Utility business models: The role of investor value

In the ongoing discussions of the changing utility industry landscape, the term business model is frequently heard, but unfortunately rarely defined in an explicit way. Statements such as “utilities need new business models” therefore ring hollow.

The management literature suggests that a business model must:

• Identify customers.
• Determine what customers value.
• Describe how the firm will generate revenue providing the products and services customers want or need.
• Explain how that revenue can be generated efficiently.

Sources: Drucker, P. (1994). The theory of business. Harvard Business Review. Magretta, J. (2002). Why business models matter. Harvard Business Review.

We must be clear as to what it means to generate revenue efficiently. In a financial sense, the economic purpose of an investor-owned business is ultimately not merely about producing revenues or even profits. Those items are necessary, but not sufficient. Focusing on either as the key item of interest is ill-advised. As Brealey, Myers, and Allen, (2006), bluntly put it in Principles of Corporate Finance: “Profit maximization makes no sense as a corporate objective.” Revenue or market share maximization are equally nonsensical objectives. See Ross, Westerfield, and Jordan (1990), Fundamentals of Corporate Finance.

Stock prices are driven by changes in economic value, not necessarily by changes in revenues or profits. In many cases increasing both revenue and profit can destroy economic value for the firm’s investors. The same holds for increases in market share. We look to the valuation literature to find the notion of economic value creation. The opening sentence of the McKinsey valuation group’s (Koller, Goedhart, and Wessels, 2015) Valuation: Measuring and Managing the Value of Companies sets forth the overarching directive:

The guiding principle of business value creation is a refreshingly simple construct: companies that grow and earn a return on capital that exceeds their cost of capital create value…when managers, boards of directors, and investors have forgotten it [this principle], the consequences have been disastrous.

The question then is not whether the firm can sell a product or service that customers want, which would create revenue, or even whether it can earn a profit on the sales of such products or services, but whether in so doing it can earn a profit that exceeds that which investors require. If a firm earns a 10% return on the capital required to provide new products or services, the more it can increase its sales of those new items the more its profits will grow. But if investors require that same 10% return on that capital, no matter how much the company’s profits then grow, there is no value created for investors. And if the company is publicly-traded, such growth, while profit enhancing, will affect neither the firm’s economic value nor its per-share stock price. Koller, Goedhart, and Wessels point out that if the firm earns returns that are positive, but lower than that which investors require, growth can simultaneously increase the firm’s profits and decrease its stock price.

The ability of a firm to earn returns on new products or services, and the returns that investors require on the capital necessary to provide those items, are both affected by the risk associated with the new activities. This suggests that a business model developed without a thorough risk analysis has a significant potential of failing to create investor value. If utilities cannot create value for their investors, from an economic perspective they should consider whether it is reasonable to proceed with new business models.

That said, there may be cases, especially for a public utility, where such offerings meet societal needs even though they do not create economic value for investors. They might be offered with such an understanding, but that should then be an explicit aspect associated with the new business model.

Would you like to continue this conversation? Contact Steve Kihm, principal and chief economist.

Steve Kihm focuses on utility strategy and corporate finance. He is also Senior Fellow at Michigan State University’s Institute of Public Utilities. He has published articles in the Journal of Applied Corporate Finance and the Energy Law Journal and is co-author of Risk Principles for Public Utility Regulators. He holds a doctorate in business administration (finance and management) from the University of Wisconsin-Whitewater and is a Chartered Financial Analyst.