22

Business Essentials

Richard E. Brown

Quanta Technology

22.1    Introduction

22.2    Accounting

More on Assets, Liabilities, and Owner’s Equity • Amortization and Depreciation • Financial Statements

22.3    Finance

Time Value of Money • Capital Structure

22.4    Financial Risk

Diversification • Portfolio Theory • Capital Asset Pricing Model • Financial Options

22.5    Financial Ratios

22.6    Asset Management

22.1  Introduction

There are many challenging power engineering problems to be solved. New customers must be served. Old equipment must be maintained. New technologies must be assessed and adopted. To solve these challenges, power engineers find themselves responsible for planning, engineering, system analysis, system design, equipment specification, maintenance management, operations, and a host of other functions. Whatever their role, power engineers make many decisions. Some of these decisions result from extensive and careful analyses. Others are made quickly during everyday activities. In virtually all cases, decisions have cost and other implications. Some options are cheap. Others options are expensive. Some options spend as little as possible now. Others options spend money now in order to save money later. Some options result in high safety margins. Other options are more risky. With so many choices, it is valuable for power engineers to understand the criteria for deciding which decisions are best from a business perspective.

Typical businesses prefer engineering decisions that result in higher profits. A cheaper engineering solution may produce higher profits if a resulting lower price causes an increase in sales. It is also possible that a more expensive engineering solution will produce higher profits if the resulting higher quality product can command a premium price. In both cases, the business objective is clear: while acting legally and ethically, maximize profits whenever possible. Utilities are a bit different. Investor-owned utilities need to be profitable, but have their profits essentially controlled by regulators. Government-owned utilities will be more political when making decisions. Member-owned utilities have yet another perspective with regards to revenues and costs.

In any case, it is helpful for power engineers to understand the basics of business. Like engineering, business has a large number of words and phrases with precise meanings. Many of these words and phrases represent simple concepts, and can be easily learned and understood. Although some terms represent difficult or confusing concepts, this section will (hopefully) remove much of the mystery and serve as a reference when necessary.

The breadth of subject matter covered in this section is necessarily extensive so that the reader can become exposed to the essentials of business. The consequence is that each topic can only be given brief treatment. These and other business topics are addressed more fully the book Business Essentials for Utility Engineers (CRC Press).

22.2  Accounting

Although many perceive accounting to be arcane and esoteric, it can be boiled down to one simple equation: the assets of a company must be equal to the claims on these assets. This basic accounting equation is most commonly represented as the following:

$\text{Assets}=\text{Liabilities}+\text{Owner’s}\text{Equity}$

An asset is something of value, and a company’s assets are the sum of all things of value that a company owns. A liability is an obligation of the company, such as a loan or an unpaid bill. When the value of all liabilities is subtracted from the value of all assets, the residual value is left for the owners. This residual value is called owner’s equity.

To illustrate the basic accounting equation in action, a simple example is now provided. Imagine a group of investor purchasing and running a small utility. These investors initially sell 10 million shares of common stock at $10 per share. The sale of stock raises $100 million in cash, which is referred to as paid-in capital. The raised cash, an asset, corresponds to $100 million in owner’s equity.

The stock transaction described earlier is reflected in the balance sheet of the company. The balance sheet can be thought of as an expanded version of the accounting equation, and describes all assets, liabilities, and owner’s equity. The balance sheet of the company (all values in millions of dollars) after the sale of common stock is

Assets			Liabilities		Owner’s Equity
100	Cash			100	Common stock
100	Assets	0	Liabilities	100	Owner’s equity

Transaction: Issue $10 million shares of common stock at $10 per share.

The aforementioned table is organized into columns corresponding to assets, liabilities, and owner’s equity. Each individual item in these categories is listed, starting from the top, in nonbold font. The total amount of each category is listed at the bottom in bold font.

After the first transaction of the company, the balance sheet confirms that assets are equal to liabilities plus owner’s equity. In a more practical sense, the company now has (1) cash on hand and (2) stockholders that expect a return on their investment. The company finds that it needs additional funds to start business operations. It therefore sells $50 million in bonds. The bond issuance raises another $50 million in cash, and results in a corresponding $50 million liability. The balance sheet is now

Assets		Liabilities			Owner’s Equity
150	Cash	50	Bonds	100	Common stock
150	Assets	50	Liabilities	100	Owner’s equity

Transaction: Issue $50 million in bonds.

The bond transaction causes the cash account to increase from $100 to $150 million. To balance the increase in assets, a $50 million liability is recorded so that the total assets of $150 million equal the liabilities plus owner’s equity.

The company now negotiates to buy a small utility system for $90 million and pays in cash. The effect is to reduce the cash account by $90 million and to add a new asset worth the same amount. Total assets have not changed, and total assets still equal liabilities plus owner’s equity; the balance sheet still balances.

Assets			Liabilities		Owner’s Equity
60	Cash	50	Bonds	100	Common stock
90	Utility system
150	Assets	50	Liabilities	100	Owner’s equity

Transaction: Purchase a $90 million utility system.

The company is now a utility. In its first month, it provides utility services to its customers and then bills them $15 million for these services. The customers have not yet paid these bills, but their legal obligation to pay these bills is an asset to the company. This type of asset is typically recorded in a category called accounts receivable.

