Applying the DCF

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Applying the DCF

• Stephen G. Hill, C.R.R.A.
• Principal, Hill Associates
• Society of Utility and Regulatory Financial
  Analysts
• 38th Annual Financial Forum
• April 27-28, 2006

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Applying the DCF

• DCF Milestones
• Sample Group Selection
• Dividend Yield Calculation
• Growth Rate Estimate
• Are Flotation Costs Necessary?
• Does the DCF Have Problems When Market Prices
  are Different From Book?

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Applying the DCF
DCF MILESTONES

• Pre-history Discounting Cash Flows/Compound
  Interest/Bond Valuation
• 1938 Williams, J. B., The Theory of Investment
  Value, North-Holland Publishing Company,
  Amsterdam.
• 1956 Gordon, M., Shapiro, E., Capital Equipment
  Analysis The Required Rate of Profit,
  Management Science, (October), pp. 102-110.
• 1962 Gordon, M., The Investment, Financing and
  Valuation of the Corporation, Richard Irwin,
  Inc., Homewood, IL.
• 1966 DCF first presented by Gordon at F.C.C. in
  ATT rate proceeding.
• 1974 Gordon, M., The Cost of Capital to a Public
  Utility, MSU Public Utility Studies, East
  Lansing, MI. brsvlong-term sustainable growth
• 1985-1990 F.E.R.C. Generic ROE Rulemaking
  Proceedings, selects DCF as primary indicator of
  equity capital costs k d(10.5g)/P g
• 1984 Morin, R., Utilities Cost of Capital,
  Public Utilities Reports, Arlington, VA M/Blt1.0,
  no problems with DCF
• 1994 Morin, R., Regulatory Finance, Utilities
  Cost of Capital, Public Utilities Reports,
  Arlington, VA M/Bgt1.0, problems with DCF

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Applying the DCF
SAMPLE GROUP

• Select a sample group of utilities with similar
  characteristics. (more is better)
• A DCF analysis of only one company does not
  provide a reliable estimate of the cost of
  equity.
• A DCF analysis of a large group of companies that
  have different risk profiles will also not
  provide a reliable estimate of the cost of
  equity.
• Important characteristics percent of regulated
  operations, bond ratings, fuel mix (electrics),
  stable operations, no dividend cuts.

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Applying the DCF

• DIVIDEND YIELD CALCULATION
• D1 Next Period Dividend.
• Dividends paid quarterly, so relevant period is
  next quarter. (Gordon, 1974, p. 81)
• If dividends have been traditionally increased in
  next quarter, then D1 d0(1g) x 4 if not,
  then, D1 d0 x 4.
• FERC ROE hearings, Generic adjustment
  d0(11/2g), quarterly compounding unnecessary.
• Stock price most recent 30-day closing average.
• Check dividend yield result with Value Line
  year-ahead dividend yield projections. (Selection
  Index)

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Applying the DCF

• GROWTH RATE ESTIMATION
• Use Sustainable Growth (b x r) as a basis.
• Review b x r growth rate trends, past 5 years
  and projected 3-to-5 years. Check for growth rate
  anomalies, look behind numbers.
• Study both 5-year historical and projected growth
  in earnings (many sources), dividends and book
  value (Value Line).
• Use centrality of data and judgment to arrive at
  a reasonable expectation for sustainable (b x r)
  growth based on available evidence.
• Estimate investor-expected growth in number of
  shares outstanding (s).
• v 1 - M/B. (fraction of new issue that
  increases expected growth)
• Compare combined (brsv) growth rate estimate to
  published data.

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Applying the DCF

• Flotation Costs
• Vast majority of flotation costs contained in
  underwriters expenses, which are not out of
  pocket expenses for the utility.
• Primary market investor (brokerage firms), savvy
  and aware of fact that certain portion of
  proceeds do not go to company.
• Stock issuances with MgtgtB, increase equity
  values.
• Similarity to bond issuance expenses - when bond
  price is above face value, then cost adjustment
  is negative not positive.
• Secondary market transaction costs offset
  flotation costs.
• Explicit flotation cost adjustment is unnecessary.

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Applying the DCF

• DCF Problems Arising in the 1990s
• DCF understates cost of equity when market price
  are above book value.
• DCF should be adjusted upward to account for
  financial risk differences that exist between
  market value capital structure and book value
  capital structure.
• These two are really the same argument.

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Applying the DCF
CLAIM DCF DEFFICIENT WHEN MARKET PRICE ? BOOK
VALUE
Situation 1 Situation 2 Situation 3
1 Initial Purchase Price 25.00 50.00 100.00
2 Initial Book Value 50.00 50.00 50.00
3 Initial M/B 0.50 1.00 2.00
4 DCF Return 1055 10.00 10.00 10.00
5 Dollar Return 5.00 5.00 5.00
6 Dollar Dividends 5 Yld 1.25 2.50 5.00
7 Dollar Growth 5 Gro 3.75 2.50 0.00
8 Market Return 20.00 10.00 5.00
SOURCE Morin 1994, p. 237
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Applying the DCF
CLAIM WHEN M?B, LEVERAGE ADJUSTMENT NECESSARY

• There is no support in the financial literature
  for the comparison of market-value and book-value
  capital structures. (MM, Gordon)
• One firm cannot have two levels of financial
  risk.
• True financial risk resides in the income
  statement, and is a function of the actual amount
  of interest expense a firm pays and its income
  volatility.
• Market-value and book-value capital structures
  are two different ways to measure financial
  riskmeaningful only when compared to other
  capital structures measured in the same way
  M-to-M or B-to-B
• 1 foot 12 inches 30.48 cm. Different
  numbers/same length.
• MgtgtB indicates utility is expected to earn a
  return that exceeds its cost of capital (Gordon).
  Leverage adjustment increases as M/B
  increases-circularity problem.
• Utility rates set on book value capital structure
  near-universal practice, investors aware of that
  long-term practice (efficient markets).
• Utility industry has been able to raise adequate
  capital with rates set on book-value capital
  structures, no leverage adjustment necessary.

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Applying the DCF

• DCF is a simple algebraic approximation of a
  complex real-world phenomenon (investor
  expectations). Use other models for support.
• DCF provides the most reliable estimate of the
  cost of equity capital, has earned near-universal
  acceptance because of that fact.
• DCF provides reliable estimates of the cost of
  equity regardless of the market-to-book ratio.

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Applying the DCF

• Stephen G. Hill, C.R.R.A.
• Principal, Hill Associates
• Society of Utility and Regulatory Financial
  Analysts
• 38th Annual Financial Forum
• April 27-28, 2006