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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 5

most important, many utility executives are loathe ever to expressly measure WACC as part of their strategic planning and performance monitoring activities in the belief that regulators later will reveal these analyses with their discovery powers during rate-case proceedings and use them to the company’s disadvantage in the cost of capital elements of future rate cases.

A scatter plot of the relationship between the MtB ratio of 68 U.S. utilities at year-end 2007 vs. their projected average ROIC over the next three-year period (derived from securities analysts’ projections) shows a very strong correlation (r-squared = 0.69), implying the MtB ratio and the expected ROIC are deeply related measures (see Figure 3).

Here is where the logic of the MtB ratio begins to become clear. The MtB ratio offers shareholders an ideal, externally-derived measure of management’s progress. The MtB ratio—unlike the WACC—is expressly observable in the market (and on a daily basis). Moreover, it is sufficiently removed from cost of capital analyses to satisfy even the most cautious regulatory regime. Simply put, without expressly measuring ROIC-WACC (for the rationale noted above), the MtB provides an excellent surrogate measure.

Figure 6

Thus, the MtB ratio captures the public’s assessment of the firm’s positioning and expected results—especially its expected ROIC, which is a critical driver to creating shareholder value.

MTB Ratio Stability

The overall industry’s levels and patterns for the MtB ratio are relatively stable over long periods (see Figures 1 and 2) . Thus, it is possible to review any individual company’s MtB ratio with a focus on its absolute level, its relative level, and its trends at any point, and thereby gain significant insight about the utility’s current and future conditions.

The MtB ratio’s stability and consistency of measurement is not available in other, popular enterprise measures. For example, in recent years many utility annual reports have touted superior total shareholder return (or TSR, which measures the total effect of both dividends and share price appreciation over a period) as a testament to management strength and ability. TSR certainly is a conceptually attractive performance measure and it also should be an important measure for management to monitor.

Figure 7

However, TSR assessments should be used with considerable caution. Virtually all recent top performers in five-year TSR are, in fact, some of the fallen angels of the early 2000s who faced severe strategic and financial challenges—even bankruptcy (see Figure 4) . Thus, a leading indicator of high TSR performance is, as often as not, born from some catastrophic decline in the value of the firm’s stock value in the recent past. Clearly, such events are not exemplars of keen management performance and thus challenge the entire notion of the TSR as a stable, effective measure of management performance.

Regrettably, most of the bragging rights for industry-leading TSR performance often belong in the same category as those of the latest hot mutual fund or hedge fund. The starting baseline is a key variable driving the overall reported value.

Finally, a prediction: Expect a deafening silence on TSR-related measures in annual reports (and in executive compensation models) in the years