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Comparable Earnings Model
Shortcomings, Caveats & Refinements
Shortcomings
- The comparable earnings model is an accounting based, rather than market based model. Two companies with exactly the same reported earnings can have very different shareholder value due to (1) different accounting policies or (2) different cash flow.
- Because it is accounting based, this is the least forward looking of any of the cost of equity models, for it is based solely on historical data. It was the first approach used, before the development of modern financial theory. Since it is not forward looking, this model is often dismissed out of hand by utility regulators.
Caveats
- The comparable earnings model may give exactly the opposite results as one would expect from modern portfolio theory, particularly in the case of utilities. Namely, since utilities with lower bond ratings are usually experiencing below average earnings, this would imply that they have a lower cost of equity, when in fact we know the reverse should be true.
Refinements
- It is necessary to establish a comparable group of companies. It is not clear from the Hope decision whether the comparable companies should be utilitites or non-utilities.
However, at least one analysis should be done with non-utilities, since there may be periods (e.g.with high inflation) when most if not all utilities are under-earning due to regulatory lag.
- Ideally, the analysis should be done over an extended period of time to smooth out anomolies from the economic cycle.
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