10. Return on Equity and Market to Book Ratio

DRA cites a Harvard Business School case study entitled "A Note on Value Drivers": "For a given industry, more profitable firms-those able to generate higher returns per dollar of equity-should have higher market-to-book ratios. Conversely, firms which are unable to generate returns in excess of their cost of equity should sell for less than book value."

DRA performed a regression study between estimated return on equity and market-to-book ratios using natural gas distribution, electric utility, and water utility companies. DRA used all companies in these three industries which are covered by Value Line and that have estimated return on equity and market-to-book ratio data. (Exhibit DRA-1, Panels A-C of Attachment JRW-6.) The average R-squares for the electric, gas, and water companies are 0.65, 0.60, and 0.92.³⁰ DRA argues that its study demonstrates the strong positive relationship between the return on equity and market-to-book ratios for public utilities.

We do not find this analysis helpful to quantify the reasonable return on equity now.

10.1. Utility Investment Risk Compared to Other Industries

DRA argues that due to the essential nature of their service as well as their regulated status, public utilities are exposed to less business risk than non-regulated businesses. The relatively low business risk allows public utilities to meet much of their capital requirements through borrowing in the financial markets, thereby incurring greater than average financial risk. (This is a liquidity risk-having the cash flow to timely pay interest and refund debt.) Nonetheless, the overall investment risk of public utilities is below most other industries because of the stable stream of revenues in a regulated environment.

Exhibit DRA-1, Attachment JRW-8 provides DRA's assessment of investment risk for 100 industries as measured by beta, which according to modern capital market theory is the only relevant measure of investment risk. DRA argues that the study shows the investment risk of water utility and gas distribution companies is very low. The average beta for water companies is 0.86 and for gas distribution companies is 0.69. These figures rank these two industries in the bottom 10 percent of the 100 industries related to investment risk and well below the Value Line average of 1.19. Therefore, DRA concludes the cost of equity for water utility and gas distribution companies should reflect this low level of risk.

We tend to agree to the extent that the protections afforded a regulated monopoly service provider should lower liquidity risks and hence the investment risk generally. While DRA may be able to provide indications of these reductions of risk, those indicators do not translate into quantifiable adjustments to a market return on equity.

³⁰ R-square measures the percentage of variation in one variable (e.g., market-to-book ratios) explained by another variable (e.g., expected return on equity). R-squares vary between zero and 1.0, with values closer to 1.0 indicating a higher relationship between two variables.