Unjust and Unreasonable: Misuse of the Dividend Growth Model in Public Utility Rate Setting

15 Pages Posted: 9 Nov 2021 Last revised: 8 Apr 2022

See all articles by J.B. Heaton

J.B. Heaton

One Hat Research LLC; Heaton Henderson LLC

Date Written: October 22, 2021

Abstract

The dividend (Gordon) growth model (DGM) is a simple stock valuation equation in four variables: (1) price; (2) next-period cash flow; (3) a perpetual and constant rate of growth in the periodic cash flow; and (4) a perpetually-constant discount rate. The DGM can be expressed to equate the perpetually-constant discount rate to the cash flow yield on the current price plus the perpetual growth rate in the periodic cash flow. But that expression would provide a reliable estimate of a real-world discount rate only if both the cash flow yield and the growth rate used as inputs to the model were perpetually constant. In rate-regulation proceedings, however, utility expert witnesses use the DGM with current (not perpetual) dividend yields and analysts' 3-5 year (not perpetual) earnings growth rates. This practice contributes to approved equity cost of capital awards above plausible cost of capital estimates, shifting wealth from rate payers to utilities.

Keywords: cost of capital, rate regulation, regulatory capture

Suggested Citation

Heaton, J.B., Unjust and Unreasonable: Misuse of the Dividend Growth Model in Public Utility Rate Setting (October 22, 2021). Available at SSRN: https://ssrn.com/abstract=3947360 or http://dx.doi.org/10.2139/ssrn.3947360

J.B. Heaton (Contact Author)

One Hat Research LLC ( email )

Chicago, IL
United States

HOME PAGE: http://www.onehatr.com/

Heaton Henderson LLC ( email )

Chicago, IL

HOME PAGE: http://www.heatonhenderson.com

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