Understanding power company volatility in the context of valuation theory.
Power industry observers have witnessed a stunning rise and fall in the valuations of genco equities over the past year. The first half of 2001, marked by high power prices and forecasts of a capacity shortage, saw genco equity prices peak at earnings multiples rarely seen before in the power industry. During the second half of 2001 and the beginning of 2002, observers witnessed the prices of the very same stocks decline to earnings multiples usually seen only in distressed situations, as overbuilding fears drove down the forward curve and as Enron-driven liquidity issues led investors to flee the sector.
In explaining the dramatic volatility of power sector stock prices, commentators have pointed to a variety of factors, including weather, the economy, price caps, transmission constraints and of course, the Enron effect. These and other factors have had an impact on valuations and have also guided investors' evolving understanding of the sector by highlighting the industry's critical valuation drivers. For industry observers trying to make sense of the dramatic swings in equity prices seen in the past year, it is helpful to consider the industry in terms of a valuation framework commonly applied by investors.
Basic Valuation- The Discounted Cash Flow Approach
In order to value a business, investors theoretically seek to approximate the stream of cash flows that will be generated by that business in the future. The present value of this stream of cash flows, discounted at the company's weighted average cost of capital (WACC) theoretically equals the value of the firm. Subtracting out the value of debt and other senior obligations derives the value of the firm's equity. This method of valuation is commonly referred to as the discounted cash flow (DCF) approach. The DCF approach is the best available framework from which to analyze the recent performance of the power sector.
While the basic assumptions underlying the DCF approach are theoretically the same for any industry, the importance of any particular assumption varies by industry. For example, the valuations of high-growth companies found in the technology sector are much more dependent on the projected growth of cash flows than are the valuations of transmission and distribution-oriented utilities, which are supported by more predictable cash flows. A 25 percent decrease in the projected growth rate of a high-growth technology company would likely have a substantial impact on a firm's valuation, while the equivalent decrease in a distribution utility's projected growth rate will have a much less substantial valuation impact. The simple reason for this is that a high growth rate company's cash flows are more heavily weighted toward the future. High growth rate companies with uncertain cash flows (like gencos) are also more susceptible to changes in the discount rate (WACC) for the cash flows, since discounting has more of an effect on distant cash flows.
Applying the DCF to Understand Market Response to Industry Events
Two of the most notable events affecting gencos last year were the California energy "crisis" in Spring 2001, and the Enron collapse of December 2001. Figure 1 summarizes the performance of a genco index versus the S&P 500 and the S&P Utilities Index during those periods. Until May 2001, gencos easily outperformed both indexes. However, during the latter part of the year, gencos markedly underperformed the indexes.
In valuation terms, the market during these periods was accounting for new information pertinent to gencos' underlying valuation drivers. The California power crisis (coupled with shortfall projections in other regions) raised fears of a nationwide shortage of generation capacity-a boon for gencos. Investors assumed that this shortage of capacity would drive new capacity construction, and that gencos would enjoy increased cash flows from the additional capacity to be constructed in the coming years and from the higher prices to be paid for that capacity (as a result of the robust forward curve). Partly as a result of expected construction and higher expected prices, industry analysts projected that gencos could increase their earnings by 25 percent to 35 percent annually over the next five years. To put this into context, at a 30 percent annual growth rate, a genco's $200 million in 2001 earnings would grow to $743 million by 2006-nearly a fourfold increase in five years. The vast majority of the earnings of this genco would be realized in excess of five years in the future. Assuming a 10 percent rise in annual earnings for the following five years and 2 percent growth thereafter, over 80 percent of the value of this genco would be derived from projected earnings more than five years in the future (using a WACC of 8 percent as a proxy for a genco WACC at the May height of the genco boom).
As 2001 progressed, investors and analysts began to question seemingly aggressive growth rate assumptions. As genco investors quickly learned, small changes in assumed growth rates can have (and very likely did have) a dramatic effect on valuations. At a 20 percent growth rate for the first five years (but retaining 10 percent for the next five), the valuation of our hypothetical genco would fall about 25 percent. However, this does not mean that the equity value (and stock price) would have declined 25 percent as well. Since debt and other obligations senior to equity must be subtracted to arrive at an equity valuation, a 25 percent decline in the company's valuation (referred to as the "enterprise value") can result in a much higher decline in equity value. Assuming that 50 percent of the enterprise value of our genco was comprised of debt and preferred stock, a change in the assumed growth rate from 30 percent to a still-aggressive 20 percent would yield over 50 percent drop in equity value. This is the power of leverage in reverse: as can be seen in the chart, the genco composite index fell nearly 40 percent from its May peak to late August.
Unfortunately, August was not the end of the slide in genco equities. As 2001 droned on and Enron began to take center stage, some analysts voiced concern over leverage in the genco industry and in the use of off-balance sheet structures as financing vehicles. Rating agencies responded by downgrading and threatening to downgrade gencos issuing new debt, raising the specter of gencos being required to post hundreds of millions in collateral for their trading operations. From mid-November until mid-December, the cost of genco debt increased in pretax terms anywhere from 40 percent for investment-grade rated debt to as much as 100 percent for non-investment-grade debt. This effectively foreclosed the ability of gencos to issue debt as a means of raising capital, leaving equity as the only option.
At the same time, the cost of issuing equity became prohibitive as genco stock prices declined. Compounding the problem was the fact that new equity investors would have required a premium return in excess of the predicted returns recognizable at the market equity price. The unfortunate effect was that gencos' marginal cost of capital skyrocketed at the very moment these companies needed capital most.
In terms of our DCF analysis, an increase in the WACC from 8 percent to 11 percent or more (accounting for the constrained liquidity situation) would reduce considerably the already battered enterprise and equity values of our hypothetical genco. Considering the effect of leverage, the reduction in the equity value is magnified more than twice, since (we assume) the face value of debt obligations remained constant over the course of the year. In fact, the chart demonstrates that the genco index fell another 40 percent between mid-November and mid-December as liquidity issues threatened to bury the sector.
Although important issues not discussed here certainly played some part, much of the extreme volatility in genco equities over the course of the past year can be explained in the context of the DCF model. As liquidity concerns begin to fade and genco WACCs fall in response, one can hope that the theory behind the DCF approach will hold and that genco equity values will continue to recover.
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