Applying the DCF

1. 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

2. 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?

3. 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 AT&T rate proceeding. • 1974 Gordon, M., The Cost of Capital to a Public Utility, MSU Public Utility Studies, East Lansing, MI. [br+sv=long-term sustainable growth] • 1985-1990 F.E.R.C. Generic ROE Rulemaking Proceedings, selects DCF as primary indicator of equity capital costs [k = d(1+0.5g)/P + g] • 1984 Morin, R., Utilities’ Cost of Capital, Public Utilities Reports, Arlington, VA [M/B<1.0, no problems with DCF] • 1994 Morin, R., Regulatory Finance, Utilities’ Cost of Capital, Public Utilities Reports, Arlington, VA [M/B>1.0, “problems” with DCF]

4. 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.

6. 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(1+g) x 4; if not, then, D1 = d0 x 4. • FERC ROE hearings, Generic adjustment: d0(1+1/2g), 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)

7. 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 (br+sv) growth rate estimate to published data.

10. 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 M>>B, 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.

11. 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.

12. Applying the DCF CLAIM: DCF “DEFFICIENT” WHEN MARKET PRICE ≠ BOOK VALUE SOURCE: Morin 1994, p. 237

14. 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 risk—meaningful 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. • M>>B 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.

16. 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.

17. 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