When a customer is obligated to pay for services rendered, the result is an increase in profits, also called earnings. Since the owners of the company have rights to these earnings, an increase in accounts receivable is balanced by an increase in an owner’s equity account called retained earnings.

Assets			Liabilities		Owner’s Equity
60	Cash	50	Bonds	100	Common stock
90	Utility system			15	Retained earnings
15	Accounts receivable
165	Assets	50	Liabilities	115	Owner’s equity

Transaction: Bill $15 million to customers.

Notice that the aforementioned balance sheet still balances. Assets are worth $165 million and the sum of liabilities and owner’s equity is worth the same amount.

In the process of providing services to its customers, the utility incurs expenses of $5 million, which it owes to a variety of contractors and outsourcing companies. The utility has not yet paid its bills, but must record the obligation to pay these bills as a liability. Unpaid obligations are typically recorded in a category called accounts payable. An increase in accounts payable results in a decrease in earnings, which is recorded as a decrease in the retained earnings account.

Assets			Liabilities		Owner’s Equity
60	Cash	50	Bonds	100	Common stock
90	Utility system	5	Accounts payable	10	Retained earnings
15	Accounts receivable
165	Assets	55	Liabilities	110	Owner’s equity

Transaction: Incur $5 million in expenses.

The company now pays the $5 million that it owes in bills. These payments come out of cash accounts, and are offset by a reduction in accounts payable. Since the company is transferring cash out of the company, total assets are lower. Since the company no longer has unpaid bills, total liabilities are also lower. The balance sheet reflects clearly the difference between a company with many unpaid bills and a company with few unpaid bills. The new balance sheet is

Assets			Liabilities		Owner’s Equity
55	Cash	50	Bonds	100	Common stock
90	Utility system	0	Accounts payable	10	Retained earnings
15	Accounts receivable
160	Assets	50	Liabilities	110	Owner’s equity

Transaction: Pay $5 million in unpaid bills.

Customers now pay $10 million of their unpaid bills. This is not the total amount owed, but has the effect of increasing cash by $10 million and reducing accounts receivable by the same amount. There is no net effect on total assets.

Assets			Liabilities		Owner’s Equity
65	Cash	50	Bonds	100	Common stock
90	Utility system	0	Accounts payable	10	Retained earnings
5	Accounts receivable
160	Assets	50	Liabilities	110	Owner’s equity

Transaction: Customers pay $10 million of their bills.

The utility system will not live forever. To account for this, the value of the utility system on the balance sheet is reduced over time. This reduction in value is called depreciation. Depreciation is covered in more detail later, but for now the assumption is a utility system depreciation amount of $1 million. This reduces the book value of the utility system by $1 million, and is treated as an expense that lowers retained earnings. The updated balance sheet is

Assets			Liabilities		Owner’s Equity
65	Cash	50	Bonds	100	Common stock
89	Utility system	0	Accounts payable	9	Retained earnings
5	Accounts receivable
159	Assets	50	Liabilities	109	Owner’s equity

Transaction: Utility system depreciates by $1 million.

In addition to operating expenses and depreciation expenses, a utility is obligated to pay interest payments to bond holders. In this case, the utility pays $1 million in interest. These payments reduce the cash account and retained earnings accordingly. The interest payment does not affect the face value of the bonds, and therefore does not affect the amount of liabilities in the bond account. If the utility paid off part of the principle of the bonds, the cash account (an asset) and the bond account (a liability) would both be reduced.

The updated balance sheet after the $1 million in bond interest payments are made is

Assets			Liabilities		Owner’s Equity
64	Cash	50	Bonds	100	Common stock
89	Utility system	0	Accounts payable	8	Retained earnings
5	Accounts receivable
158	Assets	50	Liabilities	108	Owner’s equity

Transaction: Utility pays $1 million in interest to bond holders.

From an accounting perspective, this utility is performing well. It is both profitable and generating cash. In order to transfer some of these profits to its owners, the utility now decides to distribute $2 million of retained earnings to common stockholders. This amount is taken from the cash account and is called a dividend. Since there are 10 million shares of common stock, the dividend corresponds to 20 cents per share. The resulting balance sheet is

Assets			Liabilities		Owner’s Equity
62	Cash	50	Bonds	100	Common stock
89	Utility system	0	Accounts payable	6	Retained earnings
5	Accounts receivable
156	Assets	50	Liabilities	106	Owner’s equity

Transaction: Issue $2 million in dividends.

22.2.1  More on Assets, Liabilities, and Owner’s Equity

An asset is not necessarily a tangible thing, and can include items such as owed money, patents, and prepaid insurance. Assets that can be touched and felt are called tangible assets and others are called intangible assets. Goodwill is a special type of nonmonetary intangible asset. It refers to a premium paid above market value for an asset, typically during the acquisition of a company.

Another way to classify assets is based on the expected length of time until the asset is used up. Assets that are expected to be used up within 1 year are called current assets. Typical current assets include cash, cash equivalents, accounts receivable, inventory, and short-term investments. Assets that are not expected to be used up within 1 year are called noncurrent assets or long-term assets. Typical long-term assets include land, buildings, equipment, utility infrastructure, and long-term investments. Tangible long-term assets are also called fixed assets.

