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Comment: Regulatory procedures, investment opportunities, and stock valuation
Comment: Regulatory Procedures, Investment Opportunities, and Stock Valuation Robert R. Trout, Resource Planning Associates, Inc., San Francisco, California
Several recent studies of the effect of accounting treatment on the valuation of electric utilities have concluded that investors appear to favor normalizing firms by pricing equities of such firms relatively higher than the equities of flow-through firms. The observed higher pricefearnings ratios (P/E ratios) for normalizing firms have usually been credited to the benefits of normalization, as perceived by investors. This article presents evidence that the observed preference for normalization companies is unrelated to accounting treatment. Rather, this preference is related to the fact that firms that obtain normalization benefits typically have lower costs than those which do not have such benefits. This characteristic of normalization firms results in their relatively higher PIE ratios.
In a recent article, Bower, Johnson, Lutz, and Tapley [ 11 reported the results of their investigation into the question of whether normalizing companies are valued differently in the market place than flow-through companies. In this paper they correctly pointed out that for regulated utilities there is more to the difference between normalizing and flow-through companies than simply a difference in reporting, and this difference is a result of the existence of rate of return regulation. Initially, Bower et al. [ 11 used a simulation analysis to examine the differences between flow-through and normalizing companies. They found that in the early years of a firm’s development, flowthrough accounting results in lower operating income for the firm, lower depreciation and taxes, and lower prices for consumers. The authors next analyzed certain financial ratios for a sample of electric utilities during the period 1959- 1973. Their sample was split into two groups based on type of accounting treatment, and the results of their analysis are presented in their Exhibit 3. Unfortunately, their analysis assumes that the only difference between flow-through and normalizing companies is the type of accounting treatment, and that there exists a clear demarcation between flowAddress correspondence to: Robert R. Trout, Three Embarcadero Center, Suite 2080, San Francisco, CA 94111. JOURNAL OF BUSINESS RESEARCH 0 Elsevier North Holland, Inc., 1979
259 0148-2963/79/03259-08$01.75
260
Robert R. Trout
through and normalizing companies with respect to this variable. However, the authors do recognize that this may present a problem, and in fact suggest that there may be underlying differences between the two groups which account for the observed group differences in P/E ratios. For example, the results presented in their Exhibit 3 indicate that the growth rate in total assets and in kilowatt-hour sales of electricity were nearly identical for the normalizing and flowthrough groups over the time periods examined. If rates are lower for flow-through companies, as suggested in their simulation analysis, then one would expect to see higher growth rates for such companies if consumers respond to price level changes. However, even if significant differences in growth rates between the two groups had been observed, this would not indicate anything with respect to accounting treatment unless the firms in each group were identical in all aspects, except for type of accounting treatment. The demand for power is the primary determinant of the growth rates in assets and sales. This demand is primarily influenced by such factors as population growth, growth in industrial output, growth in appliance usage, and in the long run, the prices of electricity and of competing energy sources. Given this relationship, any differences in growth rates of the two groups which happened to result from accounting treatment would most likely be unobservable. The authors also pointed out that the ratio of revenues to total assets was nearly identical for the two groups, which was contrary to the results of their simulation analysis. Once again, for such differences to be observable one has to assume that the two groups are otherwise identical. Deferred taxes accounted for less than 2% of total revenues for the average electric utility in 1973, while fuel accounted for 23% of revenues for the average electric utility in 1973. Thus, the type of fuel a firm used would have much more of an impact on the level of revenues than the type of accounting treatment, and it is extremely unlikely that the two groups of firms were identical with respect to fuel consumption. All things being equal, required revenues and rates should be lower for flow-through firms than for normalizing firms; however, all things are not equal between these two groups of electric utilities, and this fact can be demonstrated by comparing the rate levels of the two groups. Any comparison of electric rates across firms is not a straightforward matter, since the rate schedules in
