11. DRA's Discounted Cash Flow Model
11.1. DRA's Use of the Dividend Discount Model Version
of Discounted Cash Flow
A majority of investment firms use some form of the Discounted Cash Flow model as a valuation technique.31 DRA proposes the use of a three-stage Discounted Cash Flow or dividend discount model. (Exhibit DRA-1, Attachment JRW-9 presents the stages in a three-stage Discounted Cash Flow model.) This model presumes that a company's dividend payout progresses initially through a growth stage, then proceeds through a transition stage, and finally assumes a steady-state stage.32 The dividend-payment stage of a firm depends on the profitability of its internal investments, which, in turn, is largely a function of the life cycle of the product or service.33 (Exhibit DRA-1 at 22-23.)
DRA relied primarily on the Discounted Cash Flow model to estimate the cost of equity capital. DRA argues that due to the investment valuation process and the relative stability of the utility business, the Discounted Cash Flow model is the best measure of equity cost for public utilities. DRA also performed a Capital Asset Pricing Model study (discussed below), but placed less weight on this measure of risk because it contends that risk premium studies, like the Capital Asset Pricing Model, are a less reliable indication of equity cost rates for public utilities.
11.2. DRA Used a Discounted Cash Flow Model to Establish Stockholders' Expected or Required Return
DRA argues that the economics of public utilities show the industry to be in the steady-state or constant-growth stage of a three-stage Discounted Cash Flow due to the relative stability of the utility business, the maturity of the demand for public utility services, and the regulated status of public utilities (especially the return on equity).
11.3. Factors That Affect Discounted Cash Flow
Discounted Cash Flow models require a forecast of dividend yield and expected growth rate. The dividend yield can be measured at any point in time, but estimating expected growth is harder because it requires consideration of investors' expectations.
11.4. Use of Historical Earnings Growth, Dividends,
and Internal Growth
Both DRA and Applicants use historical earnings per share, dividend per share, and book value per share growth rates to develop growth expectations. The Discounted Cash Flow model's expected return on a security is the sum of the dividend yield and the expected long-term growth in dividends. Therefore, the conventional Discounted Cash Flow model uses long-term growth rate expectations to estimate the cost of common equity.
Internally generated growth is a function of the percentage of earnings retained within the firm (the earnings retention rate) and the rate of return earned on those earnings (the return on equity). The internal growth rate is computed as the retention rate times the return on equity. Internal growth is significant in determining long-run earnings and, therefore, dividends. Investors recognize the importance of internally generated growth and pay premiums for stocks of companies that retain earnings and earn high returns on internal investments. (DRA Opening Brief at 29.)
11.5. DRA's Analysis for Its Two Proxy Groups
DRA presented its Discounted Cash Flow analysis in Exhibit DRA-1, Attachment JRW-10. For the Discounted Cash Flow dividend yields for the groups, DRA used the average of the six-month and July 2009 dividend yields. The table below shows these dividend yields.
Six-Month Average |
July 2009 |
Discounted Cash Flow | |
Water Proxy |
3.7% |
3.7% |
3.7% |
Gas Proxy |
4.6% |
4.4% |
4.5% |
DRA adjusted the dividend yield by one-half (1/2) the expected growth to reflect growth over the coming year.
DRA analyzed various measures of growth for the companies in the proxy groups including historical growth rates in earnings per share, dividends per share, and book value per share.
DRA reviewed Value Line's historical and projected growth rate estimates for earnings per share, dividends per share, and book value per share. Additionally, DRA utilized Zacks,34 Reuters,35 and First Call's36 average earnings per share growth rate forecasts of Wall Street analysts. According to DRA, these services solicit five-year earning growth rate projections for securities analysts and compile and publish the averages of these forecasts on the Internet. Lastly, DRA assessed prospective growth as measured by prospective earnings retention rates and earned returns on common equity.