Like assets, liabilities are grouped according to their timeframe into current liabilities and noncurrent or long-term liabilities. Common current liabilities include unpaid wages, unpaid bills, unpaid interest, declared but unpaid dividends, and prepayments for services. Common long-term liabilities include long-term debt (e.g., bonds and bank loans), long-term leases, and employee pension obligations.

Working capital is the net amount of financial capital tied up in daily business operations. Mathematically, working capital is equal to current assets minus current liabilities.

Capital employed is defined as total assets minus current liabilities, and represents the total amount of capital used to finance a utility.

As shown in the accounting example, owner’s equity can be divided into paid-in capital and retained earnings. Paid-in capital is the amount of money raised through the issuance of common stock. Retained earnings are everything else, and are equal to cumulative revenue minus cumulative expenses minus cumulative dividends. Since paid-in capital is generated by selling common stock, it is sometimes called common stock equity.

22.2.2  Amortization and Depreciation

When a utility purchases an expensive piece of equipment, the cost of this equipment is spread over the expected useful life. This process is called amortization. When amortization is applied to a tangible asset, it is called depreciation.

Consider the purchase of an expensive construction vehicle for $1 million that is expected to last for 20 years. Accounting rules require that the total cost of the vehicle be distributed across each of these 20 years. Typically, this is done by allocating an equal amount to each year. For this example, $50,000 of the $1 million is treated as a depreciation expense for a period of 20 years; each year the vehicle is depreciated by $50,000 until the initial value has been depreciated. In accounting records, the current asset value is equal to the initial value minus accumulated depreciation expenses, and is referred to as the book value of the asset.

22.2.3  Financial Statements

When people speak of financial statements, they are typically referring to the income statement, the balance sheet, and the statement of cash flows. The income statement describes a utility’s revenues and expenses over a specific period of time. The balance sheet describes a utility’s assets, liabilities, and owner’s equity at a specific point in time. The statement of cash flows describes changes in the cash account over a specific period of time.

An income statement, also called and earnings statement or a profit and loss statement (income, earnings, and profits are all synonymous), describes the profitability of a utility over a specific period of time, such as a month, 3 months (quarter), or a year. It does this by presenting revenue and expenses in different categories so that income can be presented at different levels. Income statements start with company revenue, and successively subtract expense categories until there are no more expenses to subtract. This process generally results in operating income, earnings before interest and taxes (EBIT), earnings before interest and taxes depreciation and amortization (EBITDA), income before taxes (IBT), net operating profit after taxes (NOPAT), and net income. The relationship of revenue and income measures to each other is shown in Figure 22.1.

A balance sheet, such as the tables shown in the accounting example, shows the financial status of a utility at a specific point in time. Information is typically categorized into assets, liabilities, and owner’s equity. When looking at a balance sheet, it is important to remember that the value of assets (for the most part) are recorded at historical cost, and might not represent the value of the asset today.

Because of differences in accounting treatment, income statements and balance sheets are somewhat subjective. But cash is objective. Identical utilities could have different balance sheets, but cash flow would be the same. Most importantly, the statement of cash flows is very difficult to manipulate.

FIGURE 22.1  Measures of profitability.

An important concept in cash analysis is that of free cash flow. This is typically defined as the amount of cash generated by a company that is available for distribution to owners as dividends. In the long run, net income must be equal to free cash flow. Because they are equal in the long run, net income is a good first approximation of free cash flow. To make this approximation better, several adjustments must be made. First, all noncash expenses must be added back. Next, changes in working capital must be considered. Last, all capital expenditures must be subtracted. Free cash flow corresponds to the following equation:

$\begin{array}{l}\text{Net}\text{income}\hfill \\ +\text{Noncash}\text{expenses}\hfill \\ +\text{Decrease}\text{in working}\text{capital}\hfill \\ -\text{Capital}\text{expenditures}\hfill \\ =\text{Free}\text{cash}\text{flow}\hfill \end{array}$

The free cash flow of a utility is recorded in the statement of cash flows, which is regarded by many financial analysts as the most important financial statement. This typically includes a section on cash from operations (net income with adjustments for noncash expenses and changes in working capital), cash from investments (capital purchases and capital sales), and cash from financing (debt purchase, debt retirement, stock issuance, stock repurchase, dividends). The statement of cash flow concludes with the amount of cash at the beginning of the period, the change in cash, and the corresponding amount of cash at the end of the period.

It should be understood that this section discusses financial accounting, which is what appears in annual reports and is submitted to government agencies like the Security and Exchange Commission.

22.3  Finance

The subject of engineering economics typically deals with the time value of money and net present value (NPV) calculations. In the business world, these topics are included in the subject of finance. As a verb, finance means raising money for an investment. This section presents a summary of finance from an engineering and technical management perspective.

22.3.1  Time Value of Money

An amount of money received today is more valuable than the same amount of money received sometime in the future. Consider putting $100 today into a savings account that offers 5% interest per year. After 1 year, the $100 has turned into $105. In the terminology of finance, the present value of $100 is has a future value of $105 in 1 year. After 2 years, the amount increases by an additional 5% to $110.50. The increase in the first year is $5.00 and the increase in the second year is $5.50. Left alone, the amount of increase will grow, resulting in an exponential increase in account value. This exponential increase is caused by compound interest—interest being earned on all previous interest payments.

