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Turning Capital to Wealth: A Ranking of U. S. Utilities

Fortnightly Magazine - December 1999

MidAmerican Energy private is an example of the changing focus of institutional investors. The MVA ranking has the same focus, as it is unaffected by the payment or non-payment of dividends.

In short, an MVA ranking correlates more closely with the central tenet of project valuation - that an economically sound investment returns a stream of cash flows whose present value equals or exceeds the cost of the funds invested. In other words, the net present value of cash flows (i.e., net of the amounts invested, and discounted to the present) must be zero or positive. A project with zero NPV returns sufficient cash to just cover the cost of paying the debt and equity holders the minimum return demanded by each on a risk-adjusted basis.

The same principle is used in valuing a firm, which can be viewed as a portfolio of projects. Analysts examine the stream of expected future cash flows, projected revenues, costs, taxes, depreciation and investment, and estimate net income. Unfortunately, the minimum earnings necessary to satisfy the shareholder often are ignored. Other valuation techniques such as the method of multiples must be used with care. The analyst must recognize that multiples (such as price/earnings or price/earnings before interest) are the consequences of firm performance, and serve as a convenient shorthand only when supported by, and derived from, fundamental analysis of the business prospects of the firm.

S.R. Rajan, Ph.D., vice president and head of the Stern Stewart & Co. utility practice, advises utilities on corporate governance, shareholder wealth-creation and financial strategy. Dr. Rajan can be reached at He previously has worked at the New York Power Authority and the S. M. Stoller Corp. The author gratefully acknowledges the analytical assistance of Marsha Abarbanel and the helpful comments of Bennett Stewart, Al Ehrbar and Justin Pettit, all of Stern Stewart.

Beyond Earnings: Why a Value-Added Focus?

How earnings measures don't quite hit the mark.

Earnings-related measures account for the cost of repaying debt-holders via interest expense, but ignore the minimum required return to satisfy shareholders. Increasing earnings thus is an incomplete goal, as it does not provide information on whether the earnings are enough to cover all costs of capital (debt and equity). Earnings are also easily manipulated, making them an unreliable measure of value-creation. Consider the following.

Capital structure 50 percent debt, 50 percent equity

After-tax cost of debt 5 percent

New capital invested $100 ($50 new debt, $50 new equity, unchanged capital structure)

Additional annual debt cost $2.50

Incremental earnings $2.51

Incremental project contributions of as little as $2.51 (return on investment of 2.51 percent) will increase the firm's earnings. Clearly, a project with a return of 2.5 percent destroys value for any reasonable cost of capital, even though earnings increase.

Case 1 in the table below provides another example of increased earnings with decreased value (economic value added, or EVA).

Return on equity - on net assets, on capital employed and all their variants - attempt to overcome the shortcomings of earnings by linking accounting earnings to some balance sheet item such as