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

Fortnightly Magazine - December 1999

with standardized MVA than do earnings per share, free cash flow, net income, ROE and ROA. The recent study also found that EPS before taxes (stock ratio) was weakly correlated to market valuation of equity. Since EPS is easy to manipulate, it is no wonder that in spite of all the attention focused on earnings per share, the market does not primarily value firms on this basis.

Cost Passthrough:

Aren't All Utilities the Same?

Some question the use of a "residual income" measure such as EVA in a regulated entity. Ideally, a regulated firm would earn a return equal to its cost of capital (blended debt and equity costs weighted by the capital structure), and its EVA would be zero. This viewpoint, however, neglects the following considerations.

* Revenue Lag. There is a lag between expenditures incurred and their recovery through rates, and between over-collections and their ultimate refund to the ratepayer. Operational and capital efficiency, therefore, are important.

* Unearned Returns. Some utilities do not even earn the allowed return of equity on the capital invested due to operational and capital usage inefficiencies.

* PBR Plans. As more states adopt performance-based regulation, stockholder and ratepayer interests become more closely aligned with value-adding performance.

* Non-regulated Opportunities. Most utilities have many non-regulated opportunities to boost wealth-creation for their shareholders.

In essence, EVA serves as a measure that encompasses the efficiency of both operations and use of capital. It differs from conventional earnings in two ways:

* full capital Cost Tracking. EVA explicitly charges for the use of both debt and equity capital. Traditional financial statements ignore the cost of equity capital, and merely include interest costs of debt capital.

* Fewer Distortions. EVA transforms accounting information, using a few simple adjustments, into economic information that is less subject to distortion.

While the cost of equity does not appear explicitly in the income statement, it is a real cost. Firms must demonstrate the ability to not just cover the cost of debt but also earn enough to cover the cost of equity capital. Companies that fail to do so may have positive - even increasing - earnings, but may be steadily eroding shareholder value, and soon will lose the confidence of investors.

Utility Stocks:

No Longer the Safe Bet

Since the regulation of utilities in the 1920s, utility investments have been viewed widely as "safe" income-producing instruments - a sort of bond equivalent - with an implicit promise of steady dividends and the backing of state governments minimizing default risk. No wonder utility share prices have marched in lock step with interest rates, similar to U.S. Treasury bonds.

This income-oriented approach focuses on the dividend stream that produces income rather than any gain in share price, even though the latter could be more tax-efficient. By contrast, the more sophisticated institutional investors (who largely determine the price of utility stocks) focus increasingly on wealth-creation for equity investors. In the future, inherent efficiency and management ability should play a greater part in the valuation of utilities. The recent announcement of Berkshire Hathaway's intention to take