Cost of Common Equity Models and Current Economic/ Market Conditions

Sponsored and written by Pauline Ahern, Managing Principle, AUS Consultants

Pauline Ahern 2015

Pauline Ahern                 AUS Consultants

The Great Recession of 2008 – 2009 from which the United States, and the rest of the world, is still recovering was difficult for many individuals as well businesses, including public utilities. Houses were foreclosed upon, jobs were lost and excessive debt was hampering the ability of corporations to secure sources of financing. To say that the fallout of the Great Recession was widespread is an understatement. Although the U.S. economy is slowly recovering, some think that the possibility exists that in the near future, capital market conditions in the U.S. could worsen even more than when the housing market bubble first burst. Just witness the downward movement of the stock market during the last week of July, 2014. Under these economic and market conditions, the traditional cost of common equity models do not accurately or reliably estimate the investors’ required return which puts increasing pressure upon the rate of return experts engaged by various stakeholders to the base rate case process as well as upon regulatory commissions to estimate a reliable and accurate cost of common equity / allowed return on common equity.

Interest rates are currently artificially and historically low, being maintained at such low levels by the Federal Reserve Bank’s (Fed) Federal Open Market Committee (FOMC) policy. This is corroborated by the FOMC’s own statements in the press release it issued following its latest meeting on July 29-30, 2014 where the FOMC stated that “The Committee’s sizable and still-increasing holding of longer-term securities should maintain downward pressure on longer-term interest rates. . .” and “economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.” These artificially low interest rates have lead some analysts to the faulty conclusion that current capital costs are low. These analysts are mistaken. Their conclusion only holds true under the hypothesis of Perfectly Competitive Capital Markets (PCCM) and the classical valuation framework which underpins the traditional cost of common equity models. PCCM are capital markets in which no single trader has the power to change the prices of goods or services, including bond and stock securities. In other words, no single trader can have a significant impact on market prices. Classic valuation theory means that investors trade securities rationally with prices reflecting their perceptions of value. However, although the Fed has always had the ability to set the Fed Funds and discount rates, by its own admission, it has been maintaining low interest rates, below what it believes to be normal levels, to encourage economic and capital market recovery. The Fed is thus acting like a single trader, which has a significant impact on market prices of both bonds and stocks.

In such a capital market, the traditional cost of common equity models, Discounted Cash Flow Model (DCF), Risk Premium Model (RPM) and Capital Asset Pricing Model (CAPM), will not reflect investors’ true required return because the inputs to the models are reacting to the Fed’s management of the Fed Funds and discount rates. In the DCF model, the Fed’s interest rate intervention results in relatively low dividend yields, and high market-to-book ratios due to high market valuations, which when coupled with growth rates, historical and projected, depressed by the effects of the recent Great Recession, result in unusually low DCF-derived common equity cost rates which, in my opinion, do not reflect the investors’ required return on common equity. In RPM and CAPM models, the current level of interest and risk-free rates, no matter which term one chooses, is artificially and historically low, leading to RPM- and CAPM-derived cost rates which also do not reflect the investors’ required return on common equity.

As a result, the traditional cost of common equity models are not currently accurately or reliably estimating the investors’ required return. Therefore, rate of return analysts and regulatory commissions alike need to seriously and thoroughly evaluate the market and economy as a whole including their effects upon the inputs to these cost of common equity models. In addition, a thorough evaluation of the data used in the application of these models which reflect more normal market and economic conditions should be undertaken. The consideration of additional cost of common equity models to their analyses will likely result in cost of equity estimates which are not unduly influenced by the current highly unusual economic and market conditions, because if the cost of common equity results are unduly influenced by current conditions, the appropriate ROE may not be allowed in a rate proceeding.