It is common to consider a number of cash flow events for a single analysis. For example, a project may consist of a number of costs requiring cash outflows at various times. Once completed, the project may also result in revenue from customer payments at various times. The sum of all positive present values minus the sum of all negative present values is called net present value. When cash inflows are from revenue and cash outflows are from expenses, NPV is equal to the following:

$\text{NPV}={\displaystyle \sum _{\text{n}=0}^{\infty }\left({\text{R}}_{\text{n}}-{\text{E}}_{\text{n}}\right)}{\left(1+\text{r}\right)}^{-\text{n}}$

where

NPV represents net present value

R_n represents revenue in year n

E_n represents expense in year n

r represents interest rate

There are several types of cash flow streams that commonly arise in an NPV analysis. For this reason, it is convenient to provide a quick method of NPV calculation. The first type of cash flow stream is a perpetuity, which corresponds to a constant amount of cash at the beginning of each year, starting in Year 1. The second type of common cash flow stream is a growing perpetuity, which provides payments that increase by a fixed percentage each year, g.

The perpetuity equations are simple to remember and convenient to use. However, cash flows are typically not expected to last forever, but end after a specific number of years, n. These annuities have formulae similar to perpetuities but with an additional term that essentially subtracts out the perpetuity values in distant years.

Cash flow diagrams and their associated NPV equations for perpetuities and annuities are shown in Figure 22.2. These are the most commonly used cash flow streams, and can be combined to represent many cash flow scenarios.

The generic term for the “r” value used in time value of money calculations is the discount rate. It is possible that a discount rate corresponds to a specified interest rate, but often this is not the case. Factors that are typically considered when choosing a discount rate are inflation, time frame, and risk exposure.

FIGURE 22.2  Common NPV calculations.

It is often necessary to determine the average cost of raising cash for a company. This is done by considering the interest rates for all debt (such as bonds and bank loans) and the expected return for stockholders. This weighted average cost of capital, or WACC (pronounced “wack”), represents is the average profit that a company must achieve in order to meet all investor expectations.

22.3.2  Capital Structure

Financial capital is money available for funding a business. The sources of financial capital are owners and lenders. Financial capital provided by owners is called owner’s equity, often shortened to equity. Financial capital provided by lenders is called debt. All sources of equity and debt are called the capital structure of a company. Both the equity (e.g., common stock) and debt (i.e., bonds) of a company are typically valued by markets. The value of the total capital structure of a company is equal to the value of equity plus the value of debt.

If a company goes bankrupt, available funds are paid out to sources of capital based on seniority. A debt that must repaid before another is said to be senior. A debt that must repaid after another is said to be subordinate to the senior debt. Debts that have the same priority are said to be pari passu. A common classification of seniority is the following: senior secured debt (highest seniority), senior unsecured debt subordinated debt, convertible debt preferred stock (mezzanine), and common stock (lowest seniority).

Senior secured debt gets paid off first. The term secured means that the debt is guaranteed by the assets of the company. This is sometimes called mortgage-backed debt. Unsecured debts, also called debentures, are not secured by assets and only by the general credit worthiness of the issuer. Senior unsecured debt gets paid off after secured debt, followed by various levels of subordinate debt. Next to be paid is debt that can be converted into preferred or common stock. Mezzanine capital is senior only to common stock; in this case the mezzanine capital is preferred stock. Anything left after all senior obligations are fulfilled goes to common stockholders.

Capital structure is typically measured as amount of total debt divided by the total company value (debt plus owner’s equity). This is called a company’s debt ratio, and can vary from 0% for companies without any debt, to more than 50% for companies with very low financial risk such as regulated utilities. Alternatively, capital structure can be measured by dividing total debt by owner’s equity, resulting in the debt-to-equity ratio.

22.4  Financial Risk

Financial risk relates to the predictability of financial outcomes. Less risk is preferable to high risk in the sense that investors will pay more for more predictable outcomes. The tools of financial risk analysis allow risk-based valuations to be treated quantitatively.

Mathematical analyses based on expected values and average outcomes are insufficient for financial risk analysis. Financial risk analysis is not interested in averages. Rather, it is interested in knowing the predictability of outcomes, which requires knowledge of all possible outcomes and their likelihood of occurrence. This type of analysis can either be backward-looking or forward-looking. A backward-looking financial risk analysis examines historical data and uses the tools and techniques of statistics. A forward-looking financial risk analysis creates predictive models and uses the tools and techniques of probability theory.

22.4.1  Diversification

The essence of diversification can be summed up by the old adage, “don’t put all of your eggs in one basket.” Good investors do not care whether the value of a particular stock goes up or down, but are extremely interested in whether their overall portfolio value goes up or down.

Some stocks do better than others primarily due to random chance and/or factors not knowable through public information. These uncertainties are specific to each company and are called idiosyncratic risks which can be diversified away. Investing in one small startup company is risky, since it may succeed and it may not succeed. Investing in many small startup companies is much less risky since a certain percentage will fail and a certain percentage will succeed. In a developed market, idiosyncratic risk can be effectively eliminated by purchasing 30–40 assets with similar idiosyncratic risk characteristics.