Regulation,
Investment,
and Stock
Valuation
261
different service areas are not always identical in structure. Nonetheless, one can make a rough comparison of rate levels for normalizing and flow-through companies from the Federal Power Commission (FPC) published rate information. Table 1 presents the results of an examination of selected residential, commercial, and industrial rates for the sample of companies used in the Bower study. Six of the holding companies used in the Bower et al. [l] study were excluded due to the difficulty of selecting an appropriate rate for each class. The data in Table 1 indicate that for each of the four groups examined, the average rate for normalizing companies is lower than the average rate for flow-through companies, which is the opposite result expected if the groups were similar with respect to other characteristics. The differences observed are not statistically significant at a high level, but the significance level improves when the deferred tax effect is subtracted from the normalizing group. This was done by subtracting 2% from the rate levels of the normalizing companies, which would have the effect of approximately removing the deferred tax requirements from the level of required revenues. The differences observed after this procedure is carried out are reported in column 4, and these differences are slightly larger than the uncorrected differences reported incolumn 3, and are statistically significant at the 10% level. Thus, while theory says that rates should be lower for flow-through companies in the early years, what one observes is lower rates for normalizing companies. It was assumed that the sample companies are still in the early years, which is consistent with the assumption in the Bower study. When the ultimate value of normalization, the deferred tax effect, is removed from the revenue requirements (and thereby the rates) one observes even lower rates for normalizing companies. This indicates that there probably exists some underlying difference between the firms in each of the groups which is unrelated to accounting treatment. Rates may be lower for normalizing firms because their fuel or operating costs may be lower. For instance, the group of flowthrough companies consisted of many Eastern companies that use extensive amounts of oil in the generation of electric power, and this makes their production costs high relative to those of other companies. Conversely, the normalizing group is comprised predominantly of companies located in the South, Midwest, and Southwest. These firms generally have lower operating costs, lower property taxes, better access to cheaper fuels and lower labor costs.
262
Table
Robert R. Trout
1: Comparison of Selected Electric and Normalizing Companies
Rates for Flow Through
Electric Rates-1973 Difference Rate Class
FT
NORM
Unadjusted
Adjusted $ (4)
$
$
(1)
(2)
12.90 (2.18)
12.25 (1.72)
0.65 (0.5 2)
0.90 (0.52)“
193.15 (40.36)
178.08 (29.24)
15.07 (9.50)
18.63 (9.5O)b
100,000 KWH @ 500 KW
2298 (598)
2123 (379)
175 (136)
217 (136)c
400,000 KWH @ 1000 KW
6563 (1776)
5814 (1554)
749 (449)
865 (449)O
d,
Residential 500 KWH
Commerical 6000 KWH @ 30 KW
Industrial
Standard deviations are in parenthesis a: Statistically significant at 5% b: Statistically significant at 10% c: Statistically significant at 12% Column (3) m Column (1) - Column (2) Column (4) = Column (1) - [0.98 X Column (2)] Source: Federal Power Commission Typic01Electric Bills, 1973.
Thus, it is quite conceivable that the underlying difference between the two groups is related to operating costs. Operating costs for the firms in each group of utilities used in the Bower study were calculated to test this hypothesis, and the results are reported in Table 2. The data in Table 2 indicate that the average cost of producing power is significantly lower for normalizing companies than it is for flow-through companies. This relationship also holds true for the average cost of power sold, which includes
Regulation,
Investment,
and Stock
263
Valuation
Table 2: Comparison of 1973 Operating Costs for Flow Through and Normahzing Companies MiUs/KWH Cost of Power(a) Generated
Cost of Power@) Sold
(1)
(2)
27 Flow Through Companies
6.68 (2.52)
10.35 (3.23)
33 Normalizing Companies
5.59 (2.13)
9.19 (3.00)
1.09 (0.61)c
1.26 (0.81)d
Difference (FT-Norm)
a Cost of power generated = Total power production expense less cost of purchased power divided by total power generated. b Cost of power sold = Total electric operating and maintenance expenses divided by total kilowatt-hour sales. c Statistically significant at 8%. d Statistically significant at 12%. Standard deviations are in parenthesis. Source: Federal Power Commission, Statistics of Privately Owned Electric Utilities in the United States, 1973.
