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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


Johnny Brown, CRRA

Senior Financial Analyst

Arkansas Public Service Commission

Little Rock, Arkansas

  • 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


  • 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