THE DCF METHODOLOGY by broverya77

VIEWS: 72 PAGES: 17

									  THE DCF
METHODOLOGY
       Johnny Brown, CRRA
      Senior Financial Analyst
 Arkansas Public Service Commission
        Little Rock, Arkansas
                   Outline

   What is the DCF?

   Strengths & Weaknesses

   How do I use the model?

   New Twists
             What is the DCF?
   The model came about as the Dividend
    Discount Model.
           P0 = D1/(1+k)1+…Dn/(1+k)n


   Myron Gordon developed the model we know
    as the DCF Model.
                 k = D1/P0 + g
           Strengths of the DCF

   Easy to understand and use
   Company specific information
   Data required is readily available
   Most wide-spread regulatory acceptance
   Recognizes the time value of money and is
    forward-looking
         Weaknesses of the DCF
   Assumptions – don’t generally hold up in a
    technical sense
   Growth rate to use is uncertain
   Analyst growth forecasts are short-term/DCF is
    long-term
   Sometimes difficult to match growth with the
    yield component
   Efficient Market Hypothesis is not universally
    accepted
      Putting the Model Together
   k = D1/P0 + g
   The analyst must provide the components on
    the right side of the equation to solve for “k”.
   Match the right side with investor’s
    expectations.
   Each component is highly scrutinized by other
    witnesses.
   The result is an accurate measurement of the
    cost of equity.
             Derivation of “D”
   The dividend component is probably the least
    debated part of the DCF equation.
   The dividend should not be influenced by short-
    term anomalies.
   D1 = Annualized dividend at time period 1
                         or
   D1= quarterly dividend multiplied by four (D0)
    and grossed up by the annual growth rate, “g”
               Derivation of “D”
   Example:
               Quarterly dividend = $.50

        D0 would equal $2.00 (.50 x 4 = 2)

     D1 would equal $2.10 (2.00 x (1+g); g=5%)
             Derivation of “P”

   The price should also not be influenced by
    short-term anomalies.
   The price should be taken from the same time
    period as the dividend and growth data.
   Doing so should account for investors’
    perception of the company’s risk and return
    prospects.
              Derivation of “P”

   I like to use an average of a recent time period –
    average of 13 weekly price points
   13 weeks = 1 quarter
   Most analyst growth projections are published
    quarterly.
            Derivation of “g”



   The most CONTROVERSIAL part of the DCF
              Derivation of “g”

   Forward looking – but influenced by historical
    growth information
   Utility industry is mature and slow growing
   Remember – you are measuring long-term
    sustainable growth in dividends.
               DCF Method
   Example:

Analyst derived information:
 Quarterly Div. - $0.25

 13 week average price – $25

 Annual growth rate – 5%
               DCF Method

   k = D1/P0 + g

                k = 1.05/25 + .05

                    k = 9.2%
                   New Twists
   Title of panel is New Twists on DCF – my
    presentation doesn’t jibe.
   That’s my point – if it ain’t broke don’t fix it.
    Market to Book Value Adjustment
   Not necessary – allows for over recovery
   For a regulated utility – a market price above
    one indicates investors expect returns above
    what is required.
   Why else would they be willing to pay above
    book value for their investment?
   The fact that most regulators only allow utilities
    a return based on book value rate base is widely
    known by investors.
Growth in Dividends is the key!

            Johnny Brown
  Arkansas Public Service Commission
             501-682-5743
    johnny_brown@psc.state.ar.us

								
To top