overhead expenses and transmission and distribution costs as well as generation costs. These findings do not directly explain the effects of accounting treatment on the valuation of the firm; however, they do suggest that there are significant differences between the two groups which are unrelated to accounting treatment which must be taken into account in any empirical study of the accounting treatment question. One interpretation of these findings is that companies with low rates are in a better position to obtain normalizing benefits from rate-conscious regulatory commissions. Utilities will normally try to obtain normalization benefits because it results in a higher cash flow to the firm, and it is also a conservative accounting practice. They are more likely to gain these benefits when other costs of operation are low so that the impact of higher revenue requirements for deferred taxes under normalization are not so noticeable.
264
Robert R. Trout
On the opposite side of the bargaining table is the regulatory commission. Commissioners are probably concerned with the ultimate rate levels which will prevail in their jurisdiction, and these rate levels will be compared with those which exist in other areas of likely comparison. Industrial users of electricity and other large electricity consumers will locate, to whatever extent possible, in areas where rates are low, and regulators are aware of this fact. It is not by random choice that producers of primary aluminum, which are probably the most intensive users of electricity per unit of output of any industry, have located in areas where electric rate levels are low, such as the Pacific Northwest. Hence, one can assume regulators can be persuaded to grant normalization benefits to utilities only when the effect of normalization on rates will not cause the rate levels to escalate above those in other areas of likely comparison. This is rational behavior on the part of regulators. Eiteman [3] found that commissions that allowed the use of fair value rate base determination (which is normally higher than original cost) compensated for this fact by allowing these firms lower returns on that rate base. This interpretation implies that the results found by Bower et al. [ 1 I, and also in earlier studies by Brigham and Pappas [ 21 and Mlynarczyk [5], may be due to misspecifications in the models used to analyze the accounting treatment question. Researchers have predominantly used an indicator variable to represent the type of accounting treatment in linear regression models which attempt to explain variations in P/E ratios or other measures of value. This procedure may lead to incorrect conclusions because of the problem of correctly classifying a firm as to its accounting treatment. For example, most of the flow-through firms used in the Bower study had some deferred taxes, and in several instances the ratio of deferred taxes to net income was actually higher for flow-through firms than for some of the normalization firms. Deferred taxes for flow-through firms could result from nonutility investments, utility operations in more than one state where the states differ in their regulatory approach to this problem, or from situations where the commission may allow partial normalization treatment, as in the case where liberalized depreciation benefits are flowed through to consumers while the firm is allowed to retain the benefits of investment tax credits. Thus, the demarcation between the two groups is often imprecise, and it can be argued that some firms could be classified as belonging to either group.
Regulation, Investment,
and Stock Valuation
265
A more appropriate variable to use in measuring the accounting effect may be a continuous variable which would not depend on the ability of the researcher to subjectively determine the correct group identification. Brigham and Pappas [21 indicated that they examined several such variables, but without success. Gordon constructed a continuous variable which incorporated both deferred taxes and the allowance for funds used during construction which he called a “quality of earnings” variable, but it was not usually significant in his models. On the contrary, Roseman [6] found that the variable “deferred tax/net income” was statistically significant and explained some of the variation in market/book ratios of electric utilities. The evidence presented in Tables 1 and 2 in this comment suggests that a statistically significant indicator variable which represents accounting treatment may simply be a proxy for the fact that normalizing companies happen to be more efficient, or have lower operating costs due to their location, and therefore are in a better position to bargain successfully for normalization benefits from price conscious regulatory commissions. The security price premiums normalization firms enjoy is not due to accounting treatment but rather it is due to their preferred environmental setting and the more appealing future return opportunities resulting from probable greater future growth and a more favorable regulatory climate. The indicator variable was significant in the studies cited not because it reflected accounting treatment but because accounting treatment and general regulatory treatment are both related to another effect, which is the relative cost structures of the firms within each regulatory jurisdiction. The addition of a variable which measures cost per kilowatt-hour of output to models such as those used by Bower et al. and by Brigham and Pappas appears to render the accounting variable insignificant, which supports the theory that its primary effect in the model is to capture the variation of cost structures among firms rather than the variation of accounting treatment. The observation by Bower at al. that the observed price/earnings ratio differentials between normalization and flow through firms are unrelated to any historic risk measures is consistent with the implications presented here that the accounting variable is a surrogate for differing cost environments. Investors should be willing to bid up prices for firms with higher expected future returns regardless of historic risk measures, and due to lower costs the firms
Robert
266
R. Trout
classified as being normalization fums should be better able to earn high future returns, especially during inflationary periods in an industry with rising costs and relatively fixed prices.
