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DCF Model
Shortcomings, Caveats & Refinements
Shortcomings
- The DCF model makes the implicit assumption of constant dividend growth (or at least constant growth during each stage of the model). It also assumes a constant price/earnings ratio. Niether of these assumptions are true in the real world.
- Earnings growth and dividend growth can diverge substantially in the short run, so that using earnings growth estimates as proxies for dividend growth may not be appropriate.
- Long term growth (e.g. for the second stage in the 2 stage model) is obviously very speculative.
- The correlation between general economic growth, utility revenue growth, and utility dividend growth is not that high.
- The DCF model, if consistently applied, tends to force utility stock prices toward book value. This is because the DCF required return which is determined based on market value is applied by regulators to the book value.
Therefore, if market value is greater than book value (i.e. market-to-book ratio >1), existing stockholders will under-earn, while the reverse will be true if the market-to-book ratio is less than one. This result may be viewed as unfair to utilities during those periods when the stock market in general is trading at significant mutilples of book value.
Caveats
- Historical dividend growth is a poor proxy for future growth expectations, especially in this period of change in the industry.
- The main argument against the single stage model using analysts' forecasts for earnings growth is that analysts rarely commit themselves to long-term forecasts. Even a 5-year forecast is stretching it for most analysts.
- Another argument that some people make against any form of DCF is that the stock market is not always "rational", and therefore a model based on stock prices can't be trusted. Rational or not, they still indicate an investor's willingness to advance capital.
- Arguments are also made that stock prices are too volitile to be used for long-term rate setting. Consequently, some people use average prices over a 6-month period. However, that solution just introduces more "backward-lookingness" into the result.
Refinements
- Calculation usually are based on a group of comparable companies (see Comparable Earnings for sample screening criteria) in order to avoid anomolies. For example, it would be very inappropriate to use the last five years dividend growth for FPL as a proxy for investor expectations of growth, since FPL cut its dividend by 30% in 1994 and grew it each year since then.
- An adjustment to the dividend rate may be made to reflect quarterly compounding, since dividends are usually paid quarterly. The formula for such an adjustment is:
((1+g).25+(1+g).5+(1+g).75+(1+g))/4
- It may be appropriate to adjust for flotation costs under some circumstances. If so, the proper way to do it is to divide the dividend yield portion of the DCF equation by (1-flotation costs). Flotation costs could be anywhere from 5% to less than 1% for a utility company, depending on how stock is issued.
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