Regulatory procedures, investment opportunities and stock valuation

Regulatory Procedures, Investment Opportunities and Stock Valuation Richard S. Bower, Dartmouth College Keith B. Johnson, University of Connecticut Walter J. Lutz, Jr., Arthur Andersen & Company T. Craig Tapley, Indiana University

Electric utilities differ in their accounting procedures. By regulatory commission directive some use normalization and some use flow through to arrive at their earnings figures, Because regulation is on an allowed return on investment standard these reported’earnings are relevant for stock valuation. Any variation in price/earnings ratios between flow through and normalizing companies therefore must be explained by differences in risk to equity investors, differences in investment opportunities, or market inefficiency involving erroneous restatement of earnings. Empirical work demonstrates that there is a difference in price/earnings ratios. Firms that normalize enjoy a premium. The evidence also indicates that the premium is not explained by risk difference. Because the perverse form of market inefficiency required as an explanation seems unlikely, the most reasonable conclusion is that the premium relates to investment opportunities associated with regulatory climate. If so it promises no excess return to stock buyers because it is already impounded in stock price.

Introduction When United States tax procedures were liberalized in 1954 to permit corporations to accelerate depreciation for tax purposes while continuing straight line depreciation for other reporting purposes, state regulatory commissions and the electric utilities under their jurisdictions were faced with an interesting decision on accounting procedure. Because plant and equipment was to be expensed more rapidly for tax purposes, the undepreciated assets reported by the electric utilities had to overstate the tax shelter remaining. This could be recognized by showing on the income statement the tax charge that would be made by government, if straight line rather than accelerated depreciation had been used for Address correspondence to: Richard S. Bower, The Amos Administration,

Dartmouth

JOURNAL OFBUSINESS 0 Elsevier North-Holland,

College, New Hampshire RESEARCH Inc., 1977

Tuck School of Business

03755.

5 (March, 1977): 39-61

39

40

Richard

S. Bower et al.

tax purposes and carrying that part of the charge that acceleration had delayed on the claims side of the balance sheet as deferred taxes. This procedure is normalization. An alternative, justified by the argument that rapid asset growth would create new depreciation tax shelters to more than cover any implied overstatement, is to show only current tax charges on the income statement and have no balance sheet entry to indicate that some part of the net plant and equipment shown has already been expensed for tax purposes. This procedure is flow through. The choice between these procedures does make a difference.l Although the difference affects customers, commissions, and the federal government as tax collector, the main concern in this article is discovering the implications of flow through or normalization for investors. There is a great deal that is paradoxical in the discovery. The choice of normalization or flow through at first appears to be a matter of reporting rather than of prices, cash flows, financial structure, and investment opportunities. It is not.2 Because of the nature of rate of return regulation, variations in all of these variables follow from reporting choices. These variations then should explain any effect the flow throw or normalization choice has on investors. They do not.3 Something more remains. 1 In the United States retail sales of electricity are made to residential, commercial, industrial, and governmental customers primarily by profit making private corporations. These corporations set prices and follow practices within the state or states that they serve that are approved and regulated by state utility comissions. The commissions set policy through general orders and specific cases involving individual corporations. The policies have great diversity among states and even among corporations within a state. Not all commissions originally required the electric utilities under their jurisdictions to take advantage of accelerated depreciation, and probably no two states are identical in their requirements as to which items of plant and equipment will be accounted for in a particular way or in which situations normalized or flow through accounting is required. This policy diversity means that any simple classification of electric utility companies by required accounting procedure will fail to distinguish differences in procedure among the members of a class and fail to portray how a particular company in a class may have changed procedure over time. This fact of regulatory life makes any simple exposition of accounting differences a little misleading and biases any empirical work toward finding insignificant differences among groups of corporations classified by accounting procedures. This point is important in evaluating the work reported here. 2 Many of the articles that consider electric utilities in general or accounting procedure particularly assume that the difference between flow through and normalization is only in reporting. Examples include Miller and Modigliani [7], O’Donnell 19, IO], and Mlynarczyk [S] 3 Brigham and Pappas [5] clearly show how real differences follow from the reporting choice but find variables representing real differences unable to explain why earnings of normalizing firms command a premium.

41

Regulatory Procedures That something more-risk, return opportunity, illusion-has particular importance for investors. Only a Difference

or accounting

in Reporting

If the nature of rate of return regulation is ignored, then the choice between flow through and normaliz&ion procedures appears to be only a matter of reporting. The example in Exhibit 1 suggests why. The corporation in that exhibit has exactly the same tax and cash flow situation whether its accounting procedure is normalization or flow through. Only reported income and taxes

Exhibit 1: Only a Difference in Reporting A. The Basic Facts 1. Earnings before depreciation and taxes (EBDT) 2. Depreciation expense, book 3. Depreciation expense, tax 4. Tax rate

$39.60

$18.00 $30.00 50%

B. Normalization

EBDT Depreciation

Tax, current and deferred Net income

Reported

Tax

Cash Flow

$39.60 18.00

$39.60 30.00

$39.60

21.60 10.80

4.80

4.80

$10.80

% 4.80

$34.80

9.60

c. Flow Through Reported

Tax

Cash Flow

EBDT Depreciation

$39.60 18.00

$39.60 30.00

$39.60

Tax, current

21.60 4.80

9.60 4.80

4.80

Net income

$16.80

$ 4.80

$34.80

42

Richard S. Bower et al.

vary with the procedure. With flow through the actual tax charge, $4.80, is included in the income statement, and reported income is $16.80. If there were no dividends, then $16.80 would be added to retained earnings. With normalization the tax charge that would be paid if book depreciation were used to shelter income. $10.80, appears in the statement, and reported income is $10.80. If there were no dividends, then $10.80 would be added to retained earnings and $6.00 would be added to a balance sheet account called deferred taxes. These balance sheet accounts sum to the same $16.80 of equity claims as with flow through. The difference is only in the method of reporting or disclosure. That the only difference is in reporting seems clear. Because it is so clear, investors and security analysts in an efficient market or economists interested in market behavior could correct statements of firms using one procedure to match those of firms using the other procedure. This might be done by adding the deferred portion of taxes charged back to income and by treating the balance sheet account deferred taxes as part of retained earnings when examining normalizing companies. Correcting statements in this way is perfectly proper, and reported earnings of normalizing companies would be expected to have higher price-earning multiples as a result if earnings before depreciation and taxes were independent of the accounting procedure. For regulated electric utilities it is not.