References Bower, Richard S., Johnson, Keith B., Lutz, Walter J., Jr., and Tapley, “Regulatory Procedures, Investment Opportunities and Stock Valuation,” of Business Research, 5 (March 1977): 39-61.
T. Craig, Journal
Brigham, Eugene F. and Pappas, James L., Liberalized Depreciation and the Cost of Capital, MSU Institute of Public Utilities, East Lansing, Michigan, 1970. Eiteman, David K., “Interdependence of Utility Rate-Base Type, Permitted Rate of Return, and Utility Earnings.” Journal of Finance, 17 (March 1962): 38-62. Gordon, Myron J., The Cost of Capital to a Public Utility, MSU Institute Public Utilities, East Lansing, Michigan, 1974.
of
5.
Mlynarczyk, Francis A., Jr., “An Empirical Study of Accounting Methods and Stock Prices.” Journal of Accounting Research: Empirical Research in Accounting 7, (December 1969): 63-81.
6.
Roseman, Herman G., Testimony before the New York State Public Service Commission, Case Number 26868 (1975), Re: Consolidated Edison Company Gas Rates.
Several recent studies of the effect of accounting treatment on the valuation of electric utilities have concluded that investors appear to favor normalizing firms by pricing equities of such firms relatively higher than the equities of flow-through firms. The observed higher pricefearnings ratios (P/E ratios) for normalizing firms have usually been credited to the benefits of normalization, as perceived by investors. This article presents evidence that the observed preference for normalization companies is unrelated to accounting treatment. Rather, this preference is related to the fact that firms that obtain normalization benefits typically have lower costs than those which do not have such benefits. This characteristic of normalization firms results in their relatively higher PIE ratios.
In a recent article, Bower, Johnson, Lutz, and Tapley [ 11 reported the results of their investigation into the question of whether normalizing companies are valued differently in the market place than flow-through companies. In this paper they correctly pointed out that for regulated utilities there is more to the difference between normalizing and flow-through companies than simply a difference in reporting, and this difference is a result of the existence of rate of return regulation. Initially, Bower et al. [ 11 used a simulation analysis to examine the differences between flow-through and normalizing companies. They found that in the early years of a firm’s development, flowthrough accounting results in lower operating income for the firm, lower depreciation and taxes, and lower prices for consumers. The authors next analyzed certain financial ratios for a sample of electric utilities during the period 1959- 1973. Their sample was split into two groups based on type of accounting treatment, and the results of their analysis are presented in their Exhibit 3. Unfortunately, their analysis assumes that the only difference between flow-through and normalizing companies is the type of accounting treatment, and that there exists a clear demarcation between flowAddress correspondence to: Robert R. Trout, Three Embarcadero Center, Suite 2080, San Francisco, CA 94111. JOURNAL OF BUSINESS RESEARCH 0 Elsevier North Holland, Inc., 1979
259 0148-2963/79/03259-08$01.75
260
Robert R. Trout
through and normalizing companies with respect to this variable. However, the authors do recognize that this may present a problem, and in fact suggest that there may be underlying differences between the two groups which account for the observed group differences in P/E ratios. For example, the results presented in their Exhibit 3 indicate that the growth rate in total assets and in kilowatt-hour sales of electricity were nearly identical for the normalizing and flowthrough groups over the time periods examined. If rates are lower for flow-through companies, as suggested in their simulation analysis, then one would expect to see higher growth rates for such companies if consumers respond to price level changes. However, even if significant differences in growth rates between the two groups had been observed, this would not indicate anything with respect to accounting treatment unless the firms in each group were identical in all aspects, except for type of