Not all risk is idiosyncratic. There are some risk factors that will impact all investments at the same time. This is similar to the engineering concept of a common mode root cause. Something external is impacting many things at once. Whereas idiosyncratic risks are diversifiable, common mode risks are nondiversifiable. Another common term for nondiversifiable risk is systematic risk. Purchasing a large number of disparate investments does not impact nondiversifiable risk because all of the investments will be impacted by the common mode events in a similar way. For example, higher interest rates will reduce the value of all stock prices in a similar way. Lower consumer confidence will have a similar effect on the overall market. Some systematic risk will be specific to certain industries (such as the development of a substitute product or service), while others will be broader in scope.

22.4.2  Portfolio Theory

Portfolio theory assumes that rational investors are interested in maximizing investment returns for a given level of risk. Investment return is defined as the expected value of future returns divided by current price. Investment risk is defined as the standard deviation of this distribution.

Portfolio theory builds on diversification theory; all of the mathematics and derivations assume a fully diversified portfolio with no idiosyncratic risk, with lognormally distributed stock prices. Portfolios are created by buying and selling stock through the stock market. Portfolio theory can be easily extended to include any type of asset such as bonds, real estate, and commodities. Terms that are used synonymously are investment, company, firm, security, and asset.

Consider a large number of assets, each with an expected return and risk, allowing them to be plotted as points on a graph. Random portfolios can now be generated by selecting random mixes of asset with different asset weights. The risk and return of each portfolio can be calculated, allowing them also to be plotted on the graph. This requires a correlation matrix, or the assumption that returns are not correlated. Some of these portfolios will have returns that are higher than all other points with equal or lower risk. The set of all such portfolios is called the efficient frontier. Rational investors will only purchase a portfolio located on the efficient frontier because otherwise they could achieve higher returns for the same level of risk. The point of the efficient frontier with the lowest level of risk is called the minimum variance portfolio, which is equivalent to the lowest possible standard deviation. The efficient frontier is shown in Figure 22.3.

When a portfolio is on the efficient frontier, the trade-off between risk and return is binding. Higher portfolio returns cannot be achieved without increasing risk. Similarly, portfolio risk cannot be reduced without accepting lower levels of return. Portfolio theory is extended by consideration of a risk-free security—a security with a highly predictable return. An example of a nearly risk-free security is a U.S. treasury bill, which has nominal returns only exposed to the risk of a collapse of the U.S. government.

FIGURE 22.3  The efficient frontier.

FIGURE 22.4  The capital market line.

A risk-free security is graphically represented in Figure 22.4. There is a single point on the efficient frontier where a tangent line can be drawn through the risk-free security. This point is called the optimal risky portfolio, and the line is called the capital market line. The capital market line represents the best possible risk versus return potential for combinations of risky assets and risk-free securities.

The optimal risky portfolio represents the weighted sum of every asset in the market, with weights being proportional to market value. A portfolio with these characteristics is called the market portfolio. A reasonable estimate of the stock market portfolio can be achieved through the purchase of a mutual fund that tracks a broad market index such as the S&P 500 or the Russell 3000.

22.4.3  Capital Asset Pricing Model

The capital asset pricing model (CAPM, pronounced “Cap M”) provides a methodology for determining what the expected returns of stockholders should be. Like portfolio theory, CAPM assumes that investors are fully diversified and are only exposed to systematic risk. It also recognizes that rational investors will want to both invest in the market portfolio with the expected market return (r_m) and invest in riskfree securities with the risk-free rate of return (r_f).

Stock price risk is most commonly measured by comparing it to the overall risk of the market using covariance. The covariance of market movement and stock price movement, when divided by market variance, is called beta (β). Beta is mathematically defined as

$\beta =\frac{\text{Cavariance}\left(\text{S},\text{M}\right)}{{\text{σ}}_{\text{m}}^2}$

where

S represents individual stock prices

M represents overall market prices

${\text{σ}}_{\text{m}}^2$ represents variance of market price

The beta of a company describes how its price moves relative to the overall market. If β = 1, a stock market increase (or decrease) of 1% results in the company stock tending to increase (or decrease) by 1%. If beta is greater than 1, stock price movement tends to be greater than the overall market. For example, if β = 2, a stock market increase by 1% results in the company stock tending to increase by 2%. If beta is less than one, stock price movement tends to be less than the overall market. For example, if β = 0.5, a stock market increase of 1% results the company stock tending to increase by one half of a percent.

FIGURE 22.5  The security market line.

For a fully diversified portfolio, it can be mathematically shown that the required return on a stock is a linear function of beta. This relationship states that the required return of a stock is the following:

${\text{r}}_{\text{s}}={\text{r}}_{\text{f}}+\beta \left({\text{r}}_{\text{m}}-{\text{r}}_{\text{f}}\right)$

where

r_s represents required return on a stock

r_f represents risk-free rate

r_m represents expected market return

(r_m – r_f) represents market risk premium

CAPM states that the required return on a stock is equal to the risk free rate plus a risk premium. If the stock has the same risk as the overall market (β = 1), the risk premium is equal to the market risk premium. If the stock is twice as risky as the market (β = 2), the risk premium is twice the market risk premium. If the stock is half as risky as the market (β = 0.5), the risk premium is half the market risk premium.

