1
recommendation, which would put downward pressure on cash flow-related c
2
metrics and the qualitative factors considered in arriving at ratings determina
3
presents an element of risk, not a source of support for the Company's credit profile.
F . Capital Market Conditions and Investor Risk Perceptions
4
5
PLEASE BRIEFLY SUMMARIZE MR. GORMAN'S POSITION REGAR]
Q.
6
CURRENT CAPITAL MARKET CONDITIONS AND THEIR EFFECT ON
7
COMPANY'S COST OF EQUITY.
8
Mr. Gorman presents a review of general electric utility industry credit outlooks ni
A.
9
stock price performance, and concludes that "the market has again embraced the elec ri
10
utility industry as a safe-haven investment, and views utility equity and debt investm ni
11
ark(
as low-risk securities."86 Mr. Gorman further states that my discussion "ignores m
sentiments toward utility companies" and "instead lumps utility investments in ith
12
general corporate investments." 87 The risk metrics discussed in my Direct Testimony,
13
however, relate specifically to the effect of capital market conditions on utility comp ies
14
generally and the proxy group in particular. Moreover, while Mr. Gorman is critic 1 of
15
my use of Beta coefficients calculated over twelve months," he fails to recognize that
16
they reflect the proxy companies' return volatility relative to the volatility of ov
17
18
market returns. That is, the calculated Beta coefficient does not "lump" those secut
19
in with the broad market.
20
company's risk as a utility relative to the broad market. Consequently, Mr. Gorm
To the contrary, they specifically recognize each p
simply incorrect when he concludes that I somehow have "lumped" utilities together
21
is
with
"general corporate investments."
22
86
87
81
Direct Testimony of Michael P. Gorman, at 4.
Ibid., at 57.
Ibid., at 49.
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REBUTTAL TE^
ROBERT B.
50
1
Q.
DO YOU AGREE WITH MR. GORMAN'S CONCLUSIONS REGARDING UTILI Y
2
STOCK VALUATIONS AND THEIR IMPLICATIONS FOR THE COMPANY'S
3
COST OF EQUITY?
4
A.
No, I do not. Mr. Gorman states that certain measures of utility stock valuations, in
5
particular P/E ratios and market price to cash flow (MP/CF) ratios, "show that st ock
6
valuation measures for the proxy group are robust "89 Mr. Gorman's Schedule MPG 20,
7
does not suggest that utility stock valuations now are more robust than they historic ally
8
have been; as Mr. Gorman points out, the recent ratios are comparable to their twe l ve-
9
year average. Mr. Gorman does not point out, however, that over the twelve-year pe riod
10
covered in his analysis, the average authorized ROE (for his proxy companies) was 1.59
11
percent. Since the current (2012) valuation multiples presented in Schedule MPG-20 are
12
consistent with the long-term average, it does not appear that investors would be wil ing
13
to accept a 129 basis point reduction in returns ( 10.59 percent less 9.30 percent), as
14
Gorman suggests they should.
.
15
Lastly, while Mr. Gorman suggests that electric utility valuations remain "rob st",
16
he fails to recognize that during 2012, electric utilities were one of the worst perfo rming
17
equity market sectors. In fact, while the S&P 500 gained 13.41 percent in 2012, the
18
Electric Utility Index fell by 4.99 percent; Mr. Gorman's proxy group fell by 4.21 pe cenl
19
(see Chart 9, below).
89
&F
Ibid., at 58.
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REBUTTAL TE'.
ROBERT B.
51
Chart 9: Electric Utility, S&P 500 Price Performance (2012)90
1
2
3
On an absolute and relative basis, therefore, electric utilities were among the
4
industry sectors in 2012.
5
N. RESPONSE TO DIRECT TESTIMONY OF MR. PARCELL
6
7
Q.
TESTIMONY AND RECOMMENDATIONS.
8
9
PLEASE PROVIDE A BRIEF SUMMARY OF MR. PARCELL'S DIRECT
A.
Mr. Parcell estimates the Company's Cost of Equity based on: (1) the Constant Growth
10
DCF model; (2) the CAPM; and (3) the Comparable Earnings Model, or "CEM". 'While
11
Mr. Parcell does not suggest that his CAPM results of 6.10 to 6.30 percent shoul be
12
disregarded, he defines his ROE range of 9.35 percent to 9.75 percent by reference t the
13
mid-point of his respective DCF and CEM results.91
14
recommendation, then, is the midpoint of his 9.35 percent to 9.75 percent range.
90
91
Mr. Parcell's 9.55 pe cent
Through December 31, 2012. Source: SNL Financial.
See Direct Testimony of David C. Parcell, at 6.
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REBUTTAL TES
ROBERT B.
52
1
Q.
AS A PRELIMINARY MATTER, DO YOU BELIEVE THAT MR. PARCI
'S
RANGE AND ROE RECOMMENDATION ARE REASONABLE?
2
No, I do not. Putting aside the analytical issues discussed below, I note that Mr. Pa
's
4
9.55 percent recommendation equals the simple average of four data points (see T;
6,
5
below).
3
A.
Table 6: Summary of Mr. Parcell's ROE Range and Recommendation92
6
Low
Estimate
High
Estimate
Discounted Cash Flow
8.80%
9.90%
Comparable Earnings
9.50%
10.00%
Method
9.55%
Overall Average
7
8
Mr. Parcell's recommendation therefore gives equal weight to all four estimates
9
assuming, for example, that an ROE of 8.80 percent is equally as plausible as an RO of
.
10
10.00 percent (both are weighted by 25.00 percent). As suggested in my response to
11
Cutter, 8.80 percent would be the second lowest of nearly 1,400 ROE authorizations
12
since 1980. Simply removing that estimate and giving equal weight to the remaining
13
three estimates would increase the point estimate to 9.80 percent.
Although 9.80 percent is somewhat higher than Mr. Parcell's 9.55 percent
14
OE
15
recommendation, two of the three observations are associated with his CEM approach.
16
As discussed in more detail later in this section, that approach relies substantially on Mr.
17
Parcell's subjective judgment as to the relationship between Market-to-Book Value ratios
18
and the earned Return on Common Equity, as well as his sense of what may (or may not)
19
be an appropriate Market-to-Book ratio.
20
approach, there are a range of plausible results. For example (as also discussed in more
92
Given the highly subjective nature of that
Ibid.
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ROBERT B.
53
1
detail below) based on the data provided by Mr. Parcell, a Market-to-Book ratio of
2
approximately 1.50 would be associated with the 10.50 percent lower bound of
3
recommended range.93 That ratio (i.e., 1.50) is in approximately the 50th percentile of
4
ratios presented in Mr. Parcell's Exhibit DCP-11.
5
Q.
PARCELL'S ANALYSES AND RECOMMENDATIONS?
6
7
WHAT ARE THE SPECIFIC AREAS IN WHICH YOU DISAGREE WITH 11
A.
The principal areas in which I disagree with Mr. Parcell's analyses include: (1) the ef
8
of current market conditions on SWEPCO's Cost of Equity; (2) the growth rates used in
9
the Constant Growth DCF analysis; (3) the application of the CAPM; and (4)
10
Parcell's application of the Comparable Earnings Method. Mr. Parcell also discusses
11
effect of various environmental mandates on the Company's risk profile and Cos
12
Equity; I address those issues in my response to Dr. Szerszen.
