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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
Figure 2

noted in the early part of this decade, consistent with emergence of several failed deregulation initiatives in various states (notably California) and the demise of Enron, et al. Similarly, a clear rising trend also is apparent in recent years (2002 to 2007) as the effects of these ill-fated forays have been resolved and an era of favorable financial conditions (declining interest rates, improved dividend tax treatment, etc.) have improved the overall utility financial environment and performance.

In the most recent quarterly MtB results, overall industry levels (first quartile, average, and third quartile) have declined slightly in the past two years, beginning in 2007 (see Figures 2-A and 2-B) . This is no doubt related to challenging capital market conditions during the same period. However, as previously noted, the overall level is not materially different from that of 10 years ago.

It also is worth highlighting the MtB context for the recent unsolicited offers for both Constellation Energy Group and NRG Energy (see Figure 2-B) . These companies saw their MtB values plummet from first- to fourth-quartile levels and to market values at or below book value. This is an open invitation for change-of-control challenges from other market participants.

The Case for MtB

Figure 3

A logical and appropriate question is, “why is the MtB ratio a reliable and insightful measure?” Further, “how does the MtB ratio compare to other enterprise level performance measures?” The best way to answer these questions is to examine those characteristics that make a good enterprise level performance measure and assess how the MtB ratio performs relative to other metrics. Ideally, an enterprise level performance measure should be: externally or market-defined; stable or time-independent; comparable; and predictive.

An ideal enterprise-level performance measure should first and foremost be based on an external or market-derived value. One need only consider the quality-of-earnings challenges resulting from normal utility business activities ( e.g., allowance for funds used during construction-AFUDC) to acknowledge that purely accounting-based measures such as return on assets (ROA), return on equity (ROE), and return on invested capital (ROIC) are simply too arbitrary to be relied upon as a sole assessment of performance. These accounting-based measures are defined internally by the company and thus have no independent, external check on reality. This is not to suggest these measures (ROE, ROA, etc. ) don’t have a role in performance assessment and management; rather, it merely highlights their ability to be distorted by accounting and financing decisions and thus notes their limitations.

It is especially important to highlight that a related and very strong candidate for a single, enterprise level performance measure is, in fact, the ROIC spread ( i.e., ROIC-WACC). Analysts at Accenture and others have identified the power of this measure [(ROIC-WACC) > 0] as a predictor of when shareholder value is being created (see “ High Performance? Your Strategy Matters ,” Fortnightly, September 2006). Unfortunately, the ROIC spread fails in two areas. First, the company’s WACC simply isn’t an observable value in the market, although it can be estimated with some degree of accuracy through statistical measures. Second, and perhaps

Figure 4