11.6. DRA Used Wall Street Analysts' Earnings per Share Growth
DRA argues the appropriate Discounted Cash Flow model growth rate is the dividend growth rate, not the earnings growth rate. However, DRA believes over the very long-term dividends and earnings will have to grow at a similar rate (eventually earnings will become dividends rather than always being fully reinvested). DRA asserts one must consider other indicators of growth, including prospective dividend growth, internal growth, as well as projected earnings growth. DRA also argues the earnings per share growth rate forecasts of Wall Street securities analysts are overly optimistic and upwardly biased. Thus, using their growth rates as a Discounted Cash Flow growth rate will provide an overstated equity cost. (Exhibit DRA-1 at 30.)
11.7. Historical Growth for DRA's Proxy Groups
Exhibit DRA-1, Page 3 of Attachment JRW-10 provides the 5- and 10-year compounded annual growth rates for the companies in the two proxy groups. Due to the presence of outliers, DRA used the median as well as the mean as a measure of central tendency.37 Historical earnings per share growth for DRA's Water Proxy Group is volatile, with a mean/median range of 2.74% - 6.92%. Historical dividends per share growth is steadier, with a range of 2.36% - 4.00%. Historical book value per share growth is higher, with a range of 4.42% - 5.21%. Overall, the average of the 5- and 10-year means and medians of historical earnings per share, dividends per share, and book value per share growth rates is 3.9%. (DRA Opening Brief at 19.)
For DRA's Gas Proxy Group, earnings per share growth is the most volatile, with a 5- and 10-year mean/median range of 4.20%-4.96%. Dividends per share growth is much steadier and much lower, with a mean/median range of 1.99%-3.11%. The range for book value per share growth is above that of earnings per share and dividends per share growth, with a mean/median range of 4.17%-5.57%. Overall, the average of the 5- and 10-year means and medians of historical earnings per share, dividends per share, and book value per share growth rates is 3.9%. (Id. at 30-31.) Although we discuss DRA's Gas Proxy Group here, as noted elsewhere, we are not persuaded that any gas proxy is an appropriate proxy for water utilities.
11.8. Projected Growth Rates for DRA's Two Proxy Groups
DRA used Value Line's projections of earnings per share, dividends per share, and book value per share growth for the proxy groups. (Exhibit DRA-1, Page 5 of Attachment JRW-10.) DRA argues that due to the presence of outliers, both the means and medians should be used in the analysis. The projected Value Line data for the water companies is limited because there are only three water companies with Value Line projections. For these three companies, the central tendency measures range from 3.0% to 9.5%, with an average of 5.6%. For the Gas Proxy Group, the central tendency measures range from 2.5% to 4.5%, and an average of 3.8%.
Also Exhibit DRA-1, Page 5 of Attachment JRW-10 contains prospective internal growth for the proxy groups as measured by Value Line's average projected retention rate and return on shareholders' equity. As noted above, DRA believes internal growth is a primary driver of long-run earnings growth. For the Water Proxy Group, the average prospective internal growth rate for the three companies with data is 6.1%. The average prospective internal growth rate for the Gas Proxy Group is 4.8%.
11.9. DRA's Use of Analysts' Forecasts of Expected 5-year
Earnings per Share Growth for Proxy Groups
Zacks, First Call, and Reuters collect, summarize, and publish Wall Street analysts' 5-year earnings per share growth rate forecasts for the companies in DRA's proxy groups. These forecasts for the companies in the proxy groups are in Exhibit DRA-1, Page 6 of Attachment JRW-10. The average of analysts' projected earnings per share growth rates for the Water Proxy Group is 8.1%.38 The average of the analysts' projected earnings per share growth rates for the Gas Proxy Group is 5.4%.
11.10. Summary of DRA's Analysis
DRA argues that the data for the Gas Proxy Group is more complete and provides a much better indication of expected growth than the water data. The historical growth rate figures suggest to DRA a baseline growth rate in the 4.0%-5.0% range for the gas companies. The internal and projected earnings per share growth rates indicate to DRA higher growth of 4.8% and 5.4%, respectively. The average of the growth rates of the various indicators is 4.5%. (Exhibit DRA-1, Page 7 of Attachment JRW-10.) DRA argues it is reasonable to give more weight to the projected growth rate indicators and to prospective internal growth, and therefore an expected Discounted Cash Flow growth rate in the 5.0% range is reasonable for the group.39 DRA uses this 5% figure as the Discounted Cash Flow growth rate for its Gas Proxy Group. (Exhibit DRA-1, Page 7 of Attachment JRW-10.)
