The time-honored discounted cash flow method for determining appropriate utility returns falls short when interest rates are low. Inadequate ROEs ultimately increase cost of capital and wipe away...
A Utility Executives' Guide to 2007: A Cloudy Forecast
Experts predict the top issues that utilities will have to weather this year, and beyond.
utilities because they do not earn inflation-adjusted returns in this country.”
Bankers assert that utilities need to do something (such as M&A) to boost growth rates enough to satisfy investors, he says. But Hyman argues that investors have a pretty good idea of what utilities can achieve, and would be happy to see those modest results realized.
He supports this conclusion with analysis of 199 years of data in the United States. “During that period, investors in common stock earned total returns (dividends plus capital gains) of roughly 2 to 3 percentage points per year more than the bond yield. Bond yields, nowadays, are around 5 to 6 percent. So, investors in stock, based on historical ‘experience,’ would settle for around 7 to 9 percent,” he writes. In fact, any pension fund’s annual report will reveal an expected return of generally 8 percent, he adds.
Morgan Stanley’s Marks says he asked institutional investors (in a limited survey) for their forecast of utility stock prices during the next 18 to 24 months, and their views on valuation.
“Please keep in mind this was a group of long-only investors. Most responded their prices would increase modestly—single digit levels—and drivers cited were expected earnings growth and a stable interest-rate environment,” he said, in contrast to his own prediction that interest rates were more likely to rise.
Furthermore, Morgan Stanley asked these investors to rank the economic factors they believed would most impact the stock.
“By far, the most highly cited factor was commodity prices. The focus on commodity prices reflects the high volatility of commodity prices relative to most other macro economic factors. The impact of changing commodity prices on any utility will, of course, vary depending on whether it is in the long or short position relative to commodity exposure. Notwithstanding the strong relationship between PEs and interest rates … interest rates were deemed less important by investors surveyed.”
Eyeing metrics investors favor in valuing stocks, standard approaches include earnings, cash flow, return on invested capital, discounted cash flow, and the dividend discount model. “About half of the investors said the cash-flow metrics were increasingly used over the last 18 to 24 months,” Marks said. “The others felt there was no discernable change. Investors generally noted that cash flow metrics were much more important in assessing the value of unregulated businesses.”
And with fundamental uncertainties in demand patterns, fuel prices, and regulation, predicting cash flow will remain a rather black art in 2007 and beyond. For regulated utilities—and the unregulated generators that rely on them—the big question remains how regulators will receive utilities’ rate-recovery plans in an era of rising investment needs, commodity prices, and environmental concerns. Utilities’ abilities to manage ratemaking engagements will set the tone in the years to come.
Recipe for Volatility
As 2007 begins, natural-gas prices provide an apt metaphor for the utility industry’s business environment.
Natural-gas prices have fallen to levels far lower than many expected to see only 16 months after Hurricane Katrina. But the steady rise of prices since 2003, combined with the post-Katrina pinch, has left