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Business & Money

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

three years as the overall stock market bubble deflated. Meanwhile, on the debt side of the ledger, the basis point spread between corporate bonds and long-term Treasuries also increased, as shown in Figure 2 (p. 16). By the end of 2002, the basis point spread between AAA-rated corporate bonds and 10-year Treasuries was double the spread at the end of 1990, and the spread between BAA-rated corporate bonds and 10-year treasuries was more than 50 percent higher.

A more recent development has been the practice by some energy companies to shift their financial burdens brought on by losses from forays into unregulated, and sometimes unrelated, activities onto their utility subsidiaries, further increasing the financial risks on those subsidiaries. And, with significant amounts of corporate debt coming due-more than $25 billion in 2003 alone-energy companies are increasingly turning to higher-cost sources of funds. 2 In response to utilities' worsening balance sheets, bond rating agencies have downgraded many of those utilities' corporate bond ratings to junk bond levels, further increasing the risks borne by utility investors.

Volatility of DCF Estimates: The Ghost in the Machine

With all of these events, standard DCF calculations are affected in a number of ways. First, as stock price volatility increases, so does the volatility of the calculated dividend yield. Assuming the earnings growth rate was known with certainty, the volatility of the overall cost of equity estimated using the DCF would be the same as the volatility of the dividend yield. If one interpreted the efficient market hypothesis (EMH) strictly and used a single day's closing stock price to calculate the cost of equity, then the utility could be subject to dramatic swings in its allowed return. To see this, consider the following example.

A utility plans to file a rate case sometime this year. Suppose a utility's stock price currently has an estimated annual volatility of 35 percent, just under the average of the annual volatilities for the Electric Utility East companies in Table 1 (p. 18). Suppose the price of the stock is $20 today and that the dividend is $1.00 annually. The current dividend yield (D0/P0) is thus 5 percent. If its projected earnings growth is 5 percent per year, the utility's calculated cost of equity will equal 10 percent.

Given the utility stock's volatility and current price, the probability distribution of the stock price will look like that shown in Graph 1. 3 This probability distribution is assumed to be lognormal-the same assumption that underlies much of financial options theory, such as the Black-Scholes option pricing model. Assuming the constant earnings growth rate of 5 percent, the volatility in the stock price will cause the cost of equity (COE) to have the same overall probability distribution when calculated using the DCF, as shown in Graph 2.

The thing to notice in Graph 2 is the large potential variation in the COE, given the volatility of the utility's stock price over the year. The COE ranges between 7.5 percent and 19 percent. Thus, applying the DCF based on one day's stock price would imply a