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The rise in equity risk premiums for local gas utilities may come as a surprise.
Equity risk premiums for natural gas distributors have hit a ten-year high. Moody's Gas Distribution Index showed a jump to a 5.4 percent equity risk premium in December 2001 and has averaged an approximate five percent equity risk premium in 2002, while historically equity risk premiums have averaged 3.4 percent above the yield of 30-year Treasury bonds over the last 10 years. The variation in equity risk premiums over time and in relation to the level of interest rates, as shown in Figure 1, calls into question some commonly used analytical methods-particularly what is called the ex post risk premium analyses, or historical yield spread method, which typically uses extremely long 60- to 70-year periods.
Notwithstanding its widespread use, there is a serious conceptual problem with using the ex post or historical yield spread method to determine risk premiums.
Typically, under the ex post method, the risk premium is calculated as the difference between the historical holding period returns on an index of stocks for a particular past period and the returns from an index of bonds for the same past period. The historical risk premium is then added to a company's current bond yield or to the current yield of a Treasury security to determine the cost of equity.
This is expressed as follows:
Ke = Kd + historical equity/debt spread
where: Ke = cost of equity
Kd = cost of debt
But the cost of equity is a forward-looking concept. That is, the cost of equity is based on investor expectations, and not ex post performance. There is no reason to believe that investors expect future relative returns to be the same as those earned in the past. Actual performance may deviate substantially from what was expected, but it is expectations relative to requirements that will determine if an investment should be made. Simply because a company's stock returned either one percent or 500 percent over the cost of debt does not mean the company's cost of equity was either one percent or 500 percent over the cost of debt. Furthermore, ex post risk premium analyses typically incorporate negative risk premiums because there are many months and years when stock market returns are negative. It is illogical and contrary to financial theory regarding risk aversion and required returns to presume the cost of equity is negative or less than the cost of debt. Cost of equity analyses should be consistent with that type of financial theory.
Because it avoids some of the serious flaws of other approaches, an ex ante approach is the appropriate way to determine equity risk premiums. Under an ex ante approach, the required return on equity used to calculate equity risk premiums is determined using investor expectations, as opposed to relying on past returns.
For example, many analysts have established a 7.8 percent equity risk premium when analyzing the earned return on the S&P 500, as compared to those earnings of an index of long-term government bonds dating back to 1926,