DISCOUNTED CASH FLOW METHOD

Results
Shortcomings

FOR CALCULATION OF UTILITY COST OF EQUITY

Description

The DCF methodology is based on the premise that a company's stock price is equal to the expected discount value of future cash flows. There are both single and multi-stage variations of the DCF model.

Single Stage Model

The traditional DCF formula states that under certain assumptions, the equity investors' expected return can be viewed as the sum of an expected dividend yield, plus a single expected growth rate for future dividends. The traditional DCF model is shown below:

K_e = D₁/P_o + g

Where K_e = Investor's required return on equity

D₁ = Expected dividend for year 1

P_o = Current stock price

g = Expected dividend growth rate

For a more detailed description of the DCF model, see the attached 112 KB MSWord file containing 40 pages of rate case testimony, especially beginning on page 28, and for the corresponding calculations, see the attached 78 KB EXCEL file containing exhibits to that testimony, especially Schedules 2 of 8 and 3 of 8.

Multi-Stage Model

The multi-stage model assumes that dividend growth changes over time. In the two stage model, it is assumed that growth may be unusually high or low in the short term, but will eventually settle down to a steady state growth rate in the long term. In this model, the basic equation is the same as shown above, but the two growth rates are combined into a single rate per the following equation:

g= ((1+g_s)⁵ × (1+g_l)¹⁵))^(1/20)-1

Where it is assumed that the time horizon for the analysis is 20 years, with the first 5 years growing at a short term rate and the last 15 years growing at a long term rate.

g_s=Short term growth rate

g_l=Long term growth rate

The Federal Energy Regulatory Commission has generally tended to prefer this model in recent years (see initial decision by administrative law judge Birchman, pages134-149).

Where does the Growth Come From?

The value for "g" is, technically supposed to represent investor's expectations for dividend growth. Since that is not something that can be directly observed, one of several proxies are used instead.

For Stage 1 growth:

• Historical dividend growth
• Analysts' forecast of earnings growth

The short term proxies are available from numerous sources. The most readily available and least expensive might be from Forbes/IBES annual survey of the 500 largest companies (see issue of April 20, 1998 pp. 384-424). Forecasts are available in monthly Value Line Investment Surveys. Very current estimates are also available for a price from either IBES or Zacks.

For Stage 2 growth:

• Economists' forecasts of long term economic growth
• Forecasts of revenue growth based on economists' long term forecasts of prices

The long term proxies, economists's forecasts of growth, are available for a price from such entities as DRI and WEFA. Some current or near term regional economic forecasts are available for free on the internet, for example for the Northeast and Midwest. National economic growth forecasts are also available from the Energy Information Administration Annual Energy Outlook.