A Real Difference

for Regulated

Companies

State commissions regulate electric utility companies by approving price structures that are expected to raise the revenue required to provide a fair return on reported equity investment. This means that any accounting procedure that affects the income and the amount of equity investment reported would also affect the calculation of required revenue, the prices customers pay, and the stream of cash flows available to equity investors. Exhibit 2 illustrates this.4 If normalization is the specified * This illustration brings out a few key points that are particularly relevant to the empirical work that follows. It is not a substitute for extensive simulation work examining how flow through-normalization differences may be affected by depreciable life, growth rate, or regulatory lag. Useful similations of this sort are presented by Brigham and Nantell [4] and Pollack [ 111.

Regulatory

43

Procedures Exhibit 2: A Real Difference

A. The Basic Facts 1. Demand is not a function of price. 2. Assets required to meet demand in the next year are Year Current assets Fixed assets

%iO 90 ~ $180

Total

3 $120 120 __ $240

4 $130 130 __ $260

2 $33.60 23.60 33.30

3 $40.30 30.30 36.70

4 $48.40 38.40 40.00

3 $120.00 14.05 105.19

4 $130.00 14.85 115.15

5 $140.00 12.30 127.00

$200.00

2 $110.00 10.85 99.15 ______ $220.00

$240.00

$260.00

$280.00

$45.00 18.00 5.40 __ 21.60 4.80 6.00 $10.80

$52.16 23.60 6.00 ___ 22.56 6.43 4.85 __ .$11.28

$60.70 30.30 6.60 __ 23.80 8.70 3.20 $11.90

71.02 38.40 7.20 ~ 25.42 11.91 .80 __ $12.71

$83.54 48.10 7.80 27.64 16.37 -2.25 ~ $13.82

$4.00 $6.80

$5.15 $6.13

$6.80 $5.10

$9.20 $3.51

$12.55 $1.27

$109.78 105.95 102.32

$117.25 115.15 113.13

$127.70 127.70 127.70

2 $100 110 __ $220

SlbO 100 $200

$1540 140 $280

3. Debt is 50% of total assets and has an interest rate of 6%. 4. New investment and depreciation are 1 $;$I;

Year New fixed investment Depreciation, book Depreciation, tax

30:oo

$558.10

48.10 43.00

5. Tax rate 50%. 6. Allowed rate of return 12%.

B. Normalization Year Debt Deferred tax Equity

0

$90.00 0 90.00 ~~ $180.00

EBIDT Depreciation Interest

Tax, paid Tax, deferred Net income Additional equity required Dividend

1 $100.00 6.00 94.00

Stock Value Assuming Market Equals Book in Year 5 kE9 = 10%

kEQ = 12% kEg = 14%

$97.56 90.00 83.19

$100.51 94.00 88.03

$104.51 99.15 94.23

44

Richard

S. Bower et al.

Exhibit 2 (Continued) C. Flow Through Year Debt Deferred Equity

tax

0 $90.00 0 90.00 ~~-____

1 $100.00 0 100.00

2 $110.00 0 110.00

3 $120.00 0 120.00

4 $130.00 0 130.00 _______

$1450.00 0 140.00

$180.00

$200.00

$220.00

$240.00

$260.00

$280.00

EBIDT Depreciation Interest

$33.00 18.00 5.40 __

$34.90 23.60 6.00 -

$56.90 30.30 6.60 -

$72.80 38.40 7.20 -

$92.20 48.10 7.80 -

Tax, paid Tax deferred

9.60 -1.20 0 ___

14.30 2.30 -o~

20.00 6.80 -o-

27.20 12.80 -o-

36.30 20.70 - o-

$10.80

$12.00

$13.20

$14.40

$15.60

$l;.;;

$J;.o”;

$10.00 $3.20

$10.00 $4.40

$10.00 $5.60

$124.33 120.00 115.89

$132.36 130.00 127.72

$140.00 140.00 140.00

Net income Additional Dividend

equity

required

Stock Value Assuming

Market

k k k

procedure,

Equals Book in Year 5

$98.20 90.00 82.63

$107.22 100.00 93.39

$115.94 110.00 104.47

as it is in Part B of the exhibit, Nr, = (EQU,_,

then

)I? *,

(1)

(2) EBIDT,

= Nit + TAXt

ATAXDFDt AEQU,

+ INT, + DEPBK,,

= (DEPTX,

= ATAt

- ADBT,

- DEPBKt)T, - ATAXDFD,,

where Nr,

EQu,-I R” TAXt T

is is is is is

net income in year t book equity in year t - 1 allowed return total tax charge, paid and deferred the tax rate

(3) and

(4) (5)

45

Regulatory Procedures EBIDT, INT, DEPBK, and DEPTX, ATAXDFD

AEQut

ATA, ADBT,

is earnings before interest, depreciation, and taxes is interest paid are book and tax depreciation is the part of the tax charge that is deferred is the required addition to equity is the increase in total assets is the increase in debt

With year 0, equity investment $90, and a 12% allowed return, net income in year 1 must be $10.80. The 50% tax rate then dictates a $10.80 tax charge. Adding $5.40 interest and $18 book depreciation to net income and taxes provides the $45 EBIDT requirement revenues must satisfy. Because tax depreciation is $12 more than book depreciation, $6 of the tax charge is deferred. This deferral signifies a $6 investment by customers (or by government) which, with the $10 of added debt, covers all but $4 of asset expansion. The $4 is the additional equity required. If flow through is specified, as it is in Part C, then Nit =(EQUt-I

)R*,

CW

(1 -n 1?

