In a bid to secure growth, utility companies have been frantically buying generation capacity, distribution networks, and customer franchises in Europe’s deregulating markets, often paying extraordinary amounts of money in the process. Strategic value is cited: the strengthening of geographic position, fast entry into a new market, or access to end customers. But it is difficult to see how this kind of strategic value can amount to more than 100 percent of the fundamental value of the underlying assets—the price some have paid.

In eight recent deals for German local utilities, the average price paid per customer was about €2,200 ($1,950). Yet McKinsey’s best estimate of the value of such a customer is €900 to €1,400 (Exhibit 1, part 1). Buyers of pure retail customers in the United Kingdom have paid, on average, €330 each, as against McKinsey’s estimate of €120 to €170 in customer value—if the retailer manages to sell not only electricity but also some natural gas and telecom services (Exhibit 1, part 2). More modest premiums are being paid for generation: recent acquisition prices in Europe have averaged €700 per kilowatt of installed capacity, as against an investment cost of €450 to €500 per kilowatt for a new combined-cycle gas turbine (CCGT) plant, now the norm for new facilities (Exhibit 2).

Such is the value that companies are placing on fast entry into the market or other strategic considerations. But these prices also reflect supply and demand: with limited opportunities to grow and huge amounts of investment money looking for a home, the value of assets is bound to soar. We believe that asset prices in liberalizing utility markets follow a pattern (Exhibit 3). Understanding it should help companies make smarter purchases.

A liberalizing market attracts local and foreign interest, and the price of available assets rises quickly. In this first stage, both generators and retailers tend to enjoy comfortable profit margins, and regulators rely on new entrants rather than heavy-handed intervention to create competition. These favorable conditions encourage optimism among asset buyers, and as fewer and fewer assets become available, prices reach a peak.

In the second stage, competition among players takes root, and the regulator reassesses the market. As competition intensifies and regulatory scrutiny tightens, the outlook deteriorates. Some players, deciding that committing themselves to the market during the early phase of liberalization was a mistake, put assets up for sale. But with uncertainty rife, there are few buyers. Asset prices plummet—if not below their fundamental value, at least to more reasonable levels. Exhibit 4 shows how asset prices behaved in both these stages in the United Kingdom and Sweden, the two European markets with the longest history of liberalization.

In the third stage, companies in the market try to improve their position: they actively manage the regulator, strive for consolidation, and reduce capacity. These measures may not be enough to make the market attractive, but they at least protect existing investments. From this point forward in the pattern, asset prices behave as they do in other commodity markets; that is, they are driven by changes in fundamentals (such as commodity prices and margins) as well as by the supply of and demand for the assets themselves.

What can strategists operating in liberalizing markets learn from all this? Clearly, many structural features—including capacity margins, growth in demand, the cost and type of installed capacity, and barriers to new entry—differ substantially among markets and will influence asset prices.

But there are some generic lessons too. The first is the need to recognize the frequently negative impact of deregulation and to factor that impact into realistic asset valuations. Then, where possible, assess where you are in the asset supply-and-demand cycle in order to better scrutinize the value of buying at prevailing asset prices. If the demand for assets appears to be overheated, wait until market conditions are less favorable for the sellers. Finally, exploit the willingness of others to pay over the odds to enter. If you own assets that could go for exorbitant prices, cash in on them.

Predicting asset prices accurately in uncertain markets may not be possible, but observing the pattern of asset supply and demand is critical to making sound judgments about the right price to pay.