Discounted Cash Flow Estimates of the Cost of Equity Capital
Published in Financial Markets, Institutions, and Investments
The authors investigated the usefulness of discounted cash flow (DCF) estimates of the cost of equity capital for regulated electric and gas utilities. Cost of equity estimates were calculated with several growth rate measures for nine New York utilities, a sample of large stable utilities operating in other states, and samples of utilities designed to match specific New York utilities. Variations of the DCF model that distinguish between short- and long-term growth rate forecasts were also evaluated. The estimates obtained were generally plausible, but an inexplicable scatter remained. The strong simplifying assumptions of the DCF method are probably not satisfied for the electric and gas utilities. The scatter of estimates does not imply the DCF method is useless but underlines the importance of relying on benchmark averages rather than on single-company estimates. Moreover, the DCF method is not one but many methods, depending on which growth rate measure or variable-growth model is used. The results also underline the importance of not relying on DCF without confirmation from other methods.