TAX, = Nit + DEPBK, - DEPTXt

T

EBIDT, = Nit + TAX, + INTt + DEPBK,,

AEQU, = ATA, - ADBTt.

and

(3a) (54

This procedure yields the same year 1 net income, $10.80, because initial equity and allowed return are fixed. But tax charges in year 1 are $12 less at -$1.20 and EBZDT is only $33 as a result. Customers would pay lower prices, provide less revenue, and make none of the investment in new assets. Their missing $6 contribution is made up by additional equity investment. A comparison of Parts B and C of Exhibit 2 emphasizes the real differences associated with flow through and normalization. In the early years flow through means lower prices for customers, less earnings before interest, depreciation, and taxes for the company, a smaller tax take for government, and a greater requirement for equity investment. With debt a constant percentage of total assets it also means lower coverage ratios. As time goes on, and just how

Richard

S. Bower et al.

long it must go on is a function of growth rate and depreciable life, the situation reverses and prices, earnings, and tax take all become larger under flow through than under normalization while equity investment requirements become smaller and debt coverage better. Whether the flow through or normalization sequence has an advantage for equity investors or any of the other parties depends not only on the discount rate appropriate to each but also on other circumstances as well. With asset requirements unaffected through time, the contribution of debt unchanged, cost of equity capital constant, and realized return on book equity above the cost of equity capital, a choice of flow through over normalization would benefit equity investors by raising share prices. This is illustrated by comparing stock values in the normalization and flow through procedures when the cost of equity capital, kE Q, is 10%. Because the 10% rate used to discount the cash flows available to equity investors is less than the 12% realized return or reinvestment rate, R*, allowed by the commission, flow through’s added equity investment requirement turns into an opportunity that commands a In the very simplest terms, flow through stock compremium. mands a premium under the specified conditions because it offers more investment opportunities with return in excess of the cost of equity capital. The difficulty in stopping with this conclusion is that it seems at variance with a demonstrated preference of electric utilities for normalization.5 The preference should not be dismissed as irrational or short-sighted because it may have its explanation in conditions that change with or are related to the adoption of the flow through procedure and that so far have been assumed to be unaffected by the procedure. These conditions include the expectations for allowed and realized return, the financing mix and equity risk, and the efficiency of the market in differentiating real and reported earnings differences. A comparison of the EBIDT figures in Parts B and C indicates 5 In a very carefully developed analysis Spann [ 131 reaches the same conclusion. Having reached the conclusion that utilities and their shareholders should prefer flow through, he then is forced to note, “In practice, we observe just the opposite. Utilities prefer normalization . ...” His explanation is that “tax privileges can and do change In such situations, it might be quite rational for consumers and utilities to use extremely short time horizons . ...” This explanation does focus on the other conditions and has in it the suggestion that either risk and cost of equity capital rise with the flow through choice or the expected return on reinvested equity falls.

Regulatory

47

Procedures

that flow through means lower prices for customers now and more rapidly rising and higher prices later. Whether because of regulatory lag or because it is unlikely that the political setting causing a commission to choose lower prices for consumers now will permit the commission to grant appropriately higher prices later, it seems quite possible that flow through may be associated with lower expected return on equity investment.6 Because flow through demands that more funds be reinvested by existing shareholders or acquired through new equity or additional debt, there may be shifts in financial structure. If managers hold to traditional payout rates and debt to equity ratios, then this could mean more dependence on outside financing with its disadvantage of issue costs and movement away from optimal structure. Both these actions might help to turn flow through into a disadvantage to shareholders. Finally, a naive market that corrected flow through earnings for a reporting difference that is in fact real would work to lower stock prices of flow through companies. The flow through or normalization choice can be associated with a great many real differences among electric utilities. Some of these differences become clear in abstract analysis. Other differences and the net effect on investors can be discovered through empirical study. Observed Differences among Normalizing and Flow Through

Electric Utilities

There are 69 electric utilities that appear on the COMPUSTAT utility tape made in mid-1975 and that also have been listedon the New York Stock Exchange since January 1955 and appear on the CRSP stock price tapes. Thirty of these utilities were classified as flow through on the COMPUSTAT tape and 39 were classified as normalizing. Not all of the flow through utilities followed that procedure for the entire 20 years, 1955 to 1974, but none in the group had shifted to flow through any later than 1969 and none of the normalizing utilities had ever been flow through corporations. Data on these utilities from the COMPUSTAT and CRSP tapes are the raw material for empirical study.7 Exhibit 3 presents summary statistics on the flow through and normalizing groups of companies for two overlapping periods. In 6 The effect of regulatory lag is demonstrated by Brigham ’ The utilities included are listed in the Appendix.

and Nantell

[4].

Richard

S. Bower et al.

Exhibit 3: Flow Through vs. Normalization: An Empirical Summary

Mean 30 FT

1959-73 Values 39 NOR

F-ratio

Mean 30 FT

1969-73 Values 39 NOR

F-ratio

TAXDFDIEQU TA t/TA t--l K WHtjK WHel RE VITA

0.066 1.078 0.079 0.267

0.139 1.077 0.084 0.282

11.87b 0.09 1.78 2.04

0.039 1.116 0.075 0.261

0.141 1.110 0.082 0.281

47.20’ 0.36 1.36 4.28=

DBT/TAc DBT/(EQU+PED)= EBID T/INTc

0.472 1.158 6.574

0.446 1.087 7.587

7.87b 2.56 8.18b

0.484 1.215 4.679

0.453 1.162 5.714

12.99b 1.80 15.50b

DI V/INC SHR &HR t--l INCIEQ U

0.669 0.028 0.116

0.669 0.020 0.124

0.00 5.92” 4.57”

