Turning Capital to Wealth: A Ranking of U. S. Utilities

Fortnightly Magazine - December 1999

An alternative measure of performance - not based on dividends, earnings growth or P/E ratios.

How to place a value on a utility company? That is the question.

The traditional models no longer work very well. Dividend discount models will not work well if utilities cut dividends and buy back stock to return capital to the shareholders. Earnings growth offers no reliable performance gauge either, as utilities acquire or divest large amounts of capital. Restructuring charges often become necessary to shift resources to their best use.

Some would rank utilities by overall efficiency. That was the approach taken in "The Fortnightly 100," but the method becomes problematic when comparing utilities that differ greatly by plant type, location and other factors. (See Public Utilities Fortnightly, Sept. 1, 1998, p. 26, and the reader letters that followed at Nov. 1, 1998, p. 30.)

Our firm, Stern Stewart & Co., has developed a framework[Fn.1, 2, 3] for ranking utilities. This framework, which we call "EVA," or economic value added, highlights the extent to which utility value exceeds the value of capital investment. The method incorporates several additional terms. The term "MV" will denote the market value of total capital (the equity market capitalization plus the value of debt capital and long-term liabilities). The term "MVA," or market value added, measures the gross surplus of MV over invested capital. The term "standardized MVA" denotes MVA created per unit of capital. MVA can be thought of in one sense as determined by the stream of economic profit, or EVA, the firm is likely to generate in the future. This concept is identical to the proposition in corporate finance that the value of an asset is determined by the stream of future cash flows it generates. This idea has been used before to compare the performance of firms in other industries, but is applied here to utilities for the first time.

NSP vs. NU: Same Market Cap,

Different Value

Chief executive officers often proclaim that their mission is to "maximize" shareholder value. In fact, that goal is mistaken. Strictly speaking, management should not attempt to increase value, but instead maximize the wealth created above and beyond capital investment. The critical distinction can be understood by comparing Northern States Power and Northeast Utilities.

At the end of calendar year 1998 (all market valuations here are calculated as of that date), both companies had virtually the same total market value (as estimated by the market values of shareholders' equity plus the book values of debt and other long-term liabilities). In this case, that means approximately $7.6 billion for NSP and $7.9 billion for Northeast. However, the performance of the two firms has been quite different. Northeast invested $7.9 billion of capital investment to produce $7.9 billion in value, whereas NSP needed only $5.8 billion of capital to produce $7.6 billion in value.

MVA reveals the disparity in the performances of the two firms. It is measured by the difference between total value and the total capital employed to produce that value:

MVA = Total Value - Total Capital

Northern States