A. Capital Market Conditions
13
14
Q.
PLEASE
BRIEFLY
SUMMARIZE THE FINANCIAL AND
CONDITIONS THAT MR. PARCELL DISCUSSES IN HIS DIRECT TESTIMONY
15
16
of
A.
Mr. Parcell refers to comparatively low levels of inflation (as measured by the Cons'
17
Price Index), which he asserts are "reflective of lower capital costs",94 and histori
18
low Treasury and utility bond yields, which he attributes to a "flight to safety."95
19
Parcell further describes widening credit spreads, declining equity valuations,
20
elevated volatility, which he suggests represent a "negative perception" of the r
93
94
95
See Table 7. 1.50 is the approximate average of 1.45 and 1.53.
Direct Testimony of David C. Parcell, at 12.
Ibid., at 13.
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REBUTTAL TESTID
ROBERT B. HE
54
1
market distress, and which have resulted in the reduced valuation of "retirement
2
investment portfolios, and other assets."96
3
Q.
HAVE YOU REVIEWED SPECIFIC MARKET METRICS TO ASSESS W
4
INVESTORS' RETURN REQUIREMENTS ARE AS LOW AS THE 9.55
5
ROE THAT MR. PARCEL RECOMMENDS?
6
A.
Yes, I have. First, as noted in my response to Mr. Gorman, the electric utility secto in
7
general was among the worst performing sectors in 2012. While Mr. Parcell refers to an
8
article suggesting that utility stocks may have become more attractive to investor in
9
2011,97 that does not appear to have been the case in 2012, either on an absolut e or
10
relative basis. Interestingly, the article cited by Mr. Parcell notes that as of August 18,
11
2011 "...the utilities sector, which represents 4% of the S&P 500 Index, was up 3.21 on
12
price alone at a time when the broader S&P 500 Index was down by 9.3%."98
13
opposite has been true in 2012. As recently noted in Barron's:
14
15
16
17
18
In a reversal of fortune, financial stocks are 2012's best-performing sector,
up 26% after a horrid 2011. The sector was helped by the Federal
Reserve's easy monetary policy and improvement in the housing market.
Utility stocks fell to last from first, as investors moved away from
defensive issues.99
19
The proposition that investors viewed utilities with increasing disfavor di
20
2012 also is supported by data included in Mr. Parcell's Exhibit DCP-3. There,
21
Parcell presents information regarding the ten-year Treasury yield, along with the ;
22
on Aa, A, and Baa-rated utility bonds.
23
spreads for utility debt, especially the incremental spread on Baa-rated debt, incrc
96
97
98
99
he
As EXHIBIT RBH-14R demonstrates, c
Ibid.
See Direct Testimony of David C. Parcell, at 14.
S&P Looks to Utilities ETFs in Downtrodden Equities Market, Onwallstreet.com, August 22, 2011.
Stocks Shed 1.9% on Week on D.C. Deal Doubts, Barron's; see insert "The Last Shall be First", December 29,
2012.
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55
REBUTTAL TESTIMONY
ROBERT B. HE ERT
55
1
significantly in 2012 relative to 2011, and even 2010. It appears, therefore, that both d(
2
and equity markets have had higher return requirements for utility investments in 2012.
3
HAVE YOU UPDATED THE DIVIDEND YIELD/TREASURY YIELD ANAM
Q
CONTAINED IN YOUR DIRECT TESTIMONY?
4
A.
5
Yes, I have. Chart 10 (below) demonstrates that the average dividend yield for the S]
6
Electric Group has continued to exceed the ten-year Treasury yield since the beginning of
7
the financial crisis in late 2008.
Chart 10: Treasury Yield/Dividend Yield Spread
8
8_
7-00%
r
&00%
4.
3-00%
--
_._. ...._.._._. ._. ._.,___.,
!^.._ . . ._._. ,_ .. _._ _.
._. _._
^r; E I
^^........____^_...._......_____..._.^_______^__........__._.._..^ ............... .. _. ..._...._____._______.__..._......___...._._...._______..._....._.._....__.^___..^.^.._^_
Z00%
i
jDD%
2DOO
2005 2DW 2007 2oW 2M 2010 2014 2042
1
ca&
----- 3t# Yew 3 Ebnd
9
10
Chart 10 provides a rather straight-forward but important observation: As Treasury yi
11
continue to fall, electric utility dividend yields have remained stable, or begul
12
increase. Again, focusing on 2012 data and market conditions, it is apparent that u1
13
investments have not been favored by investors either on an absolute or relative basis,
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56
to
REBUTTAL TES
ROBERT B.
56
1
DO YOU AGREE WITH MR. PARCELL'S ASSESSMENT REGARDING T
Q.
IMPLICATIONS OF CURRENT INTEREST RATES FOR THE COST OF EQUITY
2
3
A.
:)w
No, I do not. While it is true that long-term Treasury yields remain at historically 1
4
levels, those yields are the intended result of continued Federal intervention in the cr edit
5
markets, not investors' expectations of a benign capital market.
6
discussed above), credit spreads, or the difference between Treasury yields and uti ity
7
bond yields have remained constant or even increased. If investors were of the view
8
risk had decreased, those spreads would have materially narrowed.
9
Parcell fails to consider the inverse relationship between interest rates and the equity risk
To that point (as
at
Moreover, Mr.
That relationship (based on
10
premium discussed in my response to M. Gorman.
11
authorized returns and expected returns on the S&P 500) also is clearly demonstrate in
12
Charts 11 and 12 (below).
13
Chart 11: Comnonents of Authorized Equity Returnsloo
14
100 Source: SNL Financial, Bloomberg Professional.
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57
REBUTTAL M
ROBERT B.
57
Chart 12: Components of S&P 500 Expected Market Returns 101
1
2
3
Consequently, the observation that utility bond yields are at historically low levels does
4
not demonstrate that the Cost of Equity likewise is at a commensurately low level, as
5
Parcell's recommendation would suggest.
B. DCF Growth Rates
6
7
Q.
PLEASE SUMMARIZE THE GROWTH RATES THAT MR. PARCELL RELIE"'
IN HIS CONSTANT GROWTH DCF ANALYSIS.
8
9
.
A.
Mr. Parcell relies on five measures of growth: (1) historical, five year average earn ngs
10
retention growth rates from Value Line for 2007-2011; (2) five-year average histo ical
11
growth in Earnings Per Share (EPS), Dividends Per Share (DPS) and Book Value Per
12
Share (BVPS) from Value Line; (3) projected earnings retention growth for 2012, 013
13
and 2015-2017 from Value Line; (4) projected EPS, DPS and BVPS growth rates om
101
Source: Bloomberg Professional.
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58
REBUTTAL M
ROBERT B.
58
1
Value Line for years 2008-2010 to 2015-2017; and (5) five-year projections of E P S
2
growth as reported by First Call. 102
3
Q.
PLEASE SUMMARIZE THE DIFFERENCES BETWEEN YOU AND MR. PARCE L
4
IN THE SELECTION OF GROWTH RATES IN YOUR RESPECTIVE CONSTANT
5
GROWTH DCF ANALYSES.