0.679 0.058 0.112

0.671 0.041 0.122

0.19 4.54a 6.44=

12.26 1.51

10.23’ 11.32b

PfE MKT/BOOK

15.83 1.85

17.24 2.15

6.10a 7.48”

11.17 1.25

= income taxes-deferred, balance sheet = common equity as reported = total assets TAt = electricity sales in kilowatt hours KWH = operating revenue REV = long-term debt DBT = preferred stock PFD = earnings before interest, depreciation, and taxes EBIDT = interest charges-total INT = common dividends-total DIV = net income available for common INC = number of shares outstanding, adjusted SHR = ratio of year end stock price to earnings per share for the year PfE MKT/BOOK = ratio of market price of common stock to book value of common stock = annual rate of return earned by common shareholders calculated as the RETURN price change during the year plus dividends paid during the year divided by stock price at year start TAXDFD

EQU

a The null hypothesis rejected at the 5% level. b The null hypothesis rejected at the 1% level. c The two debt ratios are 1958-73 averages and the coverage ratio is a 1960-73 average.

Regulatory

Procedures

49

the second period, 1969-73, the flow through and normalization distinction between the groups is more accurate and the process is still in its early years. s The first block of statistics indicates that deferred taxes are a significantly larger percentage of common equity for normalizing than for flow through utilities. This simply means that the groups appear to be consistent with their verbal description. The first block of statistics also indicates that growth in assets and in output does not vary between the groups and that revenues are not higher and may be lower per dollar of total assets for flow through companies. Lower is what they are expected to be based on the analysis above. The absence of a strong finding that flow through companies require less from customers in the early years suggests at least one hypothesis consistent with the return statistics that appear later in the exhibit: the commissions that require flow through may be forced to do so by political pressure to hold prices down when the utilities they regulate suffer an operating cost disadvantage. The second block of statistics indicates that the debt to total equity ratio does not vary significantly between the groups but that the debt to total asset ratio is significantly higher for flow through companies and their interest coverage is significantly lower. Whether this represents an optimal adjustment in structure considering the later, greater cash flows that may come with flow through or is simply a response to the same operating cost pressures that may motivate flow through is not clear. But it does indicate that some of the funds that come from customers in normalizing utilities are provided by long-term lenders in flow through companies. The third block of statistics shows that payout ratios are not lowered by flow through companies in spite of their greater funds needs. This is strange because if there is some payout policy that is advantageous it would seem to dictate a shift to more retention when more equity is needed. The additional equity which, with added debt, permits flow through companies to meet their financing needs is apparently provided by new equity financing. This is the implication of the more rapid growth in shares outstanding. 8 Brigham and Nantell’s simulations [4] and our own suggest a switch over in revenue and investment effects more than 20 years out if depreciable life is 30 years and growth at least 5%. This suggests that all these companies are in the early years. One problem in the empirical work, however, is that they are at different points in the early years.

Richard

50

S. Bower et al.

Whether the equity is new or old, it apparently is allowed or tends to realize a lower return for companies in the flow through group than in the normalizing group. The final block of statistics provides some information on market relationships that clearly raises the question of the difference in accounting procedure to the stockholder. The shares of normalizing utilities sell at higher price multiples and higher ratios to book value than do those of flow through utilities. The statistics that have already been reviewed suggest that this price premium associated with normalization may be explained by lower risk of normalized companies or by better prospects for return. Whether either of these differences provides the explanation may be explored in cross-sectional regressions that include variables representing both risk and investment return. Return,

Risk, and Something

More

The problems with cross-sectional regressions that attempt to explain differences among companies in share price or price earnings ratios have been emphasized in a number of papers.g With all their weaknesses the studies have some precedent in work on normalization versus flow through10 and, almost because of their problems, may help toward understanding if they provide strong results. The cross-sectional studies build from the view that price at a moment in time is the discounted value of future dividends to some horizon and the price at that horizon: PO =

DIV,

DIV, (1 +kEQ)l

+(l

+kEQj2

DIV,

+P,

+***+(l +kmdN’

(6)

In this equation the dividend in a year t can be taken to depend on initial earnings, earnings growth rate, and payout, DIV, = E. ( 1 + g)tPAY,

(7)

and the growth rate to depend on both payout be earned on reinvested earnings, g=(l The discount

-PAY)RR,Q.

rate is taken to be a function

g See Keenan [6] lo Consider Brigham and Kinsman [ 121.

and Pappas

and the return to

[S] , and Mlynarczyk

(8) of the risk in the divi[ 81, and Robichek,

Higgins,

Regulatory

51

Procedures

dend stream that might be represented by company size, debt structure, earnings variability, or, in more recent work, by the total variability of stock price relatives or their systematic movement with the market. This makes = f(PA Y,

$

RREQ ,risk variables, . ..)

(9)

0

and opens the way to cross-sectional studies that use historic data to represent the expectational independent variables and that only imperfectly capture the complicated functional form of the relationship. The cross-sectional regressions shown in Exhibit 4 are very close to a replication of work done by Brigham and Pappas [5 I and by Mlynarczyk [8]. Of the variables representing risk-the debt ratio, the mean absolute deviation of realized return on equity, and the size measure-only size has any consistent significance. It has the expected positive effect on price and is significant at the 5% level

Exhibit 4: Cross-Sectional DBT

P -=bo+blREV+b2 E P

Regressions

+b3PAY+bfiREQ+b5gA+b,$iOR+b$fADRR (EQU + PFD) = Ratio of year end stock price to earnings

72 REV

= Operating DBT

(EQu+PFD)

= Ratio

end

revenue

of long-term

per share for the year

for the year debt to common

equity

and preferred

stock

at year

for common

in the

PAY

= Average ratio of dividends to net income available four years preceding the cross-sectional year

RREQ

= Average ratio of net income available for common to common year start in the four years preceding the cross-sectional year

gA

= Geometric average of the annual total year and the four preceding years

NOR

= A dummy variable through companies

MADRR

= Mean absolute RREQ average

equal

deviation

asset growth

to 1 for normalizing

of the four annual

at

in the cross-sectional

companies

returns

equity

and 0 for flow

contributing

to the

Richard S. Bower et al.

