Measuring Return on Equity Correctly


Why current estimation models set allowed ROE too low.

Why current estimation models set allowed ROE too low.

Fortnightly Magazine - August 2005

Estimated costs of equity for utilities are, like interest rates, very low by historical standards. A standard capital asset pricing model (CAPM) value might be 9 percent, 1 although some analysts might argue for much lower values. 2 Discounted cash flow (DCF) methods may produce a wider range of answers, due to variations in the growth rates selected, but many of those answers will be low by historical standards, too. 3

These low findings are based in part on problems with the underlying models. For example, the CAPM long has been known to underestimate the cost of equity of low-beta stocks and to overestimate the cost of equity of high-beta stocks. 4 However, often there is a more fundamental problem that rate regulation in North America usually overlooks: a material mismatch between the capital structure at which the cost of equity is estimated and the ratemaking capital structure to which it is applied. 5 A material capital structure mismatch, which occurs frequently, can lead to material misestimates of the appropriate allowed return on equity, perhaps on the order of 2 percentage points. That is, a 9 percent estimate of the cost of equity can imply an allowed rate of return on equity of 11 percent.

Effect of Debt On Equity Risk

Let's start with the basics. Companies raise money for investment by issuing securities. Different securities have different claims on the firm's earnings, and if necessary, on its assets. Debt has a senior claim on a specified portion of the earnings. Common equity, the most junior security, gets what's left after everyone else has been paid.

The company's overall risk depends on the business it's in. When a company uses (reasonable amounts of) debt, the company's overall risk falls on a fraction of its capital, the common equity. 6 Since equity bears more risk, investors require a higher rate of return on equity than on debt. Except at extreme debt levels, the overall risk of the firm does not change materially due to the addition of debt. The various securities just divvy that risk up.

EES North America
Modern models of the cost of equity assume risk consists of a stock's sensitivity to one or more economic factors that affect asset values generally. Suppose changes in