# THE DCF METHODOLOGY by broverya77

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```									  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
   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.
   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

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