THE POWER PLANTS OF AT LEAST FIVE UTILITIES IN NEW England and California get swapped this year for more than $5.3 billion. And happily, those holding bonds on the plants will be given cash for...
The Fear Factor
Understanding power company volatility in the context of valuation theory.
Power industry observers have witnessed a stunning rise and fall in the valuations of genco equities over the past year. The first half of 2001, marked by high power prices and forecasts of a capacity shortage, saw genco equity prices peak at earnings multiples rarely seen before in the power industry. During the second half of 2001 and the beginning of 2002, observers witnessed the prices of the very same stocks decline to earnings multiples usually seen only in distressed situations, as overbuilding fears drove down the forward curve and as Enron-driven liquidity issues led investors to flee the sector.
In explaining the dramatic volatility of power sector stock prices, commentators have pointed to a variety of factors, including weather, the economy, price caps, transmission constraints and of course, the Enron effect. These and other factors have had an impact on valuations and have also guided investors' evolving understanding of the sector by highlighting the industry's critical valuation drivers. For industry observers trying to make sense of the dramatic swings in equity prices seen in the past year, it is helpful to consider the industry in terms of a valuation framework commonly applied by investors.
Basic Valuation- The Discounted Cash Flow Approach
In order to value a business, investors theoretically seek to approximate the stream of cash flows that will be generated by that business in the future. The present value of this stream of cash flows, discounted at the company's weighted average cost of capital (WACC) theoretically equals the value of the firm. Subtracting out the value of debt and other senior obligations derives the value of the firm's equity. This method of valuation is commonly referred to as the discounted cash flow (DCF) approach. The DCF approach is the best available framework from which to analyze the recent performance of the power sector.
While the basic assumptions underlying the DCF approach are theoretically the same for any industry, the importance of any particular assumption varies by industry. For example, the valuations of high-growth companies found in the technology sector are much more dependent on the projected growth of cash flows than are the valuations of transmission and distribution-oriented utilities, which are supported by more predictable cash flows. A 25 percent decrease in the projected growth rate of a high-growth technology company would likely have a substantial impact on a firm's valuation, while the equivalent decrease in a distribution utility's projected growth rate will have a much less substantial valuation impact. The simple reason for this is that a high growth rate company's cash flows are more heavily weighted toward the future. High growth rate companies with uncertain cash flows (like gencos) are also more susceptible to changes in the discount rate (WACC) for the cash flows, since discounting has more of an effect on distant cash flows.
Applying the DCF to Understand Market Response to Industry Events
Two of the most notable events affecting gencos last year were the California energy "crisis" in Spring 2001, and the Enron collapse of