52 Exhibit 4 (Continued)

bo

bl

b2

b3

b4

b6

b,

R2

(6) 14.37 (t) (3.03) m 20.7

0.0023

1962

(0.9) 158.9

2.17 (1.28) 1.09

-8.61 (-1.59) 0.68

50.27 43.42 (2.19)O (2.56)= 0.112 0.05

1.66 (2.42)= 0.57

142.24 (1.35) 0.005

0.35

1963

(b) 12.30 (t) (2.71) IGi 20.9

0.0025 (1.06) 167.8

1.41 (0.80) 1.07

-3.49 (-0.63) 0.67

43.81 (1.95) 0.115

47.35 (2.62)b 0.05

1.86 (2.64)b 0.57

137.99 (1.29) 0.005

0.32

(b) 10.17 (t) (2.32) Ii? 21.8

0.0021 (1.0) 177.3

1.52

-1.05

1964

51.79 (2.9)b 0.05

1.74 (2.52)” 0.57

209.45 (1.82) 0.005

0.37

(b) 7.54 (t) (1.84) M 19.7

0.0032

1965

1966

(b) 3.84 (t) (0.89) M 16.8

1967

‘:A;) .

$06072)

51.54 (2.4)= 0.117

4.55 (2.59)= 1.07

-7.58 (-1.39) 0.67

60.07 (3.2)b 0.119

44.17 (2.45)” 0.05

1.69 (2.51)= 0.57

329.38 (2.45)= 0.004

0.46

0.0034 (1.90) 201.5

2.13 (1.26) 1.14

-6.17 (-1.06) 0.66

76.03 (3.97)b 0.123

54.79 (2.9s)b 0.06

0.71 (1.05) 0.57

240.47 (1.64) 0.004

0.40

(b) 3.53 (t) (0.84) Ii? 14.9

0.004 (2.70)b 213.4

3.93 (2.59)= 1.18

0.37 (-1.97) 0.66

74.66 (4.11)b 0.126

30.40 (1.84) 0.07

1.76 (2.73)b 0.57

21.91 (0.17) 0.005

0.41

1968

(b) 8.74 (t) (3.18) @ 15.69

0.0025 (2.36)O 230.5

1.20 (1.16) 1.26

-4.29 (-1.21) 0.65

42.91 (3.45)b 0.128

18.64 (1.79) 0.078

1.13 (2.57)a 0.57

20.74 (-0.19) 0.004

0.34

1969

(b) 8.96 (t) (2.99) Ii? 12.28

0.0028 (2.56)“ 250.2

1.24 (1.15) 1.30

-7.11 (-1.91) 0.66

33.41 (2.42)= 0.128

7.07 (0.75) 0.091

1.55 (3.16)b 0.57

-18.80 (-0.17) 0.004

0.28

1970

(b) 8.98 (t) (2.95) ti 13.26

0.0020 (1.99)O 275.0

-0.30 (-0.28) 1.33

-3.28 (-0.9) 0.67

39.63 (2.79)b 0.127

8.94 (1.17) 0.099

1.09 (2.28P 0.57

-48.95 (-0.47) 0.004

0.27

1971

(b) 5.58 (t) (2.07) M 12.57

0.0018 (2.53)= 309.4

-0.01 (-0.01) 1.29

-0.044 (-0.02) 0.68

45.36 (3.91)b 0.124

7.04 (1.26) 0.107

1.06 (2.71)b 0.57

-93.32 (-1.33) 0.006

0.39

1972

(b) 8.00 (t) (2.93) 1c? 11.74

0.0016 (2.38)= 349.6

-1.42 (-1.27) 1.24

-2.00 )-0.8) 0.68

48.98 -0.68 (4.18)b(-0.13) 0.121 0.112

1.02 (2.61)‘” 0.57

-16.03 (-0.02) 0.007

0.38

1973

(b) 3.73 (t) (2.19) M 9.08

-0.79 (-1.22) 1.22

5.45 (3.62)b 0.67

22.42 (2.97)b 0.119

0.51 (2.08P 0.57

-26.07 (-0.8) 0.006

0.34

(1.7) 187.5

-0.0001 (-0.03) 392.8

(2The null hypothesis rejected at the 5% level. b The null hypoth& rejected at the 1% level.

-0.81 (-0.3) 0.123

Regulatory

53

Procedures

in 6 of the 12 cross-sectional regressions. Payout is significant just once. The return opportunity variable, RR= Q, has the right sign and is significant at the 5% level or better in 11 of 12 crosssections. The asset growth variable, which may also reflect opportunity, is significant at the 5% level 5 times. Most important, however, is the- performance of the normalization dummy variables. Even with return and risk represented explicitly, if imperfectly, the normalization procedure has a significant, positive effect on price in 11 of the 12 cross-sectionals.‘This finding is consistent with and even stronger than the results reported by others, but it need not be interpreted as a proxy for less risk and a lower cost of equity capital, as Brigham and Pappas interpret it, or as an indication that investors adjust earnings assuming a reporting rather than a real difference as Mlynarczyk interprets it. Before attempting an interpretation, it is worth noting that when market measures of risk are substituted for the debt ratio and the mean absolute deviation of realized return, the findings are not altered in any important way. The cross-sectional regressions with these variables are shown in Exhibit 5. Here, the normalization dummy is positive and significant in all but two of the regressions. The question still remains, what is the something more that explains this price premium associated with normalization? The Something More There is no simple way to reject interpretations of a dummy variable. But before accepting Brigham and Pappas’ interpretation “ . . . that use of flow through depreciation procedures increases the risk perceived by investors . . . [and] . . . leads to a higher required “... that return on investment . ..” and their policy recommendation flow through companies should be allowed an additional return on investment to cover this cost...,“l l further evidence on risk differences must be considered. There is some evidence that conflicts with this interpretation of the cross-sectional findings in Brigham and Pappas’ [5] own data and in results reported by Robichek, Higgins, and Kinsman [ 12 ] . On pages 58 and 59 of their book, Brigham and Pappas show that for the 16 different time spans ending in 1966 and beginning in 1950, 1951, . ..) 1965, there was not one time span over which shareholders in flow through companies realized higher returns on l1 Brigham

and Pappas

[S], p. 92.