6
A.
For the reasons discussed throughout my Direct and Rebuttal Testimonies, it is my view
Mr. Parce l's
7
that analysts' earnings projections are the relevant measure of growth.
8
analysis, on the other hand, includes both historical and projected growth in DPS, BV S,
9
and EPS, as well as historical and projected measures of Sustainable Growth. For the
.
10
reasons discussed below (as well as in my response to Dr. Szerszen), I disagree with
11
Parcell's use of historical data, and with his use of projected DPS, BVPS, and Sustainable
12
Growth rates.
13
Q.
WHY DO YOU DISAGREE WITH MR. PARCELL'S POSITION THAT DIVIDEND
14
OR BOOK VALUE GROWTH RATES ARE APPROPRIATE INPUTS TO HE
15
CONSTANT GROWTH DCF MODEL?
16
A.
As explained in my Direct Testimony, over the long term, dividend growth can onl be
17
sustained by earnings growth. 103 The use of earnings growth estimates also is supp orted
18
model, which state that
by the assumptions underlying the Constant Growth DCF
19
earnings, dividends and stock prices all grow at the same rate, and that the pa yout,
20
Market-to-Book (M/B), and P/E ratios remain constant, also in perpetuity. Under t ose
21
r the
assumptions, the Constant Growth DCF model produces the same result whethe
22
stock
is
held
in
perpetuity
or
sold
after
an
assumed
holding
period
102 See Direct Testimony of David C. Parcell, at 20.
103 See Direct Testimony of Robert B. Hevert, at 21.
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REBUTTAL TEE
ROBERT B.
59
Given that investors tend to value common equity on
1
(see EXHIBIT RBH-15R).
2
basis of P/E ratios, the expected (and required) return on equity is a function of the lo
3
term growth in earnings, not dividends or book value.
4
Further, Value Line is the only service noted in Mr. Parcell's direct testimony t
5
provides DPS, BVPS growth projections. While services such as Zacks and First
6
survey multiple analysts to arrive at their consensus growth estimates, Value
7
projections reflect the view of a single analyst.
8
perspectives, consensus estimates are less likely to be biased in one direction or aj
9
than a projection that reflects the views of a single analyst. It is for that reason that
10
of the criteria used to develop my proxy group is that the subject company mus
11
followed by at least two utility industry equity analysts.
Because they reflect mi
be
&
12
Lastly, I note that while Mr. Parcell introduces an article by McKinse;
13
Company (McKinsey) in support of his position that the growth rates used in my anal
14
are biased,104 the research discussed in that article is general, and does not indicate
15
there is a systemic bias on the part of utility analysts. I also note that the McKi
16
article observes that "...long-term earnings growth for the market as a whole is unli ely
17
to differ significantly from growth in GDP, as prior McKinsey research has shown.'105
18
In a footnote to that sentence, McKinsey further points out that "Real GDP has avera ed
19
3 to 4 percent over past (sic) seven or eight decades, which would indeed be consis ent
20
with nominal growth of 5 to 7 percent given current inflation of 2 to 3 percent." 10
21
anything, therefore, the McKinsey article supports the growth rates used in both my
22
Constant Growth and Multi-Stage DCF models; both are within the 5.00 to 7.00 percent
6 if
104 See Direct Testimony of David C. Parcell, at 33.
ios Exhibit DCP-15, at 5.
106
Ibid.
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REBUTTAL TESTIMONY
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60
1
range noted by McKinsey, and the terminal growth rate used in my Multi-Stage D F
2
model is the product of real GDP growth (3.24 percent) and expected inflation (2.48
3
percent).
C. Application of the CAPM
4
5
Q.
PLEASE SUMMARIZE MR. PARCELL'S CAPM ANALYSIS.
6
A.
Mr. Parcell's CAPM analyses rely on the three-month average yield on 20-year L .S.
7
Treasury securities from September through November 2012 (as the measure of the Risk-
8
Free Rate), Value Line Beta coefficients, and three estimates of the MRP including: (1)
9
the average difference between the earned equity return on the S&P 500 less the 20•
10
Treasury yield from 1978 to 2011; (2) the arithmetic average difference between the
11
return on the S&P 500 and the total return on long-term government bonds
12
Treasury securities based on data from Morningstar); and (3) the geometric
13
difference between the total return on the S&P 500 and the total return on 1
14
government bonds, also based on data from Morningstar. Those inputs produce C
15
estimates of 6.10 percent to 6.30 percent. 107
M
16
Q.
DO YOU AGREE WITH MR. PARCELL'S APPLICATION OF THE CAPM?
17
A.
r iskNo, I do not. In particular, I disagree with Mr. Parcell's assumption regarding the
18
free rate component of the model, his sole use of longer-term Beta coefficients, an his
19
estimated MRP. More important than our methodological differences, however, are our
20
respective conclusions regarding the reasonableness and reliability of an analysis that
21
produces an ROE estimate of 6.30 percent (which is the upper end of Mr. Parc 11's
22
CAPM analysis range).108 That estimate is 245 basis points below the lowest ROE award
107 See Direct Testimony of David C. Parcell, at 23-24.
10' Ibid., at 24.
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REBUTTAL TESTIM NY
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61
1
reported by Regulatory Research Associates since at least 1980,109 and represents only a
2
188 basis point equity premium over the 4.42 percent Baa Utility Bond Yield (as of
3
November 2012) presented in Mr. Parcell's Exhibit DCP-3, page 4. To put that 188 basis
4
point premium in perspective, Mr. Gorman's Exhibit MPG-12 indicates that the equity
5
premium over A-rated utility bonds was 577 basis points in 2012. Mr. Parcell's C
6
estimate, therefore, is well below any meaningful measure of the Company's Cost of
7
Equity.
8
Q.
WHY IS THE 30-YEAR TREASURY YIELD THE MOST APPROPRIATE
MEASURE OF THE RISK-FREE RATE COMPONENT OF THE CAPM?
9
10
M
A.
The primary difference between Mr. Parcell's estimates of the risk-free rate and min is
11
the term of the assumed Treasury instrument. As noted by Morningstar, the
12
the risk-free security should approximate the life of the underlying investment:
13
14
15
16
17
18
19
The horizon of the chosen Treasury security should match the horizon of
whatever is being valued. When valuing a business that is being treated as
a going concern, the appropriate Treasury yield should be that of a longterm Treasury bond. Note that the horizon is a function of the investment,
not the investor. If an investor plans to hold stock in a company for only
five years, the yield on a five-year Treasury nI ote would not be appiropriate
since the company will continue to exist beyond those five years.l o
20
In essence, equity ownership represents a perpetual claim on the su
21
company's cash flows.lll Since the 30-year Treasury bond is the longest duration
22
free security it is, in my view, the appropriate security for that purpose.
23
average useful life of the Company's electric utility plant in service is
- of
ect
'
Moreover, the
'09 See Exhibit RBH-5R
110 Morningstar, Inc., 2012 Ibbotson Stocks Bonds Bills and Inflation Valuation Yearbook, at 44.
11 The Constant Growth DCF model, for example, reflects the perpetual nature of equity investments.
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ROBERT B.
