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 Power $1.7 B = $7.6 B - $5.8 B

Northeast Utilities $0.0 B = $7.9 B - $7.9 B

Investors at Northeast Utilities are just breaking even. Their wealth remains unchanged. By contrast, the investors in NSP now own a company worth $1.7 billion more than the cash they put in (or left in) the business. As a group they are truly better off. Their additional wealth is measured by MVA.

For perspective, here are the top five and bottom three of 1,000 U.S. firms ranked by MVA at the end of 1998.

Rank Company MVA Capital

($ billion) ($ billion)

1 Microsoft $328.3 $11.0

2 General Electric $285.3 $65.3

3 Intel $166.9 $23.6

4 Wal-Mart $159.4 $36.2

5 Coca-Cola $157.5 $13.3

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998 RJR Nabisco ($12.2) $35.0

999 CNA Financial Corp. ($13.0) $20.3

1,000 General Motors ($17.9) $85.2

When a company makes a new investment, the firm's capital base expands by the amount of the investment. The company's total value increases to reflect both the increased investment and the market's estimate of the present value of the project's future cash flows. The net value change, or MVA, expands or contracts to reflect the stock market's favorable or pessimistic assessment of the net present value (NPV) of the project. As the difference between market value and invested capital, MVA simply is the market's estimate of the NPV of all past and planned capital spending projects. Taking on positive NPV projects increases MVA and shareholder wealth.

MVA also provides a clear means for judging the success of acquisitions. Acquisitions increase MVA and shareholder wealth only when the market expects the value of the target in the buyers' hands to exceed the purchase price. Earnings per share dilution doesn't matter at all, nor is EPS accretion a guarantee of success. Acquisitions often are made under the false presumption that the price-to-earnings (P/E) ratio stays constant. In fact the P/E ratio fluctuates constantly, and simply adjusts to reflect the MVA of the deal.

Under MVA thinking, too, there is no difference between the purchase and pooling methods of post-merger accounting. There is no evidence of a penalty for purchase accounting and goodwill amortization if the transaction is economically sound. On the contrary, there is clear evidence that firms overpay to get a pooling transaction (for example, the AT&T acquisition of NCR Corp.). The quality of earnings is what matters, and is reflected in a higher or lower P/E ratio. The market compares value added to value paid, regardless of the accounting treatment.

Choosing and implementing optimal dividend policies and financial strategies also becomes easier when increasing MVA is the paramount corporate goal. The distribution of cash through a dividend, for instance, does not change MVA. The firm's capital decreases as the cash is distributed and subtracted from retained earnings. Total market value falls by a similar amount as the shares go ex-dividend. Simply handing shareholders some of the firm's cash cannot increase their wealth, as they already own the company. Withdraw $5 from your bank account that has $100, and you are more liquid but not wealthier.

Paying dividends can rob a company of the capacity to borrow money and buy back stock, which is a more tax-efficient way to return capital to the shareholder. Stern Stewart clients such as FPL Group and IPALCO Enterprises have followed some variant of our firm's advice to curtail dividends, and instead, borrow and buy back stock. Both of these firms have benefited from significant increases in shareholder wealth as a result.

Florida Power & Light was the first healthy utility ever to cut dividends in anticipation of long-term regulatory changes. In the two years following the dividend cut, FP&L shares outperformed the Standard & Poor's utility index by 15 percentage points. IPALCO went one step further, and combined a dividend cut with a leveraged re-capitalization (borrow and buy back stock). Even after significantly increasing its debt-to-capital ratio, IPALCO maintained its bond rating. The reduced dividends more than paid for the increased after-tax interest costs. In 1997, the year of the recapitalization, IPALCO had a total return of 58.5 percent, the third-highest among utilities. Montana Power Co., a Stern Stewart EVA client, recently exited the generation business, a move that was applauded by the market. Montana Power won the EEI Index Award for the industry's best financial return between Jan. 1, 1994, and Dec. 31, 1998.

Such innovative financial and business strategies are born of a focus on shareholder wealth rather than on accounting measures of success.

