The time-honored discounted cash flow method for determining appropriate utility returns falls short when interest rates are low. Inadequate ROEs ultimately increase cost of capital and wipe away...
Volatile markets call for alternative financial models.
equity of a firm, and suggests that the expected returns increase linearly with a security’s risks. The risks are measured in the form of equity beta, which is the change in the price of a stock compared to change in the appropriate stock market index, such as the S&P index or the NYSE Composite Index. Beta is a measure of the company’s market risk (both business risks and financial risks) and is directly observed from the historically-traded stock prices of the firm in relation to the broader market. A beta of 1.0 signifies that stock is as risky as the market. The expected return on equity is a forward-looking approach, so accordingly forward-looking beta estimates include a factor called the “Blume adjustment,” which assumes that over time, betas tend to move towards the average market beta, which is 1.0.
The general methodological approach is relatively standard. First, equity beta estimates for each of the comparable companies are developed. The equity betas are then un-levered to strip out the financial risk and calculate the pure business risk of the firm. This is accomplished by using an approach called the “Hamada equation,” with an adjustment for the riskiness of debt for the merchant sector. The un-levered or asset beta are then unlevered at the target debt-to-equity ratio to determine the re-levered equity beta of the comparable merchant class of companies. As a final step, the CAPM is used to develop the expected equity returns.
In addition to these adjustments from the risk-free rates and the expected market-risk premium, it’s important to consider a size premium, since the CAPM doesn’t capture the difference in market risk between smaller and larger firms, particularly for merchants. With the recent crisis, the average size of merchants has fallen to roughly $3.5 billion to $4 billion in market capitalization. Research conducted by the Center of Research in Security Prices (CRSP) at the University of Chicago indicates that even after adjusting for the market risks of small stocks, they outperform large stocks. 3 Hence, the addition of a size premium to the CAPM cost of equity is reasonable. This adjustment is in the range of 60 to 100 bps and is based on size premium studies conducted by the CRSP.
• DCF Methodology : The main principle behind this methodology is that when investors price assets, they’re implicitly indicating their expected return. Thus, a reduction in stock prices would mean increased expected equity returns. Recent historical averages of the market prices of equity in conjunction with expected cash flows have been used to yield an estimate of the cost of equity.
For utilities, the expected cash flows come in the form of dividends. A two-stage dividend discount model is chosen for both periods of interest—the pre-crisis period and recent post-crisis period. The first stage is modeled as explicit cash flow for a number of years and accounts for growth phase (low growth or high growth based on economic outlook), while the second-stage model assumes stable long-term growth in perpetuity.
For the merchants, a free cash flow to equity (FCFE) model