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The Fear Factor

Understanding power company volatility in the context of valuation theory.
Fortnightly Magazine - April 15 2002

December 2001. Figure 1 summarizes the performance of a genco index versus the S&P 500 and the S&P Utilities Index during those periods. Until May 2001, gencos easily outperformed both indexes. However, during the latter part of the year, gencos markedly underperformed the indexes.

In valuation terms, the market during these periods was accounting for new information pertinent to gencos' underlying valuation drivers. The California power crisis (coupled with shortfall projections in other regions) raised fears of a nationwide shortage of generation capacity-a boon for gencos. Investors assumed that this shortage of capacity would drive new capacity construction, and that gencos would enjoy increased cash flows from the additional capacity to be constructed in the coming years and from the higher prices to be paid for that capacity (as a result of the robust forward curve). Partly as a result of expected construction and higher expected prices, industry analysts projected that gencos could increase their earnings by 25 percent to 35 percent annually over the next five years. To put this into context, at a 30 percent annual growth rate, a genco's $200 million in 2001 earnings would grow to $743 million by 2006-nearly a fourfold increase in five years. The vast majority of the earnings of this genco would be realized in excess of five years in the future. Assuming a 10 percent rise in annual earnings for the following five years and 2 percent growth thereafter, over 80 percent of the value of this genco would be derived from projected earnings more than five years in the future (using a WACC of 8 percent as a proxy for a genco WACC at the May height of the genco boom).

As 2001 progressed, investors and analysts began to question seemingly aggressive growth rate assumptions. As genco investors quickly learned, small changes in assumed growth rates can have (and very likely did have) a dramatic effect on valuations. At a 20 percent growth rate for the first five years (but retaining 10 percent for the next five), the valuation of our hypothetical genco would fall about 25 percent. However, this does not mean that the equity value (and stock price) would have declined 25 percent as well. Since debt and other obligations senior to equity must be subtracted to arrive at an equity valuation, a 25 percent decline in the company's valuation (referred to as the "enterprise value") can result in a much higher decline in equity value. Assuming that 50 percent of the enterprise value of our genco was comprised of debt and preferred stock, a change in the assumed growth rate from 30 percent to a still-aggressive 20 percent would yield over 50 percent drop in equity value. This is the power of leverage in reverse: as can be seen in the chart, the genco composite index fell nearly 40 percent from its May peak to late August.

Unfortunately, August was not the end of the slide in genco equities. As 2001 droned on and Enron began to take center stage, some analysts voiced concern over leverage in the genco