accounting treatment. The demand for power is the primary determinant of the growth rates in assets and sales. This demand is primarily influenced by such factors as population growth, growth in industrial output, growth in appliance usage, and in the long run, the prices of electricity and of competing energy sources. Given this relationship, any differences in growth rates of the two groups which happened to result from accounting treatment would most likely be unobservable. The authors also pointed out that the ratio of revenues to total assets was nearly identical for the two groups, which was contrary to the results of their simulation analysis. Once again, for such differences to be observable one has to assume that the two groups are otherwise identical. Deferred taxes accounted for less than 2% of total revenues for the average electric utility in 1973, while fuel accounted for 23% of revenues for the average electric utility in 1973. Thus, the type of fuel a firm used would have much more of an impact on the level of revenues than the type of accounting treatment, and it is extremely unlikely that the two groups of firms were identical with respect to fuel consumption. All things being equal, required revenues and rates should be lower for flow-through firms than for normalizing firms; however, all things are not equal between these two groups of electric utilities, and this fact can be demonstrated by comparing the rate levels of the two groups. Any comparison of electric rates across firms is not a straightforward matter, since the rate schedules in
Regulation,
Investment,
and Stock
Valuation
261
different service areas are not always identical in structure. Nonetheless, one can make a rough comparison of rate levels for normalizing and flow-through companies from the Federal Power Commission (FPC) published rate information. Table 1 presents the results of an examination of selected residential, commercial, and industrial rates for the sample of companies used in the Bower study. Six of the holding companies used in the Bower et al. [l] study were excluded due to the difficulty of selecting an appropriate rate for each class. The data in Table 1 indicate that for each of the four groups examined, the average rate for normalizing companies is lower than the average rate for flow-through companies, which is the opposite result expected if the groups were similar with respect to other characteristics. The differences observed are not statistically significant at a high level, but the significance level improves when the deferred tax effect is subtracted from the normalizing group. This was done by subtracting 2% from the rate levels of the normalizing companies, which would have the effect of approximately removing the deferred tax requirements from the level of required revenues. The differences observed after this procedure is carried out are reported in column 4, and these differences are slightly larger than the uncorrected differences reported incolumn 3, and are statistically significant at the 10% level. Thus, while theory says that rates should be lower for flow-through companies in the early years, what one observes is lower rates for normalizing companies. It was assumed that the sample companies are still in the early years, which is consistent with the assumption in the Bower study. When the ultimate value of normalization, the deferred tax effect, is removed from the revenue requirements (and thereby the rates) one observes even lower rates for normalizing companies. This indicates that there probably exists some underlying difference between the firms in each of the groups which is unrelated to accounting treatment. Rates may be lower for normalizing firms because their fuel or operating costs may be lower. For instance, the group of flowthrough companies consisted of many Eastern companies that use extensive amounts of oil in the generation of electric power, and this makes their production costs high relative to those of other companies. Conversely, the normalizing group is comprised predominantly of companies located in the South, Midwest, and Southwest. These firms generally have lower operating costs, lower property taxes, better access to cheaper fuels and lower labor costs.