The DRA Water Proxy Group's Discounted Cash Flow growth rate indicators are also included in DRA's analysis, but DRA argues that the data is very limited and that the data for the Gas Proxy Group is more complete and provides a better indicator of prospective growth. The historical growth rate indicators for DRA's Water Proxy Group show a baseline growth rate of 4.0%, which is slightly below DRA's Gas Proxy Group.
DRA's projected growth rate indicators for the Water Proxy Group, while very limited in number and highly variable, are higher than those of the
Gas Proxy Group. The average of the growth rate indicators is 5.7%. DRA uses a growth rate for the Water Proxy Group that is 100 basis points above that of the Gas Proxy Group-a 6.00% Discounted Cash Flow growth rate for the Water Proxy Group.40 (Id. at 33.)
11.11. DRA's Return on Equity Using the Discounted
Cash Flow Model for the Two Proxy Groups
DRA derived an equity cost range for the two proxy groups using the sum of the dividend yield, plus one-half the growth adjustment, plus the discounted cash flow growth rate. DRA summarized these results in Exhibit DRA-1, Page 1 of Attachment JRW-10, as follows:
Dividend Yield |
½ Growth |
Discounted Cash |
Equity Cost | |
Water Proxy Group |
3.7% |
1.0300 |
6.00% |
9.81%41 |
Gas Proxy Group |
4.5% |
1.0250 |
5.00% |
9.61%42 |
31 In the Discounted Cash Flow model, the current stock price equals the discounted value of all future dividends. Thus, stockholders' returns result from current as well as future dividends. The Discounted Cash Flow model presumes that any earnings not paid as dividends are reinvested in the firm to provide for future growth in earnings and dividends. The investors' discount rate for future dividends reflects the timing and riskiness of the expected cash flows, and is therefore the market's expected or required return on the common stock. Therefore, this discount rate represents the cost of common equity. Algebraically, the Discounted Cash Flow model is:
D1 D2 Dn
P = ------ + ------ + ------
(1+k)1 (1+k)2 (1+k)n
(P = the current stock price, Dn = year n dividend, and k = the cost of common equity.)
32 Maturity (steady-state) stage: Eventually the company reaches a position where its new investment opportunities offer, on average, only slightly attractive returns on equity. At that time its earnings growth rate, payout ratio, and return on equity stabilize for the remainder of its life. The constant-growth Discounted Cash Flow model is appropriate when a firm is in the maturity stage of the life cycle.
33 This description comes from William F. Sharp, Gordon J. Alexander, and Jeffrey V. Bailey, Investments (Prentice-Hall, 1995) at 590-91, as cited by DRA.
34 Zacks is a publicly available investment information source. http://www.zacks.com/.
35 Reuters is a wide range source of news and information. http://www.reuters.com/.
36 First Call is a publicly available investment information source. http://thomsonreuters.com/products_services/financial/financial_products/products_az/first_call.
37 Outliers are observations that are much larger or smaller than the majority of the observations.
38 DRA's witness averaged the expected five-year earnings per share growth rates from the three services for each company to arrive at an expected earnings per share growth rate by company.
39 This number is rounded up to 5% based on the 4.67% average of the various forward indicators listed in Exhibit DRA-1, Page 7 of Attachment JRW-10.
40 DRA did not rely on the 6.6% average ((5.6% + 6.2% + 7.9%) ÷ 3= 6.57%)of the Water Proxy Group forward indicators due to the limited data and upward bias. Instead, DRA used the proposed forward average growth rate of the Gas Proxy Group of 5% and added 120 basis points. DRA believes applying a 6% growth rate is more reasonable for the Discounted Cash Flow growth rates for the Water Proxy Group.
41 ((3.7% x 1.03) + 6.00% = 9.81%.)
42 ((4.5% x 1.025) + 5.00% = 9.61%.)
