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Maximizing Shareholders Wealth Report (Assessment)

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Updated: Sep 10th, 2021

Do electric utilities understand how to earn profits for shareholders in a competitive market?

Here’s one way to look at the problem. Gather a group of financial experts and ask this question: If a company’s long-term bonds are rated AAA, and yield 8 percent, what minimum return would you require from dividend yield and price appreciation to induce you to buy that company’s stock?

The typical expert will say 12 percent, indicating a 4-percent premium (or spread) above AA bond yields. This figure approximates the rates of return on common equity (about 3.4 percent above yields on AA-rated bonds) that regulators have allowed for electric utilities from 1986 to 1996, as compiled by Regulatory Research Associates. For companies with lower-rated debt, the spread would obviously be higher.

Today, with the advent of competition, the dam has burst. With the grass looking greener on the other side of the fence, utility managers are considering expansion. Some companies are sending other products over their existing lines and adding special related services. Others are concentrating on generation and power contracting. Still, companies can see more by spreading their wings with large investments in foreign utilities. All are caught up in a compelling rush to grow.

Unfortunately, the grass may not be any greener.

From 1981 to 1993, returns on common book value for unregulated businesses hovered at 4 percent above AA-rated bond rates, based on the Standard & Poor’s index of 400 industrial common stocks. (Since 1995, the spread has climbed above 12 percent, however.)

Utility diversification strategies are nothing new. In the not-so-recent past, utilities got into everything from insurance to banking to real estate (em but largely with poor results. In the future, however, competition will raise the bar. To diversify successfully in a competitive arena will require a new understanding of maximizing shareholder wealth. So What’s Wrong With Earning our Cost of Capital?

Technically speaking, there is nothing wrong if a company earns its cost of capital. That means it is breaking even; consumers are sufficiently interested in the product to pay all costs. In fact, an unwillingness to pay all costs (including the cost of capital), would indicate that capital was misdirected and wasted.

In this break-even example, the company’s stock will sell in the long run at a price-earnings ratio equal to the reciprocal of the common cost and at book value. Such performance falls short of what is needed to maximize shareholder wealth. To do that, utility management must do two things:

  1. earn a return above the cost of common equity, and
  2. put more capital to work at that higher return.

High earnings without growth can improve shareholder wealth, but will not alone materially raise stock prices. Earnings above the cost of common equity turn the company into a cash cow. It is the ability to put more capital to work at a higher return than really maximizes shareholder wealth.

Utility managers who believe the stock market is rational should consider asking themselves the following questions about the way the market really operates:

  • Does the stock market tend to take a short-run view (one to two years), an intermediate view (three to four years), or a long-run view (five years or more)?
  • Does the market swing widely between excess optimism and too much pessimism (yes or no)?
  • On a scale from one to ten, how do you rate the investment decisions of (a) the average individual investor, (b) institutional investors, and (c) brokers who advise investors.

To be successful, a company must thoroughly understand the cost of capital and apply it correctly. That is the basic idea in allocating capital and monitoring the results to maximize shareholder wealth. In fact, it seems that of all industries, the electric utility industry would have an in-depth knowledge of the subject. The cost of capital has long formed the basis for traditional utility regulation. But the way that utilities have handled their recent forays at diversification would appear to give some reason for doubt.

Beware the Lure of High Risk

Many utilities are now putting capital abroad. What rate of return should they earn on overseas investment?

If asked, our group of financial experts might say that a company with all assets located in Western Europe should earn a return that includes a premium of about 7 percent more than the yield on AA-rated bonds. Of course, the exact figure depends on where in Europe the investment is located, but it does suggest the need to consider a possible increase in return on foreign investment even in a good location. In less-developed nations with political instability, the premium would have to be substantially higher. It requires very astute management to judge the return required in such situations, but there is ample data available that ranks political risk in foreign countries.

For some high-risk investments, such as oil exploration or financing with a leveraged buy-out, it can prove difficult to arrive at a precise figure for the cost of common equity. Managers who can achieve success in these businesses have an innate ability to judge risk, and that will be required in some foreign utility investments. Where Value Comes From ????

To maximize shareholder wealth, a company must earn more than its cost of common equity. How much it can earn will depend upon the nature of the industry and whether the individual firm can develop a competitive edge in its own market.

In the pharmaceutical industry, for example, with its millions spent on research and development, firms can patent their products, earning a high return. By contrast, airlines carry a large, long-lasting capital investment. Price wars, until recently, cut into profits from air travel.

Similarly, power generation requires intensive capital investment, but with no ready means to distinguish the product. Overcapacity may lead to price-cutting, producing low margins.


John F. Childs __ 1997. Web.

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