262
Table
Robert R. Trout
1: Comparison of Selected Electric and Normalizing Companies
Rates for Flow Through
Electric Rates-1973 Difference Rate Class
FT
NORM
Unadjusted
Adjusted $ (4)
$
$
(1)
(2)
12.90 (2.18)
12.25 (1.72)
0.65 (0.5 2)
0.90 (0.52)“
193.15 (40.36)
178.08 (29.24)
15.07 (9.50)
18.63 (9.5O)b
100,000 KWH @ 500 KW
2298 (598)
2123 (379)
175 (136)
217 (136)c
400,000 KWH @ 1000 KW
6563 (1776)
5814 (1554)
749 (449)
865 (449)O
d,
Residential 500 KWH
Commerical 6000 KWH @ 30 KW
Industrial
Standard deviations are in parenthesis a: Statistically significant at 5% b: Statistically significant at 10% c: Statistically significant at 12% Column (3) m Column (1) - Column (2) Column (4) = Column (1) - [0.98 X Column (2)] Source: Federal Power Commission Typic01Electric Bills, 1973.
Thus, it is quite conceivable that the underlying difference between the two groups is related to operating costs. Operating costs for the firms in each group of utilities used in the Bower study were calculated to test this hypothesis, and the results are reported in Table 2. The data in Table 2 indicate that the average cost of producing power is significantly lower for normalizing companies than it is for flow-through companies. This relationship also holds true for the average cost of power sold, which includes
Regulation,
Investment,
and Stock
263
Valuation
Table 2: Comparison of 1973 Operating Costs for Flow Through and Normahzing Companies MiUs/KWH Cost of Power(a) Generated
Cost of Power@) Sold
(1)
(2)
27 Flow Through Companies
6.68 (2.52)
10.35 (3.23)
33 Normalizing Companies
5.59 (2.13)
9.19 (3.00)
1.09 (0.61)c
1.26 (0.81)d
Difference (FT-Norm)
a Cost of power generated = Total power production expense less cost of purchased power divided by total power generated. b Cost of power sold = Total electric operating and maintenance expenses divided by total kilowatt-hour sales. c Statistically significant at 8%. d Statistically significant at 12%. Standard deviations are in parenthesis. Source: Federal Power Commission, Statistics of Privately Owned Electric Utilities in the United States, 1973.
overhead expenses and transmission and distribution costs as well as generation costs. These findings do not directly explain the effects of accounting treatment on the valuation of the firm; however, they do suggest that there are significant differences between the two groups which are unrelated to accounting treatment which must be taken into account in any empirical study of the accounting treatment question. One interpretation of these findings is that companies with low rates are in a better position to obtain normalizing benefits from rate-conscious regulatory commissions. Utilities will normally try to obtain normalization benefits because it results in a higher cash flow to the firm, and it is also a conservative accounting practice. They are more likely to gain these benefits when other costs of operation are low so that the impact of higher revenue requirements for deferred taxes under normalization are not so noticeable.
264
Robert R. Trout
On the opposite side of the bargaining table is the regulatory commission. Commissioners are probably concerned with the ultimate rate levels which will prevail in their jurisdiction, and these rate levels will be compared with those which exist in other areas of likely comparison. Industrial users of electricity and other large electricity consumers will locate, to whatever extent possible, in areas where rates are low, and regulators are aware of this fact. It is not by random choice that producers of primary aluminum, which are probably the most intensive users of electricity per unit of output of any industry, have located in areas where electric rate levels are low, such as the Pacific Northwest. Hence, one can assume regulators can be persuaded to grant normalization benefits to utilities only when the effect of normalization on rates will not cause the rate levels to escalate above those in other areas of likely comparison. This is rational behavior on the part of regulators. Eiteman [3] found that commissions that allowed the use of fair value rate base determination (which is normally higher than original cost) compensated for this fact by allowing these firms lower returns on that rate base. This interpretation implies that the results found by Bower et al. [ 1 I, and also in earlier studies by Brigham and Pappas [ 21 and Mlynarczyk [5], may be due to misspecifications in the models used to analyze the accounting treatment question. Researchers have predominantly used an indicator variable to represent the type of accounting treatment in linear regression models which attempt to explain variations in P/E ratios or other measures of value. This procedure may lead to incorrect conclusions because of the problem of correctly classifying a firm as to its accounting treatment. For example, most of the flow-through firms used in the Bower study had some deferred taxes, and in several instances the ratio of deferred taxes to net income was actually higher for flow-through firms than for some of the normalization firms. Deferred taxes for flow-through firms could result from nonutility investments, utility operations in more than one state where the states differ in their regulatory approach to this problem, or from situations where the commission may allow partial normalization treatment, as in the case where liberalized depreciation benefits are flowed through to consumers while the firm is allowed to retain the benefits of investment tax credits. Thus, the demarcation between the two groups is often imprecise, and it can be argued that some firms could be classified as belonging to either group.