Plotting required return versus beta results in the security market line. The security market line is easily drawn. One point corresponds to a beta of zero and the risk-free rate. A second point corresponds to a beta of one and the expected market return. The security market line is drawn through these two points, and represents the required expected return for a security with any specified beta. The security market line is shown in Figure 22.5.

22.4.4  Financial Options

The world of finance is replete with contracts and other legal documents that have monetary value. There are innumerable possibilities such as stocks, bonds, and bank loans. Legal documents like these that have monetary value are called financial instruments. Financial instruments are broadly categorized as either cash instruments or derivative instruments. Cash instruments do not relate to hard currency per se. Rather, the monetary value of cash instruments is directly determined by the market. Examples include stocks and bonds.

Unlike cash instruments, the monetary value of derivative instruments is derived from the underlying value of one or more cash instruments (hence the name). The most common derivative instruments are options, futures, and swaps. For example, the owner of an option on a utility stock does not have any ownership rights to the utility. Rather, the value of the option rises and falls as the value of the utility stock rises or falls. It is a pure financial mechanism. Today, new and complex derivative instruments are constantly being developed through financial engineering.

A swap is an agreement between two parties to exchange a stream of cash flows. Consider a loan with a floating interest rate. The holder of the loan can purchase an interest rate swap that will exchange the floating interest rate payments with fixed payments. Purchasing the swap removes the risk of interest rate fluctuations. Other common types of swaps include foreign currency swaps, credit swaps, commodity swaps and equity swaps.

A call option is the right to buy a share of stock (or other cash instrument) at a specified price, called the strike price, at a future date. Consider a utility with stock trading at $50 per share. Now consider a call option with a strike price of $55 with an expiration of 1 year. Before the option expires, the holder has the right, but not the obligation, to exercise the option and purchase a share of stock for $55. If the utility stock is trading below the strike price, it does not make sense to exercise the call option since a share of stock can be obtained for less money through a direct purchase. If the utility stock is trading above the strike price, the call option is in the money; the holder can exercise the option and obtain the stock for a price below current market value. If the stock were trading at $60, the holder could obtain a share of stock for the strike price of $55, immediately sell the share back to the market at $60, and retain the difference of $5.

Investors can both buy and sell call options. A purchased call option is called a long call. A pure investment in a call option is a bet that the price will increase above the strike price in the future. A sold call option is called a short call. A pure sale of a call option is a bet that the price will not increase above the strike price in the future.

A put option is the right to sell a share of stock at a specified strike price before a future expiration date. Consider a utility with stock trading at $50 per share. Now, consider a put option with a strike price of $45 with an expiration of 1 year. Before the option expires, the holder can exercise the option and sell a share of stock for $45. If the utility stock is trading above the strike price, it does not make sense to exercise the put option since a share of stock can be sold for more money in the market. If the utility stock is trading below the strike price, the put option is in the money; the holder can exercise the option and sell the stock for a price above current market value. If the stock were trading at $40, the holder could purchase a share of stock on the market for $40, immediately exercise the option and sell the share for $45, and retain the difference of $5.

Like call options, investors can both buy and sell put options. A purchased put option is called a long put. A pure investment in a put option is a bet that the price will decrease below the strike price in the future. A sold call option is called a short put. A pure sale of a put option is a bet that the price will not decrease below the strike price in the future.

There are two common ways to treat the expiration date of an option. An American option allows the option to be exercised at any date up to and including the expiration date. A European option only allows the option to be exercised on the expiration date.

A mathematical way to value financial options is the famous Black–Scholes Option Pricing Model, which provides a closed-form equation for the price of a call option. The Black–Scholes equation is easily computed, and is mathematically expressed as follows:

$\begin{array}{l}{\text{P}}_{\text{call}}={\text{P}}_{\text{stock}}\cdot \text{N}\left({\text{d}}_1\right)-{\text{P}}_{\text{strike}}\cdot {\text{e}}^{-\text{r}\cdot \text{t}}\cdot \text{N}\left({\text{d}}_2\right)\hfill \\ {\text{d}}_1=\frac{1}{\text{σ}\sqrt{\text{t}}}\left(\ln \left(\frac{{\text{P}}_{\text{stock}}}{{\text{P}}_{\text{strike}}}\right)+\text{t}\cdot \left(r+\frac{{\text{σ}}^2}{2}\right)\right)\hfill \\ {\text{d}}_2={\text{d}}_1-\text{σ}\sqrt{\text{t}}\hfill \end{array}$

where

P is the price

t is the time until option expiration

r is the risk-free interest rate

σ is the volatility of underlying stock (standard deviation as a % of mean)

N is the cumulative standard normal distribution function

Black–Scholes allows the price of a call option to be computed directly. The price of a put option is calculated by first computing the price of the corresponding call option and then using the put-call parity relationship as follows:

${\text{P}}_{\text{put}}={\text{P}}_{\text{call}}+\text{PV}\left(\text{Cash}\right)-{\text{P}}_{\text{stock}}$

where PV(Cash) is the present value of cash, equal to the value of the underlying asset, invested at the risk-free rate for the term of the option.