62
1
approximately 38 years and 48 years.112 Because the Company's assets are such loi
2
duration investments, it remains appropriate to use yields on long-term Treasury bond as
3
the risk-free rate component of the CAPM
4
Q.
RISK PREMIUM (MRP) ESTIMATES INCLUDED IN YOUR CAPM ANALYSIS,
5
6
PLEASE SUMMARIZE MR. PARCELL'S CRITIQUE OF THE EX-ANTE MARKI
A.
Mr. Parcell states that those estimates "greatly exceed the long-term experience (e
7
1929 to present) of investment return differential between common stocks
8
government bonds." 113
9
Q.
WHAT IS YOUR RESPONSE TO MR. PARCELL ON THAT POINT?
10
A.
As a preliminary matter, the MRP is meant to be a forward-looking parameter.
11
12
13
14
15
16
As
Morningstar observes:
It is important to note that the expected equity risk premium, as it is used
in discount rates and cost of capital analysis, is a forward-looking concept.
That is, the equity risk premium that is used in the discount rate should be
reflective of what investors think the risk premium will be going
forward. 114
he
17
That is why my MRP estimates specifically rely on market-based data to estimat
18
expected Market Risk Premium.
19
from 2007-2011 the historical average
MRP decreased from 7.10 percei
to
20
approximately 6.60 percent, while market volatility increased from 17.54 perce
to
21
approximately 24.20 percent (see Table 4, above). That is, the effect of the 2007 to
22
financial dislocation, in which realized returns fell and volatility increased, NN
23
decrease the long-term average MRP. The assumption that investors would have a
Moreover, as noted in my response to Mr. Goi
to
112 See American Electric Power Company, Inc., SEC Form 10-K, for the Fiscal Year Ended December 31, 2011,
at 368.
1 13 Direct Testimony of David C. Parcell, at 34.
1 14 Morningstar, Inc., 2012 Ibbotson Stocks . Bonds. Bills and Inflation Valuation Yearbook, at 53.
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63
1
risk tolerance (as reflected in a lower MRP) during periods of increasing volatility is
2
counter-intuitive, and leads to unreliable analytical results. The relevant analytical is ue
3
in the application of the CAPM is to ensure that all three components of the model (i e.,
4
the Risk-Free Rate, Beta coefficient, and the MRP) are consistent with current mar et
5
conditions and investor perceptions.
6
volatility is at odds with that premise. The ex-ante MRP estimates used in my
7
analyses specifically address that concern.
8
Q.
DO YOU AGREE WITH MR. PARCELL'S USE OF THE TOTAL RETURN
LONG-TERM GOVERNMENT BONDS
9
IN
HIS
CALCULATION OF
HISTORICAL MRP?
10
11
Assuming a lower MRP during periods of
A.
No, I do not. The MRP noted in Table 4 (above) is calculated based on the differe
12
between the arithmetic average return on large company stocks and the income-c
13
return on long-term government bonds as reported by Morningstar (producing an
14
estimated risk premium in 2011 of 6.60 percent). Mr. Parcell, however, calculates the
15
risk premium as the difference between the total return on those two asset classes,
16
implying a risk premium of 4.10 percent to 5.70 percent in 2011.11s
17
As Morningstar points out, the total return on a security is composed of three
18
components: (1) the income return; (2) capital gains (or capital losses, if the value o the
19
security falls); and (3) reinvestment return.116 The income return is generally defin d as
20
the coupon, or interest rate on the security, which does not change over the life o the
21
security. In contrast, the value of the security rises or falls as interest rates change,
22
resulting in uncertain capital gains. As such, the income return is the only "risk less"
115 See Direct Testimony of David C. Parcell, at 24.
116 Morningstar, Inc., 2012 Ibbotson Stocks, Bonds, Bills, and Inflation Valuation Yearbook, at 55.
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64
1
component of the total return. Consequently, it is the income-only portion of the i
2
as opposed to the total return, that should be used in calculating the MRP.
3
Q.
PREMIUMS TO DERIVE HIS MRP ESTIMATE OF 4.10 PERCENT?
4
5
DO YOU AGREE WITH MR. PARCELL'S USE OF THE GEOMETRIC MEAN
A.
No. The important distinction between the arithmetic and geometric averages is that he
6
arithmetic mean assumes that each periodic return is an independent observation and,
7
therefore, incorporates uncertainty into the calculation of the long-term average.
8
geometric mean, by contrast, is a backward-looking calculation that essentially equates a
9
beginning value to an ending value over a specific period of time. Geometric averages,
10
therefore, provide a standardized basis of review of historical performance across
11
investments or investment managers; they do not, however, reflect forward-looking
12
uncertainty.
he
13
Since there is no uncertainty with respect to past returns, the use of geometric
14
averages is appropriate when comparing investment performance on a retrospective basis.
15
On a prospective basis, however, uncertainty exists and should be taken into
16
consideration when developing return expectations and requirements.
17
investors and researchers commonly use the arithmetic mean when estimating the risk
18
premium over historical periods for the purpose of estimating equity cost r
19
Moreover, investment risk often is measured on the basis of the standard deviation, w
20
is a function of the arithmetic, as opposed to the geometric mean. In any c
21
Morningstar notes that:
22
23
24
25
That is why
The arithmetic average equity risk premium can be demonstrated to be the
most appropriate when discounting future cash flows. For use as the
expected equity risk premium in either the CAPM or the building block
approach, the arithmetic mean or the simple difference of the arithmetic
SOAH DOCKET NO. 473-12-7519
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REBUTTAL TE' ,
ROBERT B.
65
1
2
3
means of the stock market returns and the riskless rates is the relevant
number. 117
Q.
ON THE HISTORICAL EARNED RETURN ON COMMON EQUITY?
4
5
DO YOU AGREE WITH MR. PARCELL'S CALCULATION OF THE MRP
A.
No, I do not. First, it is difficult to reconcile the data in his analysis with actual
6
experience. By way of example, Mr. Parcell's analysis assumes that in 2008,
7
earned a positive return of 3.03 percent.118 In 2008, of course, the market actually
8
37.00 percent of its value; only the year 1931 experienced a greater loss.119
9
Moreover, Mr. Parcell's analysis ignores the well-established inverse
10
between the MRP and interest rates.120 As demonstrated in EXHIBIT RBH-16R, the
11
contained in Mr. Parcell's Exhibit DCP-9 produce a statistically significant
12
relationship between the MRP and the 20-year Treasury yield.
13
Parcell is going to use the current 20-year Treasury bond yield, which is far below
14
7.26 percent average over that time, in his CAPM analysis, he should recognize that
15
MRP would be considerably higher than 5.43 percent.121 EXHIBIT RBH-16R fur
16
demonstrates that taking into consideration the inverse relationship between the MRP
17
interest rates (via both a simple linear regression analysis and a semi-log
18
analysis) suggests an MRP of 10.91 percent to 12.77 percent. Those, of course, are
Consequently, if
117 Morningstar, Inc., 2012 Ibbotson Stocks Bonds. Bills and Inflation Valuation Yearbook, at 56.
118 See Direct Testimony of David C. Parcell, Exhibit DCP-9. The market actually lost 37 percent in 2008.
119 Morningstar, Inc., 2012 Ibbotson Stocks Bonds Bills and Inflation Valuation Yearbook, Table B-1 at 168-1
120 See Robert S. Harris and Felicia C. Marston, Estimating Shareholder Risk Premia Using Analysts' Grc
Forecasts, Financial Management. Summer 1992, at 63-70; Eugene F. Brigham, Dilip K. Shome, and Stev R.
