SURFA 44 th Financial Forum

1. SURFA 44th Financial Forum Current Issues with the DCF Model- Old Reliable or Unreliable Rusty Maddox, CRRA Principal Financial Analyst Division of Utility Accounting & Finance Virginia State Corporation Commission

2. DCF-Old Reliable or Unreliable Every model based on financial theory must be premised upon some simplifying assumptions. Questions to consider in this debate may include: • What are the critical and constraining assumptions of the DCF model? • How robust do those assumptions appear from the model results indicated under varying market conditions?

3. What benchmarks may one use to interpret/ evaluate the reasonableness of the results? • Do the model results provide returns that enable capital attraction and sustain financial integrity? • Should the results of the DCF be given little or no weight or would it be better to qualify and interpret such results given an understanding of the models assumptions?

4. DCF a.k.a. The Dividend Discount Model • The simple, elegant, and theoretically sound premise of the model is that the current stock price reflects the sum of all future expected dividends discounted at the cost of equity rate. • Historically, utility companies have paid, and continue to pay, a much higher proportion of their earnings out in the form of dividends as compared to nonutility stocks. • I believe this is a crucial factor that makes the DCF Model a preferable methodology for estimating the cost of equity for utility stocks.

5. Then Versus Now • The claim that DCF results are not reliable in the current market environment begs the question as to what, if any, factors make the DCF less reliable today than in the past? • As a frame of reference, I compiled some dividend yield and payout ratio data for a sample group of three electric and two gas utilities over the 30-year period from 1980-2010, along with data from the S&P 500 and Treasury bond yields.

8. Dividend Payout Ratio Points • Two factors have contributed to the decline in utility payout ratios since the early 2000’s • Renewed emphasis on regulated utility operations have continued to grow earnings as compared to anemic results when focus and emphasis was on unregulated operations. • Utility companies have needed to hold on to more earnings to help bolster the slide in equity ratios, credit metrics, and bond ratings damaged by failed or abandoned diversification ventures in order to support the attraction of capital for increased regulated infrastructure investment needs.

9. Dividend Yield as Function of Market Price • Investors tend to view the “bird-in-the-hand” scenario of utility dividend payouts as close substitutes for bond yields. • This is apparent by the fact that the average dividend yield of my utility sample group tended to move with Treasury rates and ranged between 85-90% of 30-year Treasury yields over the review period. • Considering that dividends tend to change gradually and lower payout ratios suggest companies are retaining more earnings, it would appear that most of the change in dividend yields is related to stock price, i.e., the market’s valuation of those dividends relative to other alternatives. • Similar to changes in a bond’s value for changes in interest rates, the market will adjust prices to reflect changes in market conditions. Average utility dividend yields continued to fall with Treasury yields over the 30-year period but not to the same extent as Treasuries since the 2008 credit crisis. • Since the credit crisis of 2008, utility dividend yields have traded at an average of approximately 115% of 30-year Treasury yields.

10. Is the market’s valuation of utility dividends less rational now than in the past? • Although utility dividend yields since 2008 have not been trading on par with the historic average of 90% of Treasury yields, current dividend yields above Treasury rates would appear to be a reasonable and rational response by the market to two primary factors. • Investors are discounting utility stock values to raise dividend yields above Treasury yields due to the higher perceived risks of stocks relative to Treasury securities in current market conditions. • Investors are unwilling to raise the price of utility stocks to lower dividend yields on par with their historic relationship to Treasury yields in consideration of the artificial and temporal reductions in those yields from Federal Reserve intervention. • Now that corporate bond yields have stabilized from the shock of the 2008 financial crisis, utility stocks are being priced at levels that maintain their dividend yield in approximate proportion to the long-term average of over 70% of Baa corporate bond yields and approximately 40% of S&P 500 dividend yields, which also reflect the market’s relative assessment of risk.

11. Growth Rate Issues • Understatement of the Obvious- Growth rates reflect the most contentious and controversial element of DCF model analyses. • In the single stage or constant growth form of the DCF model, the growth in dividends, earnings and book value are presumed to be at the same rate over the infinite horizon. • Many cost of equity witnesses will use a single-stage form of the DCF model and rely solely upon analysts’ 5-year projected earnings growth rates. • Multiple studies support existence of an upward bias in analysts projected earnings growth rates. • This opens the debate as to how reasonable that 5-year projected rate is when extrapolated out over the infinite horizon of the model. • Some witnesses may attempt to address that issue by also considering Value Line projected dividend growth rates and historic growth rates. • Another means to address the long-horizon issue is to consider multi-stage (2- or even 3-stage) forms of the DCF model, which raises a variant of the single-stage question as to the reasonableness of the growth rates used over the duration of each stage.

