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Perspective

It is hard tyo foresee abandoning the discounted cash flow method relied upon so heavily for the past couple of decades.
Fortnightly Magazine - May 15 2003
  • company DCF calculations; and
  • It makes use of company growth projections from disinterested industry analysts-a key attribute for a method to gauge the opportunity cost of capital in the mind of investors. 3

It is difficult to overstate the practical importance of these three attributes of the DCF method. The CAPM, by comparison, is abstruse as a piece of theory. Further, because most of the components of the calculation are common to all companies (i.e., the risk-free rate and the market risk premium), the CAPM cannot make use of the law of large numbers. That is to say, the problems associated with which risk-free rate to pick, or which market risk premium to adopt, hinder the result, no matter how many companies the calculations are performed upon. Finally, the CAPM has no tie to disinterested company analysts that not only reflect, but also shape, the opinions of investors. It is thus no surprise that the CAPM is vastly less popular among U.S. regulatory commissions as a rate of return method.

The other methods mentioned by Lesser have more debilitating attributes still. The comparable earnings method is generally irrelevant to investor expectations, to the extent that is uses historical earnings data. Risk premium analyses take the cost of debt as given (easy to do, as debt costs are observable), but struggle perpetually with how to calculate the equity risk premium. To the extent that the equity risk premium uses historical data, it is again generally irrelevant to investor expectations. If it derives the premium by reference to a prospective cost of capital method (like the DCF or CAPM), then it is simply not an independent method at all.

In the context of U.S. rate cases, the DCF method's attributes are magnified, as are the drawbacks of the other methods. The nature of the methods to resolve disputes in U.S. utility rate cases is at least as important as the theoretical attributes of the particular methods employed. "Informationally demanding" methods, like the CAPM, do not stand a chance as a method for resolving conflict between contending parties compared to the "informationally simple" methods, with tangible parameters, like the DCF.

As a result, Lesser's "more methods" recommendation is a dead end. He is correct to point out the greater variability in estimates now than in years past. Mergers, the advent of holding companies, and deregulation all have served to shrink the number of companies to which the DCF analysis can be applied. Nevertheless, the marginal reduction in proxy group size or stability in the past decade does not countervail the three underlying reasons why the DCF is so popular.

Perhaps the best way to deal with the perpetual contention surrounding the rate of return is not to repudiate the overwhelmingly preferred DCF method or pretend that more methods and more investigation might work, but rather to shrink the scope for contention surrounding the issue.

Reducing Rate of Return Conflicts

One tried and tested method to reduce rate of return contention is to turn to alternative regulatory frameworks that either eliminate the need to set the