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Rethinking ROE

Rational estimates lead to reasonable valuations.

Fortnightly Magazine - August 2011

relationship between GDP growth and long-run stock returns, the results are sobering. The fundamentals are set forth in a Financial Analysts Journal article, “Economic Growth and Equity Investing”:

If inflation is expected to be about 3 percent going forward, then long-run nominal stock returns will be about 7 to 8 percent for stocks in general.

The evidence that long-run stock returns are expected to be in the single digits pervades not only the academic finance literature and corporate finance departments, but also the popular financial press. With the dividend yield on the S&P 500 today just under 2 percent, and with GDP growth forecasted to be in the 5 to 6 percent annual range, an expected long-run total stock return as high as 10 percent per year is simply out of the question for the typical firm, and especially for utilities. As economist Burton Malkiel predicts:

Reflecting realistic prospects relative to GDP growth potential would put long-run utility growth at about 2.8 percent per year—half the projected GDP growth rate—and when combined with the typical 4.5 percent dividend yield would produce an expected utility stock return of only 7.3 percent. This estimate is in keeping with not only the finance literature, but more importantly for those with a practical bent, with over 10,000 survey responses collected over the past decade from corporate chief financial officers (CFOs).

Current estimates from the CFOs suggest that the cost of equity for the typical firm today is about 8 percent. 9 Using the CFOs’ cost of equity estimate allows for accurate valuations of utility stocks. Using regulators’ authorized returns on equity as proxies for the utility cost of equity does not. That goes to the heart of the matter discussed.

Some rate-of-return witnesses acknowledge that while forward-looking investor returns may be lower than they have been in the past, they argue that those returns understate the utility’s cost of equity. That suggestion reveals a fundamental lack of understanding of the cost-of-equity concept. As Roger Morin writes in the New Regulatory Finance :

If the investors’ expected total return is 8 percent, then by definition the utility’s cost of equity is also 8 percent. That doesn’t mean, however, that the fair return on equity is 8 percent. That’s where the proper distinction lies. Unfortunately, most regulators aren’t making that critically important distinction.

ROE and the Cost of Equity

In contrast to the prescription that the investors’ expected return and the cost of equity are one and the same, finance principles make it clear that a firm’s return on equity and its cost of equity are fundamentally distinct variables. According to a 1970 article:

Financial researchers discovered long ago that in real markets returns on equity tend to settle in at industry averages noticeably above the cost of equity. Therefore, to value firms accurately, one must assume that the long-run return on equity will exceed the cost of equity indefinitely— i.e., that the firm will earn excess returns over the long run. As economist Aswath Damodaran states in a 2001 text:

The Value Line Investment Survey projects that