Behind the Numbers: Is Bigger Better?

The table on page 44 shows Stern Stewart's ranking of 88 investor-owned electric utilities by their MVA at the end of 1998.

America's most able wealth-creating electric utility is Duke Energy, with an MVA of $15 billion, followed by Southern Co. ($10 billion) and Con Edison ($ 6.3 billion). The table also provides information on how MVA creation has varied historically. Duke and Southern have consistently led the MVA ranking since 1991, whereas Con Ed only recently rejoined the top echelon.

The table also provides the market value (MV) size rank for the utilities (with a lower rank indicating more market value). Duke and Southern have the third-largest and largest MV, respectively. Nine of the top 10 MVA companies also rank among the top 15 in MV. At first glance, it appears that wealth-creation strongly is influenced by size. The reality, however, is more complicated.

One way to look at capital efficiency is to divide MVA by the amount of capital employed. Such a "standardized" MVA indicates the rate at which wealth is being created per unit of capital. A caveat is in order: The objective of management is to maximize MVA, not standardized MVA.

Any project that produces positive MVA adds to shareholders' wealth, and should be undertaken, even if it brings down the ratio of MVA to capital. Standardized MVA is useful as an indicator of capital efficiency, but maximizing it should not be viewed as a goal unto itself. Wealth-creation depends not only on capital efficiency, but the size of the capital base to which this efficiency is applied.

IPALCO demonstrates the highest ratio of MVA to capital, 1.1, as of the end of 1998. Through efficient capital use, IPALCO turns an MV rank of 53 into a relatively impressive MVA rank of 29. In wealth-creating efficiency, IPALCO is followed by Black Hills, Montana Power, Duke and LG&E Corp. Southern, which ranks highly on MV size and MVA, drops to the 38th place in standardized MVA. But the biggest shift among the top 10 is Edison International, which drops from fifth in MVA to 49th in standardized MVA.

Duke is the only clear winner on both measures. Not only has the company invested a lot of capital, but it has done so efficiently for the most part. Of the top 10 companies ranked by wealth-creating efficiency (i.e., standardized MVA), only Duke, Carolina Power & Light and FP&L also loom large in MV size. The other seven most efficient companies have MV ranks of 39 or lower. Thus it appears that as utilities grow larger, they create less MVA per dollar of capital invested. There are two possible reasons:

It could be a sign of governance failure, i.e., the tendency for larger companies to insulate managers from the pressures of accountability and incentives of ownership.

Large utilities tend to have more regulatory visibility. They may be "too big to succeed," and may be denied the opportunity to earn a high return on large capital bases.

Firms that do well both in the dollar and standardized MVA rankings are creating lots of shareholder wealth, and doing so efficiently. Duke, Con Edison, FP&L, Carolina P&L, New Century Energies, LG&E, Florida Progress and NiSource are in the top quartile of both the MVA and standardized MVA rankings.

The utilities at the bottom of the dollar MVA ranking also tend to be at the bottom of the standardized MVA ranking. Illinova, El Paso Electric, Niagara Mohawk, Public Service of New Mexico, Unisource Energy, Northeast Utilities and Central Vermont Public Service are some examples. Some of these firms have resolved previous problems, but still must recover from the discounting of their stocks.

Illinova, for example, decided to exit Clinton operations, resulting in a $1.8 billion after-tax charge against 1998 earnings. El Paso Electric emerged from bankruptcy in 1996. Niagara Mohawk successfully restructured expensive purchased power contracts it was forced to sign under PURPA regulations, but continues to suffer from the after-effects. Northeast Utilities recently recovered from troubled nuclear operations, and is now merging with Con Edison. Since the MVA methodology carries a memory of capital invested, the rankings accurately reflect past inefficiencies in operations and capital use. This is another example of how the EVA approach increases accountability for capital invested in a business.

Investment in Generation:

A Relevant Factor?

