regulatory environments. They also explicitly take into account how efficiently a utility manages and utilizes its resources.

Market Performance:

Objective Measures and Analytical Method

There are two popular measures of market performance: price-earnings ratio (P/E) and market-to-book ratio (M/B). These ratios combine accounting and market data to provide an objective, though admittedly imprecise, picture of market performance.

For electric utilities, and all utilities in general, the M/B ratio is a relatively stable measure with small short-term variations. Compared to other industries, these ratios are also generally very low, averaging about 2.0. M/B ratio arguably is a better measure of market performance for utilities due to this stability and also because the P/E ratio largely is subject to rate-setting cycles and affected by the lag between allowance of earnings and the actual booking by the utility. We tested each of these ratios in our analysis. The market-to-book ratio produced better results with respect to primary statistical properties of the results.

To measure the unique effects of productive efficiency on the M/B ratio, it is important to account as fully as possible for the influence of other factors thought to influence that statistic. In the parlance of econometrics, this step is often called "controlling" the effects of other variables. Regression offers the appropriate and perhaps simplest technique for this purpose. The technique is used to describe the causal relationship between a dependent variable (in this case the M/B ratio) and a set of explanatory variables that "explain" the variations in the former.fn4

In our analysis, we used a linear regression equation to describe the relationship between M/B ratio and its hypothesized determinants. We took into account five sets of factors: (1) financial indicators, (2) regulatory "assets," (3) competitive settings, (4) generating capacity mix (fuel diversity) and (5) operational efficiency.fn5 Regulatory treatment, presumably a relevant factor, was not included in the analysis due to its highly subjective nature.

1. Financial indicators: Business and financial ratios in six conventional ratio categories of liquidity, activity, profitability, stock, dividend and cash flow were included in the analysis as follows:

long-term debt as a percentage of total assets (liquidity ratio);

total revenue minus fuel purchases/ total assets (activity ratio);

operating income as a percentage of operating revenues (profitability ratio);

earnings per share before taxes

(stock ratio);

common dividend as a percentage of operating revenue (dividend ratio); and

cash flow from operations/interest payments (cash flow ratio).

2. Regulatory "assets": These items occur primarily in the form of the utility's expenditures on social programs and conservation and load management activities. Since they are not equivalent to the utility's other physical and potentially "bondable" assets, they are expected to be viewed unfavorably by the financial community, and hence have a negative effect on market performance.

3. Competitive settings: Intensity of competition in the market(s) in which a utility operates is expected to have a direct impact on its perceived financial prospects. Depending on the utility's strategic plans, how well it