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Business & Money

Today's volatile markets upset the discounted cash flow model, and others.
Fortnightly Magazine - February 15 2003

DCF Utility Valuation: Still the Gold Standard?



Today's volatile markets upset the discounted cash flow model, and others.

First used in the mid-1960s by ratepayer advocates, the discounted cash flow (DCF) method has become the most common approach used to estimate the cost of equity capital for utilities and, hence, allowed returns. Past surveys of regulators have shown a strong preference for the DCF-exclusively so for some state utility commissions, and in conjunction with alternative methods at others. 1 Perhaps such reliance was appropriate in the past, when regulated utility stocks provided "widow and orphan" stability.

But with the restructuring meltdown in California, widespread electric and gas trading fraud, and the broader market accounting scandals, new risk has been injected into energy and financial markets. That risk has been translated into greater price volatility, not only of electricity and gas, but also for regulated utility stocks, which have lost their historic price stability. Unfortunately, of all the "typical" methods used to estimate utilities' cost of equity-DCF, the capital asset pricing model (CAPM), risk premium (RP), and comparable earnings (CE)-the DCF method is, arguably, the most sensitive to short-term market volatility. And, as more utilities reduce or even eliminate dividend payments, the applicability of the DCF method becomes more limited. This does not bode well for primary (or, worse, exclusive) reliance on the DCF unless and until capital and energy markets are more stable. But in the meantime, and in consideration of these new risks, perhaps it is time to rethink the reliance on the DCF method as the of the cost of capital world.

The DCF Today: Crumbling At Its Foundation?

The DCF's popularity, at least in part, stems from its straightforward nature. However, little attention appears to have been paid to the volatility of the cost of equity estimates derived using the DCF, and the potentially adverse financial impacts that can stem from it. While that may have been appropriate in a stable pre-restructuring world, it is not appropriate today, for a number of reasons. First, utility stock price volatility has increased significantly. Second, the volatility of utility earnings has also increased, making predictions about future earnings growth far more uncertain. Third, restructuring ripped apart the electric industry, including a spate of mergers and acquisitions, forced divestitures, the still-unfinished saga of California, and controversies over price manipulation in gas and electric wholesale markets. The reverberations from all of these continue today, and the ultimate structure of the industry remains unclear. Add to that the stock market's plunge and looming threats of war, and the stable foundations upon which the DCF rests begin to crumble.

One way to illustrate the much higher volatility of utility stocks is to consider the Dow Jones Index of 15 utilities. Although the specific utilities composing this index have changed over time, it still provides a useful snapshot of volatility, as shown in Figure 1.

As Figure 1 (p. 16) shows, the annualized volatility of the Dow Jones Index of 15 utilities remained fairly constant between 1990 and 1999, but increased dramatically during the last