Regulation, Investment,
and Stock Valuation
265
A more appropriate variable to use in measuring the accounting effect may be a continuous variable which would not depend on the ability of the researcher to subjectively determine the correct group identification. Brigham and Pappas [21 indicated that they examined several such variables, but without success. Gordon constructed a continuous variable which incorporated both deferred taxes and the allowance for funds used during construction which he called a “quality of earnings” variable, but it was not usually significant in his models. On the contrary, Roseman [6] found that the variable “deferred tax/net income” was statistically significant and explained some of the variation in market/book ratios of electric utilities. The evidence presented in Tables 1 and 2 in this comment suggests that a statistically significant indicator variable which represents accounting treatment may simply be a proxy for the fact that normalizing companies happen to be more efficient, or have lower operating costs due to their location, and therefore are in a better position to bargain successfully for normalization benefits from price conscious regulatory commissions. The security price premiums normalization firms enjoy is not due to accounting treatment but rather it is due to their preferred environmental setting and the more appealing future return opportunities resulting from probable greater future growth and a more favorable regulatory climate. The indicator variable was significant in the studies cited not because it reflected accounting treatment but because accounting treatment and general regulatory treatment are both related to another effect, which is the relative cost structures of the firms within each regulatory jurisdiction. The addition of a variable which measures cost per kilowatt-hour of output to models such as those used by Bower et al. and by Brigham and Pappas appears to render the accounting variable insignificant, which supports the theory that its primary effect in the model is to capture the variation of cost structures among firms rather than the variation of accounting treatment. The observation by Bower at al. that the observed price/earnings ratio differentials between normalization and flow through firms are unrelated to any historic risk measures is consistent with the implications presented here that the accounting variable is a surrogate for differing cost environments. Investors should be willing to bid up prices for firms with higher expected future returns regardless of historic risk measures, and due to lower costs the firms
Robert
266
R. Trout
classified as being normalization fums should be better able to earn high future returns, especially during inflationary periods in an industry with rising costs and relatively fixed prices.
References Bower, Richard S., Johnson, Keith B., Lutz, Walter J., Jr., and Tapley, “Regulatory Procedures, Investment Opportunities and Stock Valuation,” of Business Research, 5 (March 1977): 39-61.
T. Craig, Journal
Brigham, Eugene F. and Pappas, James L., Liberalized Depreciation and the Cost of Capital, MSU Institute of Public Utilities, East Lansing, Michigan, 1970. Eiteman, David K., “Interdependence of Utility Rate-Base Type, Permitted Rate of Return, and Utility Earnings.” Journal of Finance, 17 (March 1962): 38-62. Gordon, Myron J., The Cost of Capital to a Public Utility, MSU Institute Public Utilities, East Lansing, Michigan, 1974.
of
5.
Mlynarczyk, Francis A., Jr., “An Empirical Study of Accounting Methods and Stock Prices.” Journal of Accounting Research: Empirical Research in Accounting 7, (December 1969): 63-81.
6.
Roseman, Herman G., Testimony before the New York State Public Service Commission, Case Number 26868 (1975), Re: Consolidated Edison Company Gas Rates.