Vinson, The Risk Premium Approach to Measuring a Utility's Cost of Equity, Financial Management, Sp
1985, at 33-45; and Farris M. Maddox, Donna T. Pippert, and Rodney N. Sullivan, An Empirical Study o Ex
Ante Risk Premiums for the Electric Utility Industry, Financial Manalzement, Autumn 1995, at 89-95.
12' See Direct Testimony of David C. Parcell, at 24.
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REBUTTAL TE,;
ROBERT B.
66
1
above the 5.43 percent MRP included in Mr. Parcell's 6.10 percent to 6.30
2
CAPM range.122
D. Market-to-Book Ratios and Comparable Earnings Method
3
4
Q.
EARNINGS ANALYSIS.
5
6
PLEASE DESCRIBE MR. PARCELL'S APPLICATION OF THE COMPA
A.
Mr. Parcell's Comparable Earnings analysis examines realized Return on (
7
Equity for several groups of companies (our respective proxy groups, and the S&P 00
8
companies) and evaluates investor acceptance of those returns by reference to he
9
resulting MB ratio.123 Mr. Parcell reasons that his results indicate historical returns of
10
9.30 percent to 12.20 percent have been adequate to produce market-to-book ratic
11
135.00 percent to 168.00 percent.124
12
Parcell considers to be representative of the competitive sector of the economy, indi
13
average earned returns from 12.60 percent to 14.70 percent, with market-to-book ra
14
ranging from 253.00 percent to 341.00 percent.125 Finally, Mr. Parcell compares the
15
levels of the utility industry with those of the competitive sector, by considering "
16
metrics as the Value Line Safety Rank, Value Line Beta coefficient, Value Line Finar
17
Strength, and S&P Stock Rank.126
of
His review of S&P 500 companies, which
Based on his Comparable Earnings analysis, Mr. Parcell concludes that "..
18
19
cost of equity for the proxy utilities is no more than 9.5 percent to 10.0 percent." 127
20
Parcell further concludes that "an earned return of 9.5 percent to 10.0 percent should
122 Ibid.
123
124
121
'26
121
Ibid., at 24-28.
Ibid., at 26.
Ibid., at 27.
Ibid., Exhibit DCP-13.
Ibid., at 27.
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REBUTTAL TESTM
ROBERT B. HEN
67
1
result in a market-to-book ratio of over 100 percent," 128 and that "...the fact that
2
to-book ratios substantially exceed 100 percent indicates that historic and
3
returns of over 10 percent reflect earnings levels that exceed the cost of equity for those
4
regulated companies."129
5
Q.
DO YOU AGREE WITH MR. PARCELL'S COMPARABLE EARNINGS ANALYS S?
6
A.
No, I do not. With respect to the structure of his analysis, I disagree with Mr. Parce 1's
7
assumption that the earned Return on Common Equity (ROCE)13o is the sole determinant
8
of the M/B ratio. Even if his assumption was correct, Mr. Parcell provides no empirical
9
basis regarding the relationship between M/B ratios and the earned ROCE. Nor, for hat
10
matter, does Mr. Parcell provide an empirical basis for his determination regarding the
11
appropriate M/B ratio. Rather, Mr. Parcell's analysis is substantially subjective in nature
12
and as such, his assumptions and conclusions (as presented) cannot be replicated, veri ied
13
or falsified. Given that the CEM analysis defines the upper end of Mr. Parcell's
14
range, the subjective nature of his conclusions have a significant effect on his even
15
point estimate (i.e., 9.55 percent).
16
Q.
AS A PRELIMINARY MATTER, PLEASE PROVIDE A BRIEF DEFINITION OF
THE MARKET-TO-BOOK RATIO.
17
18
OF
A.
The M/B ratio equals the market value (or stock price) per share, divided by the total
Book value per share is an accounting
19
common equity (or book equity) per share.
20
the
construct, which reflects historical costs. In contrast, market value per share (i.e.,
21
stock price) is forward-looking, and is a function of many variables, including (bu not
22
limited to) expected earnings and cash flow growth, expected payout ratios, measures of
128
129
Ibid.
Ibid.
130 Mr. Parcell's analysis assumes that the Return on Common Equity is interchangeable with the ROE.
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REBUTTAL TESTIM NY
ROBERT B. HE ERT
68
1
"earnings quality", the regulatory climate, the equity ratio, expected capital
2
and the expected return on book equity.131 It follows, therefore, that the M!B
3
likewise is a function of numerous variables in addition to the historical or
4
Return on Common Equity.
5
Q.
AS A PRACTICAL MATTER, WOULD A RATIONAL INVESTOR INVEST IN
6
UTILITY STOCKS IF THEY BELIEVED THAT UTILITY COMMISSIONS WOULD
7
SET RATES IN AN EFFORT TO MOVE THE M/B RATIO TOWARD UNITY?
8
A.
No. While Mr. Parcell states that his CEM "recommendation is not designed to resi
9
market-to-book ratios as low as 1.0",132 he suggests that "maintenance of a fmanc
10
stable utility's market-to-book ratio at 100 percent, or a bit higher, is fully adequa
11
maintain the utility's financial stability." 133 If, however, an investor purchased a u
12
stock at the long-term average M/B ratio of approximately 153.00 percent (i.e.,
13
Parcell's proxy group average from 2002-2011 as noted in Exhibit DCP- 11), that in-v
14
would incur a loss of approximately 27.45 percent if the M!B ratio fell to 111.00 pe
15
(i.e., a level that presumably is "a bit higher" than 100.00 percent). 134 Such a
16
would certainly impede the ability to attract the capital required to support its
131 See, for example, Roger A. Morin, New Regulatory Finance, Public Utility Reports, Inc., 2006, at 366.
note that Dr. Morin cites several academic articles that address the various factors that affect the ME
Book ratio for utilities. In addition, the notion that book values should be set at a value approaching i
regulatory commissions has been refuted for many years. As noted by Stewart Meyers in 1972: "In
straightforward application of the cost of capital to a book value rate base does not automatically imply
market and book values will be equal. This is an obvious but important point. If straightforward apI
did imply equality of market and book values, then there would be no need to estimate the cost of ca;
would suffice to lower (raise) allowed earnings whenever markets were above (below) book." Ste
Meyers, The Application of Finance Theory to Public Utility Rate Cases, The Bell Journal of Econon
Management Science, Vol. 3, No. 1 (Spring 1972), at 58-97.
132 Direct Testimony of David C. Parcell, at 28.
133
in
to
by
t, a
the
It
C.
ibid.
134 Even assuming the 142.00 percent M/B ratio for Mr. Parcell's proxy group in 2011, the loss w
approximately 22.00 percent. As discussed below, 111.00 percent reflects a 10.00 percent factor for
and flotation costs.
