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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


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Outline

  • What is the DCF?

  • Strengths & Weaknesses

  • How do I use the model?

  • New Twists


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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


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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


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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


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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.


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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”


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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%)


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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.


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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.


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Derivation of “g”

  • The most CONTROVERSIAL part of the DCF


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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.


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DCF Method

  • Example:

    Analyst derived information:

  • Quarterly Div. - $0.25

  • 13 week average price – $25

  • Annual growth rate – 5%


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DCF Method

  • k = D1/P0 + g

    k = 1.05/25 + .05

    k = 9.2%


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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.


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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.


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Growth in Dividends is the key!

Johnny Brown

Arkansas Public Service Commission

501-682-5743

johnny_brown@psc.state.ar.us