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Business & Money

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

the 65 electric and natural gas utilities shown in Table 1, the average ratio of the low-to-high spread in earnings growth to mean earnings growth is 1.1. That is, the spread in the earnings estimates is greater than the average estimates themselves. Additionally, while one might expect that Western electric utilities would have greater earnings uncertainty than either Central or Eastern utilities because of the California restructuring meltdown, this is not the case. In fact, earnings-growth- estimate volatility for Western electric utilities was the lowest, on average, of the three categories. Gas distribution utilities have, on average, less uncertainty in their earnings growth forecasts than do electric utilities. That is not unexpected, since the gas industry has experienced relatively less instability than the electric industry.

Some Possible Solutions to The DCF Conundrum

There are a number of potential solutions to the problem of volatile DCF estimates. While abandoning the DCF might come to mind, that raises the question of what to replace it with.

No single methodology can ever provide the "correct" rate of return, because market conditions change much faster than regulators act. Moreover, the allowed rate of return ultimately decided upon by regulators will almost always encompass more than just investment efficiency; it will also incorporate equity concerns, judgments about a utility's management capability, corrections for past "wrongs," and even political calculations. 6

First, and foremost, the cost of equity should be determined in consideration of overall market trends, not just a snapshot of current conditions. While the EMH states that today's stock price reflects all expectations about the future, those expectations can change quickly. The more volatile a utility's stock price, the less likely current market expectations will reflect longer-term financial realities going forward. Thus, one approach is to examine the nature of stock price volatility and earnings growth uncertainty. Is there increasing seasonality of earnings? Has the stock price been trending downward or upward, especially in comparison with broader market trends? Performing regression analysis can help determine whether real trends exist and, depending on the results of the analysis, influence the allowed rate of return. It's also important to understand that examining trends is not the same thing as just selecting average values, whether the "average" stock price or the "average" of the analysts' earnings growth forecast.

Using the DCF with other methodologies is another solution. More importantly, however, is examining the differences in the results produced and the causes of those differences. If a DCF analysis determines a cost of equity of 12 percent, while the CAPM determines 8 percent, the risk premium 13 percent, and the comparable earnings approach 9 percent, the "correct" cost of equity, at least from the standpoint of the "commensurate" risk standard set out in the Supreme Court's 1944 decision is unlikely to be the simple average of all four methods.

Finally, automatic adjustment mechanisms that change the allowed rate of return based on financial market conditions should be considered. Besides being responsive to the increasing volatility in those markets, such mechanisms can overcome the problem of regulatory lag. Of course, as