Today's volatile markets upset the discounted cash flow model, and others.
First used in the mid-1960s by ratepayer advocates, the discounted cash flow (DCF) method has become the most common approach used to estimate the cost of equity capital for utilities and, hence, allowed returns. Past surveys of regulators have shown a strong preference for the DCF-exclusively so for some state utility commissions, and in conjunction with alternative methods at others.1 Perhaps such reliance was appropriate in the past, when regulated utility stocks provided "widow and orphan" stability.
But with the restructuring meltdown in California, widespread electric and gas trading fraud, and the broader market accounting scandals, new risk has been injected into energy and financial markets. That risk has been translated into greater price volatility, not only of electricity and gas, but also for regulated utility stocks, which have lost their historic price stability. Unfortunately, of all the "typical" methods used to estimate utilities' cost of equity-DCF, the capital asset pricing model (CAPM), risk premium (RP), and comparable earnings (CE)-the DCF method is, arguably, the most sensitive to short-term market volatility. And, as more utilities reduce or even eliminate dividend payments, the applicability of the DCF method becomes more limited. This does not bode well for primary (or, worse, exclusive) reliance on the DCF unless and until capital and energy markets are more stable. But in the meantime, and in consideration of these new risks, perhaps it is time to rethink the reliance on the DCF method as the of the cost of capital world.