Inside Out

By peston, robert | Management Today, June 2001 | Go to article overview

Inside Out


peston, robert, Management Today


At Quest, the online service for fund managers that I'm helping to develop, we run a simple quality check on every European blue-chip company. We calculate the cash it has earned on the money invested over the previous 10 years. And we look at whether its capital base is growing or shrinking. This is the simplest and best way of determining whether it can be trusted to employ shareholders' money wisely.

A company that consistently earns positive cashflow returns in excess of the cost of financing the business is, by definition, a good company. And if it does that at the same time as investing to grow, then it is a great company. Meanwhile, any company earning less than its cost of capital is rotten.

This is common sense. And if you are a follower of free-market fundamentalism, you would believe that all incremental capital would go to good companies and that the bad ones would be starved of investment funds.

Yet global capitalism does not work like that. Time and again, good money is thrown after bad. The airline industry, for example, is filled with mediocre companies that have never made a reasonable return, and yet investors continue to provide them with incremental financial resources to waste.

Now, an example of a really terrible company is E.ON, the German utility giant. Over the past 10 years it has never earned a return even close to its cost of capital (it would be more accurate to say this is true of Veba and Viag, which merged to form E.ON in 1999). In fact, during the past decade it has actually lost money in aggregate on a capital base that has grown by billions of euros - quite a feat.

By contrast, Powergen in the UK is a pretty good business. It has earned an 8% return over the past decade and beaten its cost-of-capital almost every year - all in the context of a tough regulatory climate.

In a rational world, therefore, Powergen would be taking over E.ON. The UK business' aggressive management should be going over to Germany, closing down its loss-makers and pruning its overheads. But the reverse is happening: E.ON is buying Powergen for Eu8.2 billion ([pound]5.2 billion).

How has this happened? The simple answer is that E.ON is an enormous company, with a market value of Eu56 billion and an estimated Eu50 billion of resources earmarked for acquisitions. Even after buying Powergen, it would have enough funds to buy the UK's biggest water business, United Utilities, its biggest gas company, Centrica, and its biggest electricity company, ScottishPower, and still have a few billion euros left in change. …

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