22.5  Financial Ratios

Since companies come in many sizes, it is often difficult to compare financial performance using raw accounting numbers. For example, it is difficult to know whether a company with $100 million in earnings is doing better than a company with $500 million in earnings without knowing the size each company. It is equally difficult to compare the stock price of different companies without knowing the total number of issued shares. To help with the interpretation of accounting numbers, financial analysts often use financial ratios.

There are a large number of financial ratios. Some are commonly used and others are rarely used. This section does not attempt to be comprehensive and address every obscure ratio that will occasionally be encountered. Rather, it focuses on the more commonly seen ratios.

Profitability ratios reflect how much money a company is making compared to some measure of company size. There are many different profitability ratios using different measures of profit for the numerator and different size measures for the denominator. Some of the more common profitability ratios are now presented:

$\text{Operating}\text{profit}\text{margin}=\frac{\text{Operating}\text{income}}{\text{Operating}\text{revenue}}$

Operating profit margin, often referred to as operating margin, is the average amount of profit made per sale considering all operating expenses. If operating margin is positive, the company is fundamentally profitable not considering nonoperational expenses such as interest payments, taxes, and other possible nonoperational items:

$\text{Net}\text{profit}\text{margin}=\frac{\text{Net}\text{income}}{\text{Total}\text{revenue}}$

Net profit margin, often referred to as net margin, is the average amount of profit made per sale considering all revenue sources and all expenses. Net margin represents the amount of profit that is left for common shareholders, and can be either kept as retained earnings or distributed as dividends. Net profit margin is best used to compare companies within the same industry. Some healthy companies can have very low net margins but very high revenues (e.g., Wal-Mart). Other healthy companies can have very high net margins but relatively low revenues (e.g., Rolex):

$\text{Return}\text{on}\text{assets}\left(\text{ROA}\right)=\frac{\text{Net}\text{income}}{\text{Assets}}$

Return on assets (ROA) is a measure of how effectively a company is utilizing its assets to generate profits for its shareholders. Since assets are a good measure of the overall amount that has been invested in a utility, ROA provides a good measure of profitability normalized by size. The problem with ROA is that it normalizes profits available for shareholders by investments made by both shareholders and lenders (recall that assets are equal to liabilities plus owner’s equity). Therefore, a highly leveraged company will have a relatively low ROA (since it has high interest payments), even though shareholder returns will be higher precisely due to this leverage. Because of this problem, ROA should be used with caution when comparing companies with differing capital structures:

$\text{Return on}\text{capital employed}\left(\text{ROCE}\right)=\frac{\text{EBIT}}{\text{Assets}-\text{Current}\text{liabilities}}$

Return on capital employed (ROCE, pronounced “Rocky”) is a measure of how efficiently a company is utilizing net invested capital to generate profits for all stakeholders (i.e., interest, taxes, and dividends). Of the ratios examined so far, ROCE is probably the best for comparing the profitability of different companies. It is somewhat insensitive to capital structure and tax situation, since it includes both interest payments and taxes in the numerator. It is also a good measure of capital efficiency, since the denominator subtracts current liabilities (which reduce capital requirements) from assets:

$\text{Return}\text{on}\text{equity}\left(\text{ROE}\right)\frac{\text{Net}\text{income}}{\text{Owner's}\text{equity}}$

Return on equity (ROE) is a measure of how efficiently a company is utilizing equity investments to generate profits for shareholders. It is the best measure of “bottom line” profitability for the book value of shareholder’s equity, which represents retained earnings plus the original paid-in capital from the issuance of common stock. It is important to remember that the market value of common stock (i.e., market capitalization) will be different from the book value of common stock:

$\text{Payout}\text{ratio}=\frac{\text{Dividend}\text{payments}}{\text{Net}\text{income}}$

Payout ratio is a measure of how much net income is distributed as dividends (the rest being kept as retained earnings). Companies that do not distribute any dividends will have a payout ratio of zero. Companies with a negative net income that still distribute dividends will have, confusingly, a negative payout ratio. Investors expect mature companies to have stable net incomes and stable payout ratios. Since the stock price of a company is based on expected future dividends, payout ratio is an important ratio that investors consider when valuing companies.

A common criticism of profitability ratios is that they are based on accounting values and not market values. Analysts and investors in agreement with this criticism tend to use market ratios, which are ratios based wholly or partly on values determined by the market:

$\text{Price-to-earnings}\left(\text{P/E}\right)=\frac{\text{Stock}\text{price}\times \text{Shares}}{\text{Net}\text{income}}$

Price-to-earnings (P/E, pronounced “P to E,” or “Pee Eee Ratio”) is a measure of how the share price of a stock compared to per-share earnings. Equivalently, it compares market capitalization (share price times shares outstanding) to net income. Price-to-earnings is one of the most important financial indicators of a company, especially when compared to industry peers. A high P/E indicates a high stock price, most likely due to strong financial performance and high earnings growth expectations. A low P/E indicates a low stock price, most likely due to weak financial performance and low earnings growth expectations. Low P/E ratios may indicate a bargain, since very low P/E stocks have historically outperformed very high P/E stocks:

$\text{Price-to-book}\left(\text{P/B}\right)=\frac{\text{Stock}\text{price}\times \text{Shares}}{\text{Owner's}\text{equity}}$