No single strategy appears to be winning the MVA sweepstakes. The approaches of leaders in both the MVA and standardized MVA rankings represent a cross-section of industry strategies. Duke and Southern are large, internationally diversified utilities with regulated and unregulated businesses, and participate in all portions of the value chain - generation, transmission, distribution and services. Others such as Con Edison, FP&L, Black Hills, Montana Power and IPALCO are focused regionally. Con Edison and Montana Power are exiting the generation business altogether. There are no clear winners in any dimension of competition - local vs. global focus, full value chain vs. niche participation, or single energy source vs. gas-electric combinations.

Perhaps this outcome should be expected in an industry in flux. New business models are still being developed and tested. Some firms are buying what others are selling as both groups attempt to specialize and establish core competencies. During the next three to five years, winners surely will be more widely separated from the pack, and dominant strategies and success factors will emerge.

It is very interesting that 14 of the top 15 MVA-creating companies are nuclear utilities. Of those 14, Duke, CP&L, Con Ed and FP&L also do well in the standardized MVA rankings. These utilities have an aging, well-depreciated nuclear fleet whose book value may understate the true value of capital invested, thus leading to large EVA and MVA (or market valuation). The significant MVA accorded by the market to these utilities also may reflect a belief that the government will bail out the large nuclear decommissioning liabilities of these firms.

Practical Considerations:

MVA and EVA

Is MVA a reliable and useful measure of performance? How well does MVA correlate with other traditional performance measures, such as earnings per share or return on equity?

Figure 2 shows the correlation between standardized MVA and various performance measures. The correlation between standardized EVA and MVA is superior to the correlation between standardized MVA and EPS, net income, return on assets (ROA), return on equity (ROE) and free cash flow. Free cash flow and EPS have little correlation with MVA. EPS completely ignores balance sheet efficiency, and free cash flow doesn't allow differentiation between poor operations and high investment. ROA and ROE have a higher correlation, as they attempt to link operating efficiency (net income) with capital efficiency (assets or equity). Net income also has a higher correlation with MVA than is observed for non-regulated industries because revenues in the utility industry are adjusted to guarantee a return on equity. It must be noted that the EVA measure used here is generic. In our experience, a tailored EVA measure, such as we develop in an EVA implementation, has a still higher correlation with MVA.

Nevertheless, the MVA method does have shortcomings that might discourage its use as a day-to-day performance measure. For instance, MVA fluctuates by the minute as stock prices fluctuate. The fluctuations may or may not be related to the firm's operating performance. MVA is observable only for the consolidated firm as a whole, and not for individual business units. Finally, firms that are not publicly traded will not have an observable MVA.

Our firm's EVA method can help overcome objections that MVA is impractical for use in benchmarking.

EVA is defined simply as annual operating profit less a charge for the use of all capital - debt and equity.

EVA = Operating profit - capital charge = Operating profit - [(cost of capital) * (capital employed)]

Thus EVA is a measure of total factor productivity. It not only accounts for O&M items, but all forms of capital (working capital, trade financing, net plant and other assets).

EVA has a separate but equal focus on both operating efficiency and capital efficiency. Over the long-term, increasing EVA leads unambiguously to increasing MVA. In fact, MVA merely is the present value of all future expected EVA. This equivalence is the key to linking a period performance measure (EVA) to a value-creation measure (MVA). Since MVA is based on share price - the market's consensus of future expected value creation - EVA is linked directly to shareholder value creation.

The crucial advantage in using EVA for financial and business management is that it can be operationalized, and linked to all business activities: from strategy and goal setting, to capital budgeting, resource allocation, performance measurement and incentives. A high degree of cohesion results from a single-minded focus on EVA, resulting in large MVA. That sets EVA apart from accounting measures that are hard to link to operational parameters and that ignore the key value determinant: Do earnings exceed the minimum return required by the shareholders? The sidebar, "Beyond Earnings: Why a Value-Added Focus?" examines this question.

Operational Efficiency: A Red Herring?

