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The Pulse of a Utility

The market-to-book ratio is a vital sign of a utility’s health.

Fortnightly Magazine - January 2009

Shareholders and directors of electric and gas utilities need a consistent, credible, and intuitively clear way to evaluate how management is marshalling the company’s resources and to gauge management’s contribution to overall results. They need a single performance measure to summarize—as well as any one measure can—how the utility is performing both in absolute and relative terms and what the owners and stakeholders should expect in the future. Like a physician with her stethoscope at the outset of a check-up, astute shareholders and directors should use the level and trend of a utility’s market-to-book ratio (MtB) as one of the first vital signs they monitor and as an ongoing and leading measure of a utility’s strategic health.

The market-to-book ratio is the ratio of the market value of all of the firm’s capital (both debt and equity) divided by the book value of the firm’s capital. The market value is determined by valuations made by the public capital markets (common and preferred share prices, debt prices, etc.); the book value is determined by the utility’s accrual accounting value stated in the periodic financial statements.

At the most summary level, the MtB ratio offers a simple and readily accessible vital sign of what the market ( i.e., an external, independent arbiter) really believes the firm is worth relative to the current net investment in it. Simply put, a MtB ratio of less than 1.0 suggests management has not created, or is not expected to create, any value in excess of the net investment in the firm. A ratio of greater than 1.0 suggests management has generated or is generating returns on capital in excess of the cost of capital. Even more important is the overall trend of a utility’s MtB ratio; a rising MtB and especially an MtB ratio in excess of industry average is indicative of returns greater than the cost of capital ( i.e., ROIC > WACC, or return on invested capital greater than weighted average cost of capital).

Figure 1

The MtB ratio is a key measure for any capital-intensive industrial or financial firm. It is especially useful in regulated industries such as electric and gas utilities, where rate base closely approximates the book value of the firm (with some adjustments).

A perspective on the utility industry’s MtB ratio trends is a necessary foundation to understand any individual utility’s current performance and prospects. For example, an examination of the market-to-book ratio trends (by quartile) for the overall U.S. utilities industry (65 companies) during the period from 1997 to 2007 highlights several overall trends (see Figure 1).

First, the general level of the MtB ratio is relatively stable over long periods (10 years). The industry average MtB ratio at year end 2007 was 1.33 and was identical to its 1997 level. This stability is expected—the U.S. utilities industry is highly regulated and based on mature technologies. Second, a clear decline was

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