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be
REBUTTAL TEST
ROBERT B. H
69
That example points out a substantial shortcoming of Mr. Parcell's analysis: w
1
2
he suggests that the current level of M/B ratios indicates returns that exceed the Cos of
3
Equity, he fails to identify the ratio that would set the required return equal to the reali
4
return. It is not surprising that Mr. Parcell has not done so since, as discussed be]
5
there are a number of variables beyond the earned ROE that affect the M/B r,
6
Because the data presented by Mr. Parcell focuses on only one of those factors (i.e.,
7
earned return on equity), they produce empirical results that are highly inconsistent,
8
market realities.
9
Q.
HOW DOES MR. PARCELL REFLECT THE RELATIONSHIP BETWEEN :
RATIOS AND THE RETURN ON COMMON EQUITY IN HIS CEM ANALYSIS?
10
11
,
A.
Mr. Parcell first compares the historical earned returns on book equity with histo
12
MB ratios for our respective proxy groups, 135 and concludes that historical ea
13
returns on book equity support M/B ratios from 135.00 percent to 168.00 percent.136
14
Parcell then considers the historical earned returns on book equity and concurrent
15
ratios for the S&P 500 (for the years 1992 through 2011), together with a comparisc
16
the risk levels for both the S&P 500 and our respective proxy groups. Based on 1
17
observations, Mr. Parcell concludes that the "competitive sector" (i.e., the S&P 5C
is
18
more risky than the proxy companies, and has historical earned returns and M/B i
s
19
that exceed those of the proxy groups.137
of
135
See Direct Testimony of David C. Parcell, at 26.
136
Ibid.
137 Ibid., at 27.
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REBUTTAL TES
ROBERT B.
70
1
Q.
2
3
DOES MR. PARCELL CONSIDER VARIABLES OTHER THAN THE
RETURN ON EQUITY IN ARRIVING COST OF EQUITY ESTIMATE?
A.
No. Although Mr. Parcell considers differences in the level of risk between the p]
4
group and the S&P 500 to arrive at his conclusion that unregulated companies
5
relatively more risky than regulated companies, that point is not in dispute. Beyond
6
Mr. Parcell does not consider any other variables that may affect M/B ratios.
7
Q.
WHAT ARE THE IMPLICATIONS OF HIS FAILURE TO DO SO?
8
A.
By failing to consider other variables, Mr. Parcell's CEM analysis assumes that the o
factor that has a "direct relationship" to the M/B ratio is the earned ROE.138 If that vc
9
10
the case, the relationship between earned returns and the M/B ratio could be estimated ia
11
linear regression analysis. Using the data contained in Mr. Parcell's Exhibit DCP-1 , I
12
developed a simple linear regression, in which the MB ratio is the dependent variable,
13
and the ROCE (the "Return on Average Common Equity" presented in Page 1 of at
14
Schedule) is the sole explanatory variable.139
15
Q.
STRUCTURED.
16
17
PLEASE BRIEFLY DESCRIBE HOW YOUR REGRESSION ANALYSIS IS
A.
My first analysis is focused on the average equity returns and M/B ratios presented in
.
For Mr. Parcell's proxy group, I performed a linear regres s ion
18
Parcell's DCP-11.1ao
19
analysis in which the M/B ratio was modeled as a function of the ROCE. In that case, the
20
regression equation was statistically significant at the 95.00 percent confidence le el,
21
although the explanatory value was somewhat low (the adjusted R2 for Mr. Parc 11's
138 Ibid., at 28.
'39
See Exhibit RBH-17R
140 Please note that because Mr. Parcell did not provide projected Market-to-Book ratios, my analysis r
was based on historical data.
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REBUTTAL TES
ROBERT B.
71
1
group was approximately 30.00 percent). I then used the regression coeff
2
determine the ROCE that would be associated with various levels of M/B ratios.
3
Q.
ON WHAT BASIS DID YOU SELECT THE RANGE OF M/B RATIOS?
4
A.
While Mr. Parcell did not specify what he would consider to be the optimal ratio, he
to
5
note that an objective of setting the ROE would be to "attract new equity capital witl
6
dilution." 141
7
market pressure associated with new shares, the M/B ratio should exceed 100.00 per
8
in an amount sufficient to reflect those costs. Assuming a dilution cost of 10.00
9
(reflecting both direct costs and market pressure) would be quite reasonable, if riot
10
conservative.142 Based on a 10.00 percent dilution rate, the adjusted M/B ratio would be
11
approximately 111.00 percent.143
Since dilution would be a function of both equity issuance costs and
Using the regression coefficients (see EXHIBIT RBH-17R), I then calculated
12
13
ROE that would correspond to an M/B ratio of I11.00 percent for the respective proxy
14
groups. In the case of Mr. Parcell's proxy group, the resulting ROE is approximately
15
5.97 percent; the resulting ROE for my proxy group is approximately 5.37 perc nt.
16
Those results are so low as to have no relevance to the determination of the Compa y's
17
Cost of Equity.
18
Q.
DID YOU PERFORM SIMILAR ANALYSES TO DETERMINE THE M/B RA
19
THAT WOULD BE ASSOCIATED WITH THE LOW END OF
20
RECOMMENDED ROE RANGE?
21
22
A.
Yes, I did.
Based on our respective proxy groups, I calculated the M/B ratios
correspond to an ROE of 10.50 percent.
Using the data in Exhibit DCP-11, I
'"' Direct Testimony of David C. Parcell, at 25.
142
See Roger A. Morin, New Regulatory Finance, Public Utility Reports, Inc., 2006, at 323-327.
143 Equals ( 1/(1-dilution costs).
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REBUTTAL TESTIMONY
ROBERT B. HEV RT
72
1
calculated the percentile in which the implied M/B ratio fell within the hisl
2
observations (I performed the same calculation for both my and Mr. Parcell's
3
groups).
4
recommendation. The results of those analyses are presented in Table 7 (below).
5
Table 7: Implied Market-to-Book Ratios at 10.50 Percent and 11.25 Percent RI
I performed the same set of calculations assuming my 11.25 percent
Implied
Market-Book Ratio
145% (47'h)
Implied ROE (Parcell Proxy
Group)
10.50%
Implied ROE (Hevert Proxy
Grou
153% (52nd)
---
10.50%
151% (55U`)
11.25%
---
160% (56th)
---
11.25%
--
6
7
Q.
COMPARABLE EARNINGS METHOD?
8
9
WHAT ARE YOUR CONCLUSIONS REGARDING MR. PARCEL 'S
A.
My principal conclusion is that Mr. Parcell's suggestion that 9.55 percent to 10.00
10
percent represents a reasonable range of ROE estimates lacks an empirical, and
11
substantially under-estimates the Company's Cost of Equity. Based on the data presented
12
in Exhibit DCP-11, the lower end of my recommended range, 10.50 percent to 11.25
13
percent, is a more reasonable estimate.
144 See Exhibit RBH-17R
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REBUTTAL TES
ROBERT B.
73
V. RESPONSE TO DIRECT T^STIMONY OF MR. HILL
1
2
Q.
THIS PROCEEDING.
3
4
PLEASE SU1Vl1V1ARIZE MR. HILL'S TESTIMONY AND RECOMMENDATION
A.
Mr. Hill recommends an ROE range 8.50 percent to 9.50 percent, with a point estimat of
Mr. Hill's analytical results and recommendation are based on f ur
5
9.00 percent. 141
6
methods, including the Constant Growth DCF model, the CAPM, his "Modi
7
Earnings-Price Ratio" (MEPR) analysis, and his "Market-to-Book Ratio" (M
8
analysis.
