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THE DCF METHODOLOGY. Johnny Brown, CRRA Senior Financial Analyst Arkansas Public Service Commission Little Rock, Arkansas. Outline. What is the DCF? Strengths & Weaknesses How do I use the model? New Twists. What is the DCF?. The model came about as the Dividend Discount Model.

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the dcf methodology

THE DCF METHODOLOGY

Johnny Brown, CRRA

Senior Financial Analyst

Arkansas Public Service Commission

Little Rock, Arkansas

outline
Outline
  • What is the DCF?
  • Strengths & Weaknesses
  • How do I use the model?
  • New Twists
what is the dcf
What is the DCF?
  • The model came about as the Dividend Discount Model.
  • P0 = D1/(1+k)1+…Dn/(1+k)n
  • Myron Gordon developed the model we know as the DCF Model.
  • k = D1/P0 + g
strengths of the dcf
Strengths of the DCF
  • Easy to understand and use
  • Company specific information
  • Data required is readily available
  • Most wide-spread regulatory acceptance
  • Recognizes the time value of money and is forward-looking
weaknesses of the dcf
Weaknesses of the DCF
  • Assumptions – don’t generally hold up in a technical sense
  • Growth rate to use is uncertain
  • Analyst growth forecasts are short-term/DCF is long-term
  • Sometimes difficult to match growth with the yield component
  • Efficient Market Hypothesis is not universally accepted
putting the model together
Putting the Model Together
  • k = D1/P0 + g
  • The analyst must provide the components on the right side of the equation to solve for “k”.
  • Match the right side with investor’s expectations.
  • Each component is highly scrutinized by other witnesses.
  • The result is an accurate measurement of the cost of equity.
derivation of d
Derivation of “D”
  • The dividend component is probably the least debated part of the DCF equation.
  • The dividend should not be influenced by short-term anomalies.
  • D1 = Annualized dividend at time period 1

or

  • D1= quarterly dividend multiplied by four (D0) and grossed up by the annual growth rate, “g”
derivation of d1
Derivation of “D”
  • Example:

Quarterly dividend = $.50

D0 would equal $2.00 (.50 x 4 = 2)

D1 would equal $2.10 (2.00 x (1+g); g=5%)

derivation of p
Derivation of “P”
  • The price should also not be influenced by short-term anomalies.
  • The price should be taken from the same time period as the dividend and growth data.
  • Doing so should account for investors’ perception of the company’s risk and return prospects.
derivation of p1
Derivation of “P”
  • I like to use an average of a recent time period – average of 13 weekly price points
  • 13 weeks = 1 quarter
  • Most analyst growth projections are published quarterly.
derivation of g
Derivation of “g”
  • The most CONTROVERSIAL part of the DCF
derivation of g1
Derivation of “g”
  • Forward looking – but influenced by historical growth information
  • Utility industry is mature and slow growing
  • Remember – you are measuring long-term sustainable growth in dividends.
dcf method
DCF Method
  • Example:

Analyst derived information:

  • Quarterly Div. - $0.25
  • 13 week average price – $25
  • Annual growth rate – 5%
dcf method1
DCF Method
  • k = D1/P0 + g

k = 1.05/25 + .05

k = 9.2%

new twists
New Twists
  • Title of panel is New Twists on DCF – my presentation doesn’t jibe.
  • That’s my point – if it ain’t broke don’t fix it.
market to book value adjustment
Market to Book Value Adjustment
  • Not necessary – allows for over recovery
  • For a regulated utility – a market price above one indicates investors expect returns above what is required.
  • Why else would they be willing to pay above book value for their investment?
  • The fact that most regulators only allow utilities a return based on book value rate base is widely known by investors.
growth in dividends is the key

Growth in Dividends is the key!

Johnny Brown

Arkansas Public Service Commission

501-682-5743

johnny_brown@psc.state.ar.us