Richard

54 5 : More Cross-Sectional

Exhibit P ~ = b, + blPAY E $

PAY,

f b2RREQ

+ b$+

b&/,

Regressions

+ bflOR

+ b6VAR

NOR, and REV are defined

RREQ,~A,

S. Bower et al.

in Exhibit

+ b,REV 4

= The slope coefficient of a time-series regression of the company’s monthly price relatives on the S&P 500 monthly relatives for the 60 months ending in December of the cross-sectional year

P

VAR = The variance of the monthly company December of the cross-sectional year

price relatives

in the 60 months

ending

in

bo

bl

b2

b3

b4

bs

b6

b,

R2

1962 (b)

8.16

(0

(1.76)

2.81 (0.58)

20.23 (0.94)

8.17 (3.21)b

41.64 (2.73)b

1 .I5 (2.83)b

361.04 (0.54)

0.0006 (0.27)

0.47

8.40 (1.83)

15.37 (0.80)

10.32 (3.54)b

25.59 (1.65)

1.92 (3.3O)b

273.78 (0.40)

0.0012 (0.55)

0.53

10.06 (2.03)=

34.45 (1.77)

6.09 (1.95)

36.62 (2.19)=

1.55 (2.45)a

968.99 (1.33)

0.0019 (0.85)

0.48

8.33 (1.66)

41.02 (2.19)=

5.18 (1.58)

37.13 (2.15)”

1.50 (2.30)=

1164.58 (1.30)

0.0025 (1.21)

0.49

(0.24)

2.89 (0.57)

62.74 (3.38)b

7.40 (2.23)”

48.62 (2.87)b

1.07 (1.58)

0.0018 (0.89)

0.46

-1.08 (0.23)

2.87 (0.54)

45.98 (2.45)=

5.12 (1.46)

32.98 (1.96)

1.5 1 (2.21)a

25 1.66 (0.24)

0.0025 (1.33)

0.43

1968 (b)

8.27

(0

(2.88)

0.10 (0.03)

25.96 (2.12)=

-2.23 (-1.48)

24.34 (2.64)b

0.86 (2.09)”

1296.4 (2.90)b

0.0028 (2.67)b

0.41

1969 (b) (t)

8.80 (2.74)

-3.85 (-1.08)

19.00 (1.33)

-1.41 (0.77)

13.59 (1.53)

1.35 (2.85)b

789.90 (1.74)

0.0028 (2.60)a

0.30

1970(b) (t)

8.52 (2.89)

-2.13 (-0.64)

29.22 (2.18)’

-3.30 (-1.87)

7.36 (1.06)

1.01 (2.29)”

1031.77 (2.93)b

0.0024 (2.53)=

0.35

1971 (b) (1)

6.07 (2.46)

-0.35 (-0.13)

39.44 (3.45)b

-3.11 (-1.65)

4.90 (0.97)

1.11 (3.04)b

724.09 (2.58)=

0.0021 (2.73)b

0.44

1972 (b) (r)

6.91 (2.85)

-2.02 (-0.85)

46.89 (3.99)b

-3.46 (-1.95)

-2.83 (-0.59)

0.94 (2.47)=

623.65 (2.63)b

0.0019

26.53 (3.32)b

-0.09 (-0.08)

-0.629 (-0.25)

0.48 (1.96)

Year

1963 (6)

2.76

(0

(0.65)

1964 (b)

1.33

(r)

(0.29)

1965 (b)

-0.45

(f)

(0.10)

1966(b) @) 1967 (b) (t)

-1.17

1973 (b)

3.13

(0

(1.98)

4.41 (2.90)b

a The null hypothesis b The null hypothesis

rejected rejected

at the 5% level. at the 1% level.

-444.22 (0.39)

-112.13 (-0.67)

0.43 0.0001 (0.26)

0.33

Regulatory

Procedures

55

the shares than did shareholders in normalizing companies. Although this type of performance might be expected during a span of years that included unexpected shifts to flow through accounting, it is very unlikely over a period when the procedure is in effect. For observations of this sort to be made, flow through shareholders who required a higher return would have to err repeatedly in their stock selections in order to realize a lower return. Robichek, Higgins, and Kinsman [ 121 make estimates of kE Q for utilities that build explicitly on investment return rates, new issue rates, payout, dividend yield, and asset growth. They explain the differences in kE Q among companies in each of the years from 1962 to 1970 with variables that include a flow through dummy. Their finding is that the cost of equity capital is less for flow through companies. To carry the matter further, Exhibit 6 presents the results of work that has been done using stock price relatives in 243 months, January 1955 through March 1975, for the 30 flow through and 39 normalizing companies. For each of three successive periods of 60 months, one of 63 months, and one of all 243 months, esti-

Exhibit

6: Flow Through,

Normalization,

and Stock Price Performance

1955-59

1960-64

1965-69

1970-74

AllMonths

P

30 Flow Through 39 Normalizing F-ratio

0.3818 0.4128 0.45

0.7534 0.7143 0.88

0.6543 0.6734 0.21

0.7530 0.7922 0.73

0.6735 0.6922 0.36

SW

30 Flow Through 39 Normalizing F-ratio

0.0016 0.0019 2.31

0.0023 0.0025 1.28

0.0025 0.0027 0.77

0.0050 0.0056 1.56

0.0029 0.0032 2.94

RC

30 Flow Through 39 Normalizing F-ratio

0.0788 0.1058 5.22“

0.1244 0.1283 0.28

-0.0526 -0.0475 0.38

-0.0546 -0.0375 4.14a

2.30 3.63 10.216

30 Flow Through 39 Normalizing F-ratio

0.0115 0.0363 5.990

0.0560 0.0617 0.62

-0.0824 -0.0771 0.40

-0.0626 -0.0432 5.63a

-0.0248 -0.0116 10.88b

a-(1-

@)RFC

’ The null hypothesis b The null hypothesis ’ Annual rates.

rejected rejected

at the 5% level. at the 1% level.

Richard

56 mates were made of each company’s

S. Bower et al.

capital market line,

Rit = ‘% ’ PiRMKTt,

(10)

where Ritis the monthly price relative for company i in month t, R M K Tt is the S&P500 index relative for the same month, pi is a measure of systematic risk and (Yi is a return scalar that should have a value equal to (1 - pi) multiplied by the risk free rate (RF) in equilibrium. Also calculated was the average value of the price relative, Ri, and the variance of the price relative. Averages for each of the statistics estimated for the flow through and normalizing companies appear in Exhibit 6 with F-ratios indicating the results of an analysis of variance. The findings seem completely inconsistent with the interpretation that the higher observed P/E of normalizing companies is explained by less risk and a lower required return. Neither the systematic risk, p, nor the total variance of price relatives, SDR 2,a second market measure of risk, differs significantly between flow through and normalizing companies. If there is any difference at all that might be detected, it is associated with the not quite perfectly consistent tendency of flow through firms to indicate lower levels of risk according to each of the market measures from period to period. This finding suggests that the lower interest coverage of flow through companies and their higher debt to total asset ratio simply compensate for residual earning power left in assets in the early years by the restraining influence on revenue of the flow through procedure. It also seems consistent with the failure of risk variables to play a significant role in the crosssectional regressions. There may be almost no real difference in the risk of equity among utilities and so no difference in required return or cost of equity capital and no effect on P/E. The return, R, and excess return, CY- (1 - p)RF,findings reported do nothing to alter the conclusion that it is a mistake to interpret the lower P/E ratios of flow through utilities as an indication of more risk and a higher cost of equity capital. Neither realized return nor excess return is higher for flow through than for normalizing companies in any time span tested in the 20-year period of procedural difference. They are, in fact, lower in two periods, the first 60 months during which the procedural differences were introduced and the last 63 months during which the Arab oil embargo dramatized a shift in the situation of all electric utilities. In both these periods, and over the full 243 months, the significantly lower realized returns for flow through investors seem

Regulatory

Procedures

57

to be explained by the arrival of new information. The performance over the 243 months would be consistent with a claim of a higher required return or cost of equity capital only if the conclusion is made that the market continuously errs in a single direction, disappointing flow through investors who hold their shares at a price that promises a return that is never realized.12 The Mlynaczyk [8] interpretation of the significant positive coefficient on the normalization dummy variable in the crosssectional regressions is more difficult to dismiss. Ultimately it can only be disposed of as a matter of faith in stock market efficiency. Correcting deferred taxes as a reporting difference has been shown to be analytically in error because commissions allow returns on book common equity, not on book common equity plus deferred taxes. Brigham has repeatedly emphasized this, the analysis has been available to analysts and investors, and the real differences have been publicized by companies and commissions to further their own interests. It is difficult to believe that analysts and investors with 20 years to consider these accounting procedures could be so continuously misled into making a correction in reported earnings that is not only unnecessary but in error. How then should the P/E disadvantage of flow through companies be explained if explicit variables representing differences from normalizing utilities, unidentified extra risk, or market inefficiency will not do it? Limitations on allowed and realized return in the future seem the most appealing explanation available. Commissions come to flow through as a procedure in order to provide immediate price relief to customers in spite of the added funds requirement that follows for investors. These commissions are l2 The CRSP data used here do not include dividends. The dividend yield for normalizing companies is below that for flow through companies. Brigham and Pappas [S] show that in cross-sectional regressions explaining dividend yields that are in essence the turned over version of the P/E cross-sections. (This is because DIV = E X PAY, and PAY varies little across companies.) The groups of firms used here show the same relationship but the difference is slight-not significant at the 5% level and not capable of reversing the finding of a lower realized return to shareholders in flow through companies. Using COMPUSTAT data as in Exhibit 3, the findings are 1959-73

DI V/P (DIV + AP)tP

Mean

Values

30 FT

39 N

0.045 0.055

0.043 0.062

F-ratio 2.61 3.05

Mean

1969-73 Values

30 FT

39 N

0.056 -0.021

0.053 -0.003

F-ratio 3.37 5.35*

58

Richard

S. Bower et al.

unlikely to avoid substantial lags when flow through calls for price increases in later years and probably are politically unable to relax the tight return standards that seem to accompany flow through. This future return prospect, not fully reflected in the historic data on realized return on book equity, not added risk or market error, appears to be the something more that accompanies the real differences between flow through and normalization accounting procedures.

Conclusion Struck by the lower ratios of price to earnings and the smaller premium that market price has over book value for flow through utilities, and having recognized that more than reporting differences are involved, it has been natural to seek an explanation in the explicit return, risk, and policy variables that might differ because of or in association with the choice of accounting procedure. Finding the explanations incomplete, there is some temptation to conclude that some unidentified risk attaches to flow through or that some market imperfection causes investors to make perverse adjustments to reported earnings. The temptation to accept one or the other of these conclusions should be avoided. Each suggests that investors can expect a higher return if they buy shares in flow through companies: the one because they would be taking greater risk, the other because they could expect the market error eventually to be corrected. The suggestion seems clearly wrong. Wrong also is the policy implication of these conclusions that commissions requiring flow through could benefit shareholders and customers alike by permitting normalization. A much more reasonable conclusion is that flow through shares are priced lower because flow through commissions can be expected to allow smaller returns on equity that is reinvested or acquired from the outside. The shares of both flow through and normalizing companies are priced properly considering this and, since both groups seem to have the same risk, that means investors can expect the same return from stock holdings in either group. Flow through commissions are neither short-sighted nor naive. They are simply doing their job: providing investors just enough return to keep market price a little over book. Investors apparently recognize this. So should academics.

Regulatory

Procedures

59

References 1.

Brigham, Eugene F., The Effects of Alternative Tax Depreciation Policies on Public Utility Rate Structures, National Tax J. 20 (June, 1967): 204-217.

2.

Brigham, Eugene F., The Effects of Alternative Depreciation Profits,AccountingRev. 43 (January, 1968): 46-61.

3.

Brigham, Eugene F., Public Utility Tax J. 18 (June, 1966): 144-155.

4.

Brigham, Eugene F., and Nantell, Timothy J., Normalization Through for Utility Companies Using Liberalized Tax Depreciation, Rev. 49 (July, 1974): 436-441.

5.

Brigham, Eugene F., and Pappas, J. L., Liberalized Depreciation and the Cost of Capitcl, MSU Institute of Public Utilities, East Lansing, Michigan, 1970.

6.

Keenan, Michael, Models of Equity 25 (May, 1970): 243-265.

I.

Miller, Merton H., and Modigliani, France, to the Electric Utility Industry: 1954-57 (June, 1966): 333-391, (December, 1967):

8.

Mlynarczyk, F. A., An Empirical J. Accounting Res. 7 (December,

9.

O’Donnell, the Electric

J. L., Relationships Between Reported Earnings and Stock Prices in Utility Industry, Accounting Rev. 40 (January, 1965): 135-143.

10.

O’Donnell, Accounting

J. L., Further Rev. 43 (July,

11.

Pollock, Richard, ciation on Utility

12.

Robichek, Alexander A., Higgins, of Leverage on the Cost of Equity (May, 1973): 353-367.

13.

Spann, Robert M., Taxation and Electric Utility Regulation and the Efficient Allocation of Energy Resources, Studies in Electric Utility Regulation, edited by Charles J. Cicchetti and John L. Jurewitz, Ballinger, Cambridge, Massachusetts, 1975.

COMPUSTAT 017411 025537 059165 153609 172070

Valuation:

Practices

The Great

and Policies,

J. Finance

Some Estimates of the Cost of Capital and Reply, Am. Economic Rev. 56 1299-1300.

Study of Accounting 1969): 63-81.

Observations on Reported 1968): 549-553.

Robert Captial

National

Versus Flow Accounting

Serm Bubble,

Methods

Earnings

and Stock Prices,

and Stock

The Effect of Alternative Regulatory Treatment Tax Payments, National Tax J. 26 (March, 1973):

Appendix : Companies Flow Through

Depreciation

Policies on Reported

C., and Kinsman, of Electric Utility

Prices,

of Tax Depre43-57.

Michael, The Effect Firms, J. Finance 28

Included

(30)

Also Used in this Classification by Brigham O’Donnell

& CRSP # Allegheny Power System American Electric Power, Inc. Baltimore Gas & Electric Co. Central Hudson Gas & Electric Cincinatti Gas & Electric

X X

Richard S. Bower et al.

60 Appendix (Continued) Flow Through COMPUSTAT

(30)

& CRSP if Cleveland Electric Illuminating Co. Columbus & Southern Ohio Electric Consolidate Edison of NY Dayton Power & Light Delmarva Power & Light Duquesne Light General Public Utilities Kansas City Power & Light Long Island Lighting New York State Electric & Gas Niagra Mohowk Power Ohio Edison Co. Pacific Gas & Electric Pennsylvania Power & Light Potomac Electric Power Public Service of Colorado Public Service Electric & Gas Rochester Gas & Electric San Diego Gas & Electric Southern California Edison Toledo Edison Union Electric Utah Power & Light Virginia Electric & Power Washington Water Power

186108 198846 209111 240019 247109 266228 370550 485134 542671 649840 653522 677347 694308 70905 1 737679 744448 744567 771367 797440 842400 889175 906548 917508 927804 940688 Normalized 048303 100599 144141 152357 153645 153663 202795 210615 250847 291641 341081 341099 402550 442164 451380 452092 455434

Also Used in this Classification by Brigham O’Donnell X X X

X

X

X X X X

X

X X X X X

(39) Atlantic City Electric Boston Edison Carolina Power & Light Central & Southwest Central Illinois Light Central IllinoisPublic Service Commonwealth Edison Consumers Power Detroit Edison Empire District Electric Florida Power & Light Florida Power Gulf States Utilities Houston Lighting & Power Idaho Power Illinois Power Indianapolis Power & Light

X

X

X X X X

X X X X X

X X

X

X X X

X X X

Regulatory Procedures

61

Appendix (Continued) Also Used in this Classification by O’Donnell Brigham

Normalized (39) COMPUSTAT & CRSP # 461074 462470 462506 485314 546676 595832 604110 612017 612085 644001 665772 678858 717537 744465 790654 837007 842587 843163 845743 882848 976656 976843

Interstate Power Iowa-Illinois Gas & Electric Iowa Power & Light Kansas Power & Light Louisville Gas & Electric Middle South Utilities Minnesota Power & Light Montana-Dakota Utilities Montana Power New England Electric Northern States Power Oklahoma Gas & Electric Philadelphia Electric Public Service of Indiana St. Joseph Light & Power South Carolina Electric & Gas Southern Company Southern Indiana Gas & Electric Southwestern Public Service Texas Utilities Wisconsin Electric Power Wisconsin Public Service

X X X

X X

X X X

X

X

X

X X