12. Growth Rates Over the Long-Term • Economic cycles, construction programs, and failed/abandoned unregulated ventures contributed to much variability in projected 5-year growth rates for my sample group over the 30-year review period. • June 3, 2005 Value Line showed Dominion Resources to have a projected 5-year earnings growth rate of 9.0%, projected 5-year dividend rate of 3.0% and a projected 5-year book value growth rate of 8.0%. • After American Electric Power had cut its dividend and refocused on regulated operations with numerous rate increases across its jurisdictions, the March 30, 2007, Value Line showed AEP to have a projected 5-year earnings growth rate of 7.0%, a projected 5-year dividend growth rate of 7.5%, and a projected 5-year book value growth rate of 5.5%. • Given the infinite horizon of the DCF Model, what is reflected by growth rates over longer periods?

14. Big Kahuna Question • Is the DCF model assumption that earnings, dividend, and book value grow at same rate over the long-term reasonable and realistic or a fatal flaw?

17. Summary of Long-Term Perspective • The Value Line data appears to support that growth rates do converge toward the same rate over the long-term horizon consistent with the DCF model assumption. • The rate of growth for the entire economy as reflected by the change in GDP over that same 85 year period was 5.95%. Data for the annual average of the S&P 500 was only available beginning at 1928, however over the 1928-2005 period, it grew at a rage of 5.47% and a rate of 5.26% from 1928 – 2011. • This data also appears to support that the growth rate of stock earning/dividends/book value over the long-term do not outpace the overall rate of growth of the economy as reflected by GDP. • As one would expect for the mature utility industry segment of the economy, the average utility growth rates over the earlier noted 30-year review period were less than the broader market growth exhibited by the S&P 500.

18. Screening Data for DCF Analysis of the Dividend Paying Stock of the S&P 500

20. Long-Term Constant Growth Rate Considerations • Over the long-term the growth in stocks cannot exceed the rate of growth of the overall economy. • 5-Year projected earnings growth rates may be relevant for the 5-year period they are intended, however the eventual rate of growth has to be limited by the long-term growth of the economy • Recognizing long-term economic growth as a limiting constraint, use of long-term projected economic growth in GDP should be offer a reasonable maximum limit in the constant growth stage of a multi-stage DCF analysis. • Projected GDP growth rates are available from sources such as the Congressional Budget Office, Energy Information Administration, and Global Insight. • Presently those projected growth rates range between 4.5% - 5.0%, roughly reflecting 3.0% or less of real growth and 2.0% or less of inflation.

22. Practical Considerations for Transition from 5-Year to Constant Growth • Rather than a flash cut transition from 5-year projected growth to long-term constant growth, it would seem reasonable to presume some intermediate transition period considering that material movement toward convergence was not readily apparent until the 30-year horizon from the earlier noted growth rate analysis. • The first 5 years of discounted dividends in the 2-stage DCF analysis of the dividend paying stocks of the S&P 500 account for approximately 12% of the current weighted market value. Understanding that subsequent 5-year intervals would account for diminishing proportions of marked value due to discounting, it would seem reasonable that six, five-year intervals could be expected to reflect about 50% of market value (e.g., 50% would equal sum of 12%, 11%, 9%, 7%, 6%, 5% ). • Rather that introducing the complication of adding one or more intermediate growth rates and the contention it would raise concerning the level and term of such rates, it would seem sufficient to average a single stage analysis using 5-year projected growth rates and 2-stage DCF analysis with a constant growth rate for projected GDP to approximate the results likely to be indicated by introducing a transition stage. • With utilities higher dividend payouts, I have observed that the discounted value of the first five years of utility dividends has averaged approximately 20 - 22% of market value from prior analyses. However, a simple average of a constant growth and a 2-stage DCF analysis using projected GDP growth would still seem to offer a reasonable result considering that utility growth rates have been and are likely to continue to be lower that the overall growth in the broad market and the economy over the long-term.

23. My Ballot Cast For Old Reliable • Alternatively known as the Dividend Discount Model, the basic valuation premise remains that current price reflects investors discounted value of all future expected dividends, which tend to be more steady and stable than comparatively more volatile (and sometimes misstated/manipulated) earnings. • Even with growth of initial five years of dividends at 5-year projected earnings rates, which may be higher than a reasonably sustainable long-term rate, most of the current market value of a stock resides in the discounted value of dividends beyond the initial five years. • Evidence appears to support that converging utility growth rates over the long term are less than the broad market, and given the mature nature of the industry that would be a reasonable expectation going forward. • We may not be able to peg a projected long-term sustainable utility growth rate below projected GDP, however it would be reasonable to view long-term projected GDP as a maximum limit in developing a utility cost of equity estimate. • Considering that a broad market cost of equity estimate of approximately 10% or less would be indicated from a multi-stage DCF analysis due to the maximum constraining limit of long-term GDP growth, this appears to reasonably corroborate the reliability of utility DCF cost of equity estimates below 10.0% in the current market environment.