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