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Utility Valuation: Shedding Light on the Black Box

Experts debate how energy companies should be valued in the wake of electric restructuring and Enron.
Fortnightly Magazine - April 15 2002

in basically sticking with something that they know, [that utility companies] do well." He believes in companies that generate free cash flow, pay solid dividends, and even buy back stock from time to time. "We think that it is [important to demonstrate] disciplined management rather than taking excess cash flow or free cash flow and making investments that are far astray," says Quackenbush.

When evaluating individual companies, he applies a higher discount rate to take higher risks into account. "We wouldn't necessarily say a company has to grow by 5 percent or 10 percent. Growth would be one factor to take into consideration. But there could be a very solid company with a lower growth rate that would be acceptable compared to another company that is in a completely different situation."

Quackenbush measures success by comparing the performance of the utility stocks within UBS Global Asset Management's funds against utility benchmarks, like Standards & Poor's utility index and the MSCI World Standard Utilities Index. For example, since year-end 2000, the global utility stocks owned by UBS Global Asset Management have outperformed the MSCI World Standard Utilities Index by 1,100 basis points.

—R.S.

Of course, Malko believes the real issue will be how regulations are developed in reaction to Enron, and how those new regulations affect the future cash flows of energy companies.

"Until some of this stuff settles, you'll have that uncertainty. If you look at business risk, competition, weather, regulation, [and] availability of power supply are [will be] the drivers of valuation."

In a nutshell, Malko says the problem you get into is the qualification and quantification of all these business risk components, the changing of those components. The way these factors impact cash flows is certainly more complex today than it was 10 years ago.

"So, that's really what analysts are trying to get a handle on. We do have indicators based on actual sales that we didn't have 10 years ago that gives us some direction. But on the other hand, we have complexities and uncertainties about what kind of regulation we are going to have. What is going to happen to the holding company act and what kind of new accounting standard will come in play? Then, there is the state vs. federal issue. These are business risk factors that make the forecasting of these forward looking cash flows much more complex," he says.

"What has gone on in the past year or so is raising flags that analysts have to be sensitive to what assumptions companies are making regarding these earnings projections and how sensitive they are to changes in the business risk climate."

Meanwhile, with a possible increase in interest rates on the horizon, analysts are already looking at how valuations might possibly change.

"Everything else being equal, if treasury rates are going up, the rational investor is going to want more for an expected cost of common equity. In terms of the utilities cost-of-capital going up, it depends on the debt position and whether the company needs new debt."

John D. Quackenbush, a certified financial