As mentioned, "The Fortnightly 100," a previous study in this magazine, ranked utilities by their overall efficiency. While several input factors - including book value of plant - were considered, the study focused on operational efficiency. Firms such as Duke, LG&E, Montana Power Co., FP&L, SIGCORP, IPALCO and Black Hills, which fare well in the standardized MVA ranking, also fared well in the earlier study. Large utilities, such as Southern, TXU and PG&E, that did well in the current dollar MVA ranking but not in the standardized MVA ranking, also did well in the earlier ranking.

That suggests that an operationally efficient large utility with inefficient capital use still could have scored well in the previous study. The earlier study noted that the larger utilities had decreasing returns to scale, and alluded to the 40 percent average under-utilization of input factors. This fact is confirmed by our study, where mid-sized utilities outperform the larger utilities in creating standardized MVA.

The earlier study was criticized[Fn.4] for comparing fossil and nuclear utilities, utilities in fuel-producing and non-producing regions and urban and rural utilities. Such criticism misses the point from a shareholder wealth-creation view. Operational excellence is not an end in itself, but a means to create shareholder wealth. While there may be real differences in the operational characteristics of different utility segments, there certainly is a rationale for comparing wealth-creation.

A more recent study[Fn.5] in this journal by some of the authors of "The Fortnightly 100" correlated the market-to-book ratio (M/B) of equity with 12 independent variables, of which productive efficiency was found to be most significant. The M/B ratio is analogous to standardized MVA used in the current study. The results of the two studies thus should produce similar results.

In fact, they do. Standardized EVA has a stronger correlation with standardized MVA than do earnings per share, free cash flow, net income, ROE and ROA. The recent study also found that EPS before taxes (stock ratio) was weakly correlated to market valuation of equity. Since EPS is easy to manipulate, it is no wonder that in spite of all the attention focused on earnings per share, the market does not primarily value firms on this basis.

Cost Passthrough:

Aren't All Utilities the Same?

Some question the use of a "residual income" measure such as EVA in a regulated entity. Ideally, a regulated firm would earn a return equal to its cost of capital (blended debt and equity costs weighted by the capital structure), and its EVA would be zero. This viewpoint, however, neglects the following considerations.

* Revenue Lag. There is a lag between expenditures incurred and their recovery through rates, and between over-collections and their ultimate refund to the ratepayer. Operational and capital efficiency, therefore, are important.

* Unearned Returns. Some utilities do not even earn the allowed return of equity on the capital invested due to operational and capital usage inefficiencies.

* PBR Plans. As more states adopt performance-based regulation, stockholder and ratepayer interests become more closely aligned with value-adding performance.

* Non-regulated Opportunities. Most utilities have many non-regulated opportunities to boost wealth-creation for their shareholders.

In essence, EVA serves as a measure that encompasses the efficiency of both operations and use of capital. It differs from conventional earnings in two ways:

* full capital Cost Tracking. EVA explicitly charges for the use of both debt and equity capital. Traditional financial statements ignore the cost of equity capital, and merely include interest costs of debt capital.

* Fewer Distortions. EVA transforms accounting information, using a few simple adjustments, into economic information that is less subject to distortion.

While the cost of equity does not appear explicitly in the income statement, it is a real cost. Firms must demonstrate the ability to not just cover the cost of debt but also earn enough to cover the cost of equity capital. Companies that fail to do so may have positive - even increasing - earnings, but may be steadily eroding shareholder value, and soon will lose the confidence of investors.

Utility Stocks:

No Longer the Safe Bet

Since the regulation of utilities in the 1920s, utility investments have been viewed widely as "safe" income-producing instruments - a sort of bond equivalent - with an implicit promise of steady dividends and the backing of state governments minimizing default risk. No wonder utility share prices have marched in lock step with interest rates, similar to U.S. Treasury bonds.

