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# THE DCF METHODOLOGY - PowerPoint PPT Presentation

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

• 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

• Easy to understand and use

• Company specific information

• Data required is readily available

• Recognizes the time value of money and is forward-looking

• 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

• 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.

• 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”

• 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%)

• 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.

• 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.

• The most CONTROVERSIAL part of the DCF

• 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.

• Example:

Analyst derived information:

• Quarterly Div. - \$0.25

• 13 week average price – \$25

• Annual growth rate – 5%

• k = D1/P0 + g

k = 1.05/25 + .05

k = 9.2%

• 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.

• 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!

Johnny Brown

Arkansas Public Service Commission

501-682-5743

johnny_brown@psc.state.ar.us