Simple valuation of electric utilities – a comparison of the residual income model and a real options approach

Since deregulation of the energy market in Norway, there has been a number of mergers and acquisitions of electric utilities. In all these transactions, the companies have been valued. Many of the transactions have sparked significant controversy (by politicians, consultants and others) who claim that the companies have been sold too cheaply, especially concerning hydropower generating companies. How can business valuation of these enterprises be explained? Real option theory is, in this study, applied in order to explain the value beyond a traditional approach. The residual income model proposed by Feltham and Ohlson (1995) is considered.
The empirical analysis shows that an enhancement in explanatory power of 100% is brought about through the introduction of independent variables based on real option theory. This supports the use of real options in helping to explain values in this industry