Responce From The Author
April 1, 2003
Stephen Hill's long letter raises a number of theoretical and empirical criticisms of my article, as well as raising accusations of my "bias" in favor of utilities. Briefly, Mr. Hill appears to have three thrusts to his criticism: 1) I understand neither the theory of DCF valuation nor its implementation, yet advocate its abandonment by regulators; 2) I reject the Efficient Market Hypothesis (EMH) and, therefore, all market-based techniques for estimating the cost of equity; and 3) in raising the volatility of cost of equity (COE) estimates produced by the DCF, I have simply created a straw man issue, which I then conveniently knock down. In raising these criticisms, Mr. Hill, who predominantly testifies on behalf of ratepayer advocates, has completely misrepresented the conclusions of my article. Furthermore, his own arguments are inconsistent and illogical, a sin of which he accuses me.
Regarding the first criticism, it is fairly common knowledge that the DCF was developed in the 1930s. I stated that the DCF was not introduced into regulatory proceedings until the late 1960s. The basis for my statement was the comprehensive article I cited (footnote 7) by Win Whitaker. Interestingly, the last paragraph of Mr. Hill's letter states that the DCF has been the primary method used to estimate the COE "since its inception in the 1960s." Another aspect of this first criticism concerns appropriate growth rates. Mr. Hill states that I err in using earnings growth rates, rather than dividend growth rates. Strictly speaking, the perpetual DCF is based on dividend growth rates. But, unless I am mistaken, the only sustainable source of dividends is earnings. To one who advocates the "sustainable DCF" model (as Mr. Hill does), which is based on the premise of a steady payout ratio, this requires long-run dividend growth to equal long-run earnings growth. Finally, Mr. Hill erroneously suggests I advocate abandoning the DCF. I do not. What I say is that "regulators should no longer rely solely on the DCF." Some state regulators do rely exclusively on the DCF; many others rely heavily on it. My article suggests there have been structural changes in utility markets that make the DCF less a fountainhead of truth than Mr. Hill believes it to be. Yes, markets have been volatile in the past, but never has there been a confluence of events-external and internal to the utility industry-like those in the last few years. I believe those events require a rethinking of the traditional regulatory reliance on the DCF.
Regarding the second criticism, Mr. Hill states that I "cast aspersions" at the EMH. I do not. Ironically, Mr. Hill's own statements about volatility being attributed to "illegal activities" and "loss of investor confidence" indicate weakness of the EMH, since such activities ought not to adversely affect "well-behaved" utilities. Further, since the EMH is forward-looking, reliance on any past average of stock prices violates the EMH's premise. Use of averages of daily stock prices in DCF calculations reduces the volatility, but the greater the reduction achieved using a longer averging period, the greater the implied violation of the EMH.
Finally, regarding the third criticism, Mr. Hill thinks the entire volatility issue is a "straw man" I created, and that the DCF method has worked well for 30 years, producing "the most accurate" cost of equity estimates. My point is this: Increasingly, volatile utility stock prices can lead to widely varying COE estimates using the DCF, even when stock prices are averaged (in violation of the EMH). COE swings of 100 to 200 basis points can have a significant financial impact on utilities and their customers. Of all the common methods used to estimate a utility's COE, the DCF has the greatest volatility. Since Mr. Hill asserts that the DCF produces COE estimates closer to the "true" cost than any other method, one wonders how a utility's long-term COE can change so much so quickly, if its underlying financial fundamentals have changed little. Nor does Mr. Hill explain how he, or anyone else, can "know" the "true" COE, which cannot be observed directly. Nor does he explain why it provides greater certainty to this unknown truth than other market methods, which are also based on the EMH.
Ultimately, it is Mr. Hill whose advocacy is clear, but whose judgment is cloudy. I myself continue to use the DCF, in part because regulators require it. I am concerned about heavy reliance on the DCF, given what I see as fundamental changes in utility markets. Perhaps these markets will settle down and utilities will once again be the "widows and orphans" stocks they once were, but I doubt it. Until then, "DCF forever!" may be a nice sound bite for Mr. Hill, but it could sell his own clients short in the long run.
Jonathan Lesser
Navigant Consulting
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Utilities Fortnightly & Spark