Price-to-book (P/B) is a measure of how market capitalization compares to owner’s equity as shown on the balance sheet. Market capitalization is equal to the trading price of common stock multiplied by shares outstanding. Owner’s equity is equal to paid-in capital plus retained earnings. A price-to-book ratio greater than one shows that the market values the company more than what investors have provided in equity:

$\text{Dividend}\text{yield}=\frac{\text{Dividends}}{\text{Stock}\text{price}\times \text{Shares}}\times 100\%$

Dividend yield is a measure of dividends per share compared to stock price. For example, if a company’s stock is trading at $50 per share and it distributes $5 per share in dividends, the dividend yield is 10%. Dividend yield is an important measure for mature companies with stable dividend payments. This is certainly true for utilities, where many utility stock owners count on dividend payments to supplement other sources of personal income:

$\text{Earnings}\text{per}\text{share}\left(\text{EPS}\right)=\frac{\text{Net}\text{income}}{\text{Number of common shares}}$

Earnings per share (EPS) is, as its name implies, the amount of net earnings divided by the number of outstanding common shares. Earnings per share is difficult to compare across companies since the number of common shares outstanding may not be proportional to company size. Regardless, it is common for earnings targets and earnings reports to be reported on a per-share basis. It is also common for earnings results to be stated relative to the target, such as “the utility beat its quarterly earnings target by two cents a share.”

22.6  Asset Management

Asset management is a business approach designed to align the management of asset-related spending to corporate goals. The objective is to make all infrastructure-related decisions according to a single set of stakeholder-driven criteria. The outcome is a set of spending decisions capable of delivering the greatest stakeholder value from the investment dollars available.

Asset management is a well-defined term that has a long history in the financial community. When an investment banker is asked about asset management services, the answer is very specific and will be similar to the following: financial asset management is a process to make financial investment decisions so that returns are maximized while satisfying risk tolerance and other investor requirements.

Power system assets are different from financial assets. They deteriorate with age. They require periodic inspection and maintenance. They are part of an integrated system. Once installed, they cannot easily be taken out of service and sold. The list goes on. With all of these differences, it is expected that power system asset management will not be identical to financial asset management, and will likely be more complicated. With this point in mind, the definition of power system asset management becomes the following:

Power system asset management—Making data-driven power system investment decisions so that life cycle costs are minimized while satisfying performance, risk tolerance, budget, and other operational requirements.

Stated simply, asset management is a corporate strategy that seeks to balance performance, cost, and risk. Achieving this balance requires the alignment of corporate goals, management decisions, and engineering decisions. It also requires the corporate culture, business processes, and information systems capable of making rigorous and consistent spending decisions based on asset-level data. The result is a multi-year investment plan that maximizes shareholder value while meeting all performance, cost, and risk constraints. With these points in mind, the goals of asset management become the following: (1) balance cost, performance, and risk; (2) align spending decisions with corporate objectives; and (3) base spending decisions on asset-level data.

It is becoming more common for asset management companies to separate the asset management function from asset ownership and asset operations. The asset owner is responsible for setting financial, technical, and risk criteria. The asset manager is responsible for translating these criteria into a multiyear asset plan. The asset service provider is responsible for executing these decisions and providing feedback on actual cost and benefits. This decoupled structure allows each asset function to have focus: owners on corporate strategy, asset managers on planning and budgeting, and service providers on operational excellence.

Asset management is also about process. Instead of a hierarchical organization where decisions and budgets follow the chain of command into functional silos, asset management is a single process that links asset owners, asset managers, and asset service providers in a manner that allows all spending decisions to be aligned with corporate objectives and supported by asset data.

A conceptual diagram of an asset management organization is shown in Figure 22.6. The center circle represents primary functions. The outer ring represents the asset management process that links the primary functions. The primary inputs for the asset manager are corporate objectives from the asset owner and data from the asset service provider. The asset manager is then responsible for developing a multi-year asset plan that is able to achieve all corporate objectives for the least life cycle cost. Once a plan is developed, the asset manager translates the short-term portion of the asset plan into a budget and work packages that are contracted out to the asset service provider.

FIGURE 22.6  Asset management structure.

FIGURE 22.7  Example asset management process.

Figure 22.7 shows a typical asset management system from an organizational process perspective. The asset manager is given high level goals and objectives from the asset owner. The asset manager then examines current and potential performance gaps, identifies an optimal long-term asset plan, creates budgets based on the short-term component of the long-term plan, and contracts with the service provider to perform the work.

In many ways, an asset manager is a hybrid engineer and businessperson. An asset manager is able to understand the business objectives of power systems and communicate with senior management using business language and business concepts. An asset manager is also able to understand the engineering issues of the power system and communicate with operational staff using engineering language and engineering concepts. An asset manager takes pride in spending as little as possible so that profits can be maximized. An asset manager also takes pride in good engineering solutions that result in the achievement of all technical performance objectives.

A large amount of spending decisions will always be made during everyday operations. It is therefore important for all power engineers to shift their mind-set and become familiar with basic business concepts and jargon. Asset managers will need to thoroughly learn these business skills and will apply them extensively. But in order to achieve the next level in business performance, all power engineers should learn the essentials of business and supplement their engineering prowess with business acumen.