The Superiority of Spot Yields in Estimating Cost of Capital

Financial experts often depart from standard financial principles and practices in recommending the appropriate rate of return for public utilities. But ratemaking draws from many fields, not just finance; there may be good reasons for some alterations. In other cases, however, analysts are unaware of violating principles. This article discusses the tendency of some analysts to use historic averages of certain financial variables, as opposed to current spot values, in

return-on-equity (ROE) analyses. More specifically, the question centers on the choice of dividend and bond yields in cost-of-equity models.

The discounted cash flow (DCF) model follows this general form:

Required Return = DIVIDEND YIELD + Expected Dividend Growth

To estimate the required ROE with this model, the analyst must select a dividend yield as well as a growth rate.

Similarly, the risk premium model involves selecting a bond yield and an expected risk premium estimate:

Required Return = BOND YIELD + Expected Risk Premium

Ideally, when using either model, it would be helpful to know what the dividend or bond yield will be in the near future, since regulators are setting rates that will be in effect for the indefinite future. Unfortunately, professional forecasts of financial variables are notoriously unreliable and appear to be getting worse, not better, over time.1 In keeping with these financial research findings, I develop yield estimates based on actual rather than forecasted data.

There are two basic choices for the yield: 1) averages of historic yields (such as a 12-month average), and 2) the current or spot yield (such as today's dividend yield).

Statistical Characteristics of Dividend and Bond Yields