Prefaced by Lewis Mills, Missouri Public Counsel, Missouri Office of Public Counsel
Written by David Murray, Chartered Financial Analyst and Manager of the Financial Analysis Unit for the Missouri Public Service Commission
The process that state utility commissions use to set the Return on Equity (ROE) for regulated utilities is perhaps the most self-absorbed process since Narcissus starved to death staring at his own reflection. In year one, the ROE for Utility A is set, with the state commission relying largely on the previous commission-allowed ROEs for Utilities B, C, D, E and F. In year two, the ROE for Utility B is set, with the state commission relying largely on the ROEs of Utilities A, C, D, E and F. And so it goes. Does this process result in commission-allowed ROEs that are the same as investor-required ROEs? Does it result in ROEs that are fair and reasonable? I asked David Murray, Chartered Financial Analyst and Manager of the Financial Analysis Unit for the Missouri Public Service Commission, to answer these questions for this month’s Point of View.
As most utility regulators re aware, rate of return (“ROR”) witnesses often base their ROE recommendations on their estimate of the cost of common equity. These witnesses claim their cost of common equity estimates are based on investors’ requirements and expectations. Many witnesses also believe that because investors rely on investment analysts for their investment decisions, stock prices must reflect the assumptions used by these investment analysts. However, these witnesses then rely on only one piece of information from the entirety of investment analysts’ analyses, the projected 5-year compound annual growth rate (“CAGR”) in earnings per share. Many witnesses add the consensus CAGR to a dividend yield to estimate the cost of common equity, . based on the premise that this is what investors do when they make decisions to buy or sell stock. I wish investing were this easy, but it’s not.
I believe that most investors rely on the entirety of investment analysts’ research. A basic question regulators should ask is whether the investment analysts’ themselves use their projected 5-year CAGR in EPS in the same way the witnesses do to estimate the cost of equity? The answer is they do not. I have yet to discover any published equity analyst’s research that performs a Discounted Cash Flow (“DCF”) analysis similar to how it is performed by many ROR witnesses. Equity analysts that do perform a DCF analysis usually estimate discrete cash flows in early periods and then use a much lower growth rate than the 5-year CAGR in EPS for a perpetuity growth rate. If these equity analysts assumed allowed ROEs equaled the cost of equity when discounting their projected cash flows, they would be of the opinion that all utility stocks are extremely overpriced. However, they do not hold this opinion in the aggregate because the cost of equity (i.e., the required return on equity) that equity analysts use to value utility stocks is much lower than commission-allowed ROEs.
I have analyzed published research from well-known capital market specialists such as Goldman Sachs, Wells Fargo, Bank of America and International Strategy and Investment Group. Their research clearly indicates the cost of equity is less than allowed ROEs. In fact, some of these analysts even go so far as to explicitly state that the allowed ROE to cost of common equity spread has recently been higher than historical norms due mainly to higher valuations of utility stocks in response to a decline in interest rates. However, this does not necessarily mean these analysts believe it is reasonable to set the allowed ROE based on the cost of common equity. Although these analysts do not identify a basis they believe commissions should use to set the allowed ROE, they clearly do not perceive it to be based on the cost of equity.
If allowed ROEs are higher than the cost of common equity used by investors, then are allowed ROEs fair and reasonable? They would be only if the regulator determines that the allowed ROE should be set higher than the cost of equity for other valid reasons. These other valid reasons go beyond a technical perspective designed to determine the cost of equity, but I believe this step should be taken to enhance the integrity of the ratemaking process.