This income-oriented approach focuses on the dividend stream that produces income rather than any gain in share price, even though the latter could be more tax-efficient. By contrast, the more sophisticated institutional investors (who largely determine the price of utility stocks) focus increasingly on wealth-creation for equity investors. In the future, inherent efficiency and management ability should play a greater part in the valuation of utilities. The recent announcement of Berkshire Hathaway's intention to take MidAmerican Energy private is an example of the changing focus of institutional investors. The MVA ranking has the same focus, as it is unaffected by the payment or non-payment of dividends.

In short, an MVA ranking correlates more closely with the central tenet of project valuation - that an economically sound investment returns a stream of cash flows whose present value equals or exceeds the cost of the funds invested. In other words, the net present value of cash flows (i.e., net of the amounts invested, and discounted to the present) must be zero or positive. A project with zero NPV returns sufficient cash to just cover the cost of paying the debt and equity holders the minimum return demanded by each on a risk-adjusted basis.

The same principle is used in valuing a firm, which can be viewed as a portfolio of projects. Analysts examine the stream of expected future cash flows, projected revenues, costs, taxes, depreciation and investment, and estimate net income. Unfortunately, the minimum earnings necessary to satisfy the shareholder often are ignored. Other valuation techniques such as the method of multiples must be used with care. The analyst must recognize that multiples (such as price/earnings or price/earnings before interest) are the consequences of firm performance, and serve as a convenient shorthand only when supported by, and derived from, fundamental analysis of the business prospects of the firm.

S.R. Rajan, Ph.D., vice president and head of the Stern Stewart & Co. utility practice, advises utilities on corporate governance, shareholder wealth-creation and financial strategy. Dr. Rajan can be reached at srajan@sternstewart.com. He previously has worked at the New York Power Authority and the S. M. Stoller Corp. The author gratefully acknowledges the analytical assistance of Marsha Abarbanel and the helpful comments of Bennett Stewart, Al Ehrbar and Justin Pettit, all of Stern Stewart.

Beyond Earnings: Why a Value-Added Focus?

How earnings measures don't quite hit the mark.

Earnings-related measures account for the cost of repaying debt-holders via interest expense, but ignore the minimum required return to satisfy shareholders. Increasing earnings thus is an incomplete goal, as it does not provide information on whether the earnings are enough to cover all costs of capital (debt and equity). Earnings are also easily manipulated, making them an unreliable measure of value-creation. Consider the following.

Capital structure 50 percent debt, 50 percent equity

After-tax cost of debt 5 percent

New capital invested $100 ($50 new debt, $50 new equity, unchanged capital structure)

Additional annual debt cost $2.50

Incremental earnings $2.51

Incremental project contributions of as little as $2.51 (return on investment of 2.51 percent) will increase the firm's earnings. Clearly, a project with a return of 2.5 percent destroys value for any reasonable cost of capital, even though earnings increase.

Case 1 in the table below provides another example of increased earnings with decreased value (economic value added, or EVA).

Return on equity - on net assets, on capital employed and all their variants - attempt to overcome the shortcomings of earnings by linking accounting earnings to some balance sheet item such as equity, assets or capital employed. That is a step in the right direction because these measures recognize the existence of the balance sheet, and the need to relate earnings to the capital producing the earnings, i.e., they attempt to measure the efficiency of capital use. But they remain flawed because they do not provide information on the minimum return acceptable to the shareholder, given the risk of the business.

In Case 1 below, overall return on capital, or ROC, grows but value declines. In Case 2, overall ROC declines, but value grows.

1 Stewart III, G. Bennett, "The Quest for Value," Harper Business, 1990.

2 Ehrbar, Al, "The Real Key To Creating Wealth," John Wiley and Sons, 1998.

3 "America's Greatest Wealth Creators," Fortune, Nov. 9, 1998.

4 Mail, "Voodoo, Perhaps. Econometrics, No," Public Utilities Fortnightly, Nov 1., 1998, p. 30.

5 Haeri, Ph.D., Hossein, Matei Perussi and M. Sami Khawaja, Ph.D., "The Fortnightly 100 Revisited: Do Utility Stock Prices Reflect Operational Efficiency?" Public Utilities Fortnightly, Feb. 15, 1999, p. 36.


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