9
Commission accept the Company's proposal, which includes 49.10 percent com]
10
equity and 50.90 percent long-term debt, although he suggests that because the indL
11
average is closer to 46.10 percent equity, the Company's ROE should be
12
downward. 146
13
Q.
PLEASE NOW SUMMARIZE THE KEY AREAS IN WHICH YOU DISAGREE
MR. HILL.
14
15
Regarding the Company's capital structure, Mr. Hill recommends that
A.
There are several areas in which Mr. Hill and I disagree, including: (1) the interpretation
16
and effect of current and projected market conditions on the Cost of Equity for regulated
17
utilities; (2) the growth rates used in our respective DCF analyses and the implication of
18
those growth rates for the determination of the Company's ROE; (3) certain element of
19
and inputs to our respective CAPM analyses; (4) the application and relevance of the
20
MEPR and MBR approaches to the estimation of the ROE for SWEPCO; (5) the
21
relevance of the Risk Premium method; (6) Mr. Hill's pro forma Pre-Tax Coverage Ratio
22
calculation and his interpretation of those results; (7) the relevance of certain
145
See Direct Testimony of Stephen G. Hill, at 6.
146
Ibta., at 26.
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REBUTTAL M
ROBERT B.
74
1
of investor expectations for broad market performance that Mr. Hill asserts corrobor
2
his analyses; (8) the appropriateness of the recovery of flotation costs; and (9) the not:
3
that the Company's requested capital structure requires a downward adjustment to its
4
ROE. I discuss each of those issues in turn, below.
A. Current Market Conditions
5
6
Q.
PLEASE
SUMMARIZE
MR.
HILL'S
TESTIMONY REGARDING
7
INTERPRETATION AND EFFECT OF CURRENT AND EXPECTED M
8
CONDITIONS ON THE COST OF EQUITY FOR REGULATED UTILITIES.
9
A.
Although Mr. Hill and I agree that it is important to consider capital market c,
10
we arrive at considerably different conclusions as to the effect of current and
11
market conditions on the Cost of Equity for regulated utilities. By way of example, b sed
12
primarily on the current yield of government-issued debt instruments (i.e., Treasury ills,
13
notes, and bonds), Mr. Hill concludes that "the broad economic environment currently is
14
more benign than it was prior to the financial crisis-capital costs are lower-and, t us,
15
more favorable for capital intensive industries like utilities.
16
in my Rebuttal Testimony, the currently low level Treasury yields are the resu t of
17
substantial government intervention in the capital markets and continued risk aversion on
18
the part of investors; they are not the result of a benign capital market and
19
correspondingly low equity return requirements.
20
market intervention may itself be creating further uncertainty.
21
Federal Reserve, Ben Bernanke, recently remarked on the uncertain nature of curren Fed
22
policy:
„ 147 As discussed elsew ere
Importantly, the Federal Reserve
The Chairman o the
'a' Ibid., at 18-19.
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75
REBUTTAL TESTI ONY
ROBERT B. HE ERT
75
1
2
3
4
5
[G]iven that we are now in the world of unconventional policy that has
both uncertain cost and uncertain efficacy or uncertain benefits, you know,
that creates a more--somewhat more complicated policy decision than the
old style of just changing the federal funds rate. 148
Q.
6
7
HAVE AUTHORIZED EQUITY RETURNS FALLEN CONIlVIENSURATELY
TREASURY YIELDS?
A.
No, they have not. As Chart 13 (below) demonstrates, since 2011 authorized
8
have remained relatively stable even as long-term Treasury yields have
9
decreased.
10
Chart 13: Authorized ROEs vs. 30-Year Treasury Yields 149
5.
i400%
1 3- M -
_n
^
^ f2
3
^
4
n
'.
4
n
yM
V
1€ .
4
^
^
.
4_0M
nn n
0
n
6
%
n
n n
^
^
1-
n n
n n ^ ^
n
n
n
n
n ^
n
n^ n
n n
n
0
3_' '
^
n
^
*^^^^^
n n
^^
n
3_
^-
2U1#}
n
2042
^'^
Auftdzod ROE
-----^F-`w`^T
)
11
12
The fact that authorized returns have remained stable as interest rates have
13
is not surprising when we consider the circumstances underlying the unprecei
14
decline in Treasury yields. As a result of investor risk aversion and Federal intervE
15
investors have bid down yields to the point that they currently are willing to accept
148 Transcript of Chairman Bernanke's Press Conference, December 12, 2012, at 20.
149 Sources: Regulatory Research Associates and Bloomberg Professional.
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REBUTTAL TEST]
ROBERT B. H.
76
That behavior, of
1
on ten-year Treasury bonds that are below the rate of inflation. 150
2
course, is not consistent with the notion that equity investors have materially decrea
3
their required Return on Equity, as Mr. Hill's 9.00 percent ROE recommendat
4
suggests.
5
6
B. DCF Growth Rates
Q.
DOES MR. HILL EXPRESS ANY SPECIFIC CONCERNS WITH YOUR USE
7
ANALYSTS' EARNINGS GROWTH PROJECTIONS IN THE CONST.
8
GROWTH DCF MODEL?
9
A.
Yes, Mr. Hill devotes several pages of his Direct Testimony asserting in rather
terms that analysts' earnings forecasts are overly optimistic and "rosy." 151
10
11
Q.
WHAT IS YOUR RESPONSE TO MR. HILL IN THAT REGARD?
12
A.
Despite his assertions, Mr. Hill has provided no analyses supporting his position that the
13
sources of growth rates used in my (and for that matter, Mr. Cutter's and Mr. Gorm 's)
14
DCF analyses are subject to a systemic and pervasive bias. As to Mr. Hill's asserti i
15
that "services offer relatively `rosy' expectations for the stock they follow", that anal <.
16
"overstate growth expectations", and that securities can be affected by "`the Cinder e]
17
effect' (analysts' overstating stock expectation)" 152 recent research reaches the oppo i
18
conclusion. A 2010 article in Financial Analyst Journal found that analyst forecast i
19
has declined significantly or disappeared entirely since the 2003 Global Settlement:
20
21
22
23
Introduced in 2002, the Global Settlement and related regulations had an
even bigger impact than Reg FD on analyst behavior. After the Global
Settlement, the mean forecast bias declined significantly, whereas the
median forecast bias essentially disappeared. Although disentangling the
150 See, for example, Treasurys Slide After Lackluster Sale, The Wall Street Journal. August 8, 2012. The tenTIPS yield has been consistently negative since December, 2011. See Federal Reserve Board Schedule H.1 .
15' See Direct Testimony of Stephen G. Hill, at 38 - 43.
112 Ibid., at 40.
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REBUTTAL TESTIM 1
ROBERT B. HEV
77
1
2
3
4
5
impact of the Global Settlement from that or related rules and regulations
aimed at mitigating analysts' conflicts of interest is impossible, forecast
bias clearly declined around the time the Global Settlement was
announced. These results suggest that the recent efforts of regulators have
helped neutralize analysts' conflicts of interest.153
6
Moreover, while Mr. Hill asserts that analysts'
growth projections
7
inappropriate because analysts may "overstate growth expectations to make the st(
8
they want to sell look more attractive", he has provided no support for the notion that
9
of the proxy companies are subject to the "Cinderella effect." 154 Based on a reviei
of
10
disclosures contained in recent analyst reports for certain of the proxy companies,
is
11
apparent that the standard industry practice is to avoid conflicts of interest by ensu
12
that compensation is not, either directly or indirectly, linked to the opinions contain(
13
those reports. In fact, some reports go so far as to demonstrate the specific factors
14
determine compensation, including the accuracy of earnings estimates, which creal
15
disincentive for either over- or under-estimating earnings.155
16
in
a
Regardless of whether Mr. Hill believes that analysts' growth rate projections
17
systemically biased, the relevant analytical question is whether investors rely on
18
estimates in making their investment decisions. There is, in fact, a substantial
of
^s3 Armen Hovakimian and Ekkachai Saenyasiri, Conflicts of Interest and Analyst Behavior: Evidence firom
Recent Changes in Regulation, Financial Analysts Journal, Volume 66, Number 4, July/August 2010, at 195.
The Global Settlement was an enforcement agreement among the SEC, the New York Stock Exchange the
National Association of Securities Dealers and ten investment banks regarding conflict of interest issues.
154 See Direct Testimony of Stephen G. Hill, at 40.
155 For example, see BMO Capital Markets, Viewpoint, September 18, 2012, at 8.
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1
academic research supporting that conclusion. 156
2
conclude that the use of analysts' forecasts is superior to measures of historical growth
3
when using the DCF model to estimate the Cost of Equity. 157
Moreover, certain of those articles
4
In order to assess whether analyst growth rates are excessively optimistic, I
5
examined the extent to which the consensus forecast earnings either under- or over-
6
estimated quarterly earnings in 2011 and 2012 for the proxy companies. Based on data
7
provided by Zacks Investment Research (a source of consensus earnings forecasts use in
8
my DCF model), EXHIBIT RBH-18R demonstrates that the average annual difference
9
between actual and projected earnings (that is, the "Earnings Surprise") was nega ive
10
2.26 percent.158 That is, actual earnings were 2.26 percent higher than projected earnings
11
for my proxy group and there where an equal number of overestimates and
12
underestimates.
13
growth rate projections used in the Constant Growth DCF model. If Mr. Hill is
14
and earnings projections are overly optimistic, however, it would stand to reason
15
such a bias would exist in near-term forecasts, as well. As demonstrated above,
16
that has not been the case.
I understand that quarterly earnings estimates are not the long-
156 In The Risk Premium Approach to Measuring a Utility's Cost of Equity, published in Financial Mana%
Spring 1985, Brigham, Shome and Vinson noted that "evidence in the current literature indicates I
analysts' forecasts are superior to forecasts based solely on time series data; and (2) investors do
analysts' forecasts." Similarly, in a review of literature regarding the extent to which analyst forec
reflected in stock prices (Using Analyst's Growth Forecasts to Estimate Shareholder Required Rates of
Financial Management. Spring 1986), Harris noted: "VanderWeide and Carleton recently compare coi
[financial analyst forecasts] of earnings growth to 41 different historical growth measures. They conch
`there is overwhelming evidence that the consensus analysts' forecast of future growth is sup(
historically-oriented growth measures in predicting the firm's stock price.. .consistent with the hypothe
investors use analysts' forecasts, rather than historically-oriented growth calculations, in making stock t
sell decisions." The VanderWeide and Carleton study was updated in 2004 under the direction
VanderWeide. The results of the updated study were consistent with the original study's conclusions.
157 Harris and Marston, Estimating Shareholder Risk Premia Using Analysts' Growth Forecasts, Fi
,
(1)
on
are
that
rto
that
and
Dr.
Management, at 21 (Summer 1992).
iss See Exhibit RBH-18R.
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1
While Mr. Hill criticizes the use of analyst growth rates, those rates are
2
observable and, as discussed in my response to Dr. Szerszen, have a demonstr ated
3
empirical relationship to electric utility valuation multiples. The growth rates include in
4
Mr. Hill's analysis, on the other hand, based on his subjective opinion as to what ma y or
5
may not be "reasonable." 159 That is, rather than rely on an independent, observable,
6
verifiable source of growth rate projections, Mr. Hill provides a discussion of each pr o xy
7
company's historical and projected growth rates, and in the context of that narrat i ve,
8
applies his subjective judgment to arrive at what he considers to be a suitable growth r ate.
9
Because it is substantially a function of his judgment, Mr. Hill's analysis cannot be
10
replicated; it is quite likely that other analysts looking at the same information w ould
11
arrive at entirely different conclusions. Given the empirical support for using published,
12
observable, and verifiable analysts' growth rate projections, Mr. Hill's appro ch
13
essentially substitutes his judgment for that of the market.
14
Q.
WERE YOU ABLE TO UPDATE MR. HILL'S DCF ANALYSIS THROUGH
NOVEMBER 30, 2012?
15
16
d
A.
No, it is not possible to do so. Since Mr. Hill applies a different rationale for determining
17
the reasonableness of each proxy company's growth rate, it is not possible to determine
18
how updated values would affect what Mr. Hill deems "reasonable" in selecting the
19
growth rate for a given proxy company. For instance, the rationale Mr. Hill use in
20
describing the selection of Ameren's 3.00 percent sustainable growth rate focuses the
21
historical sustainable growth rate of 2.49 percent, with an emphasis on an "upward trend
22
showing higher growth (3.5%) in the last three years." 160
Mr. Hill has chose a
159 See Direct Testimony of Stephen G. Hill, Attachment C.
160
Ibid.
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sustainable growth rate above the historical average of 2.49 percent despite his
2
observation that "Value Line expects AEE's sustainable growth rate to moderate to 2.1%
3
through the 2015-17 period",161 the recent decline in the sustainable growth rate from
4
3.82 percent in 2010 to 2.76 percent in 2011, and a projected decline in 2012 to .47
5
percent.162 In effect, Mr. Hill has determined that Ameren's sustainable growth rate will
6
increase above the historical average, notwithstanding Value Line's projections that the
7
sustainable growth rate will decline. In fact, every growth rate for Ameren presented in
8
Mr. Hill's Schedule 4 is below his selected sustainable growth rate of 3.00 percent.
9
Q.
HIS DCF ANALYSIS?
10
11
ARE THERE ANY ERRORS IN MR. HILL'S ANALYSIS THAT COULD AFFECT
A.
Yes. Mr. Hill relied upon incorrect data when coming to the conclusion that 5.00 percent
Mr. Hill stated that the average
12
was the correct growth rate for UNS Energy (UNS).
13
sustainable growth rate from 2007 through 2011 was 3.39 percent and is expected to
14
increase to 4.00 percent by 2015-2017.163
15
historical sustainable growth rate is 3.86 percent, and the expected growth rate is .60
16
percent. Both are significantly higher than what Mr. Hill stated. The historical growth
17
rate also is influenced by one year of negative growth (which is the only year of negative
18
growth since at least 1996, Value Line provides historical data as far back as 199 for
19
UNS). If that one observation is removed, the historical sustainable growth rate is
20