NORTH AMERICAN POWER BUSINESS: EARNINGS QUALITY MATTERS
The pressing strategic issues in the power sector today-vertical integration, fuel mix, mergers and acquisitions, geographic scope, financial hedging, and business mix-all influence the pattern of company earnings per share through time. CERA's recent survey of industry executives clearly indicates that the leaders of America's power companies think earnings quality-stable and predictable earnings per share through time-matters. Yet, modern portfolio and finance theory argues that investors will not value earnings quality in assembling an investment portfolio, implying that management wastes effort and expense on improving this metric.
Are power executives expending time and effort needlessly to improve earnings stability and predictability? The answer is no; although investors balancing portfolio risk may not seek reduced earnings-per-share volatility, this is not the only reason that investors value stable and predictable earnings. A company with lower earnings-per-share volatility can reduce business costs and improve prospects for cash flow growth.
Examining the data for 63 power companies over the past decade suggests earnings quality does matter to a power company's stock price: the market-to-book ratios of the top third in earnings quality are 21 percent higher than the bottom third of companies. In addition, the average annual total return to investors provided by the top third in earnings quality exceeded the bottom third by 3.2 percent on average. Clearly, understanding the sources of value for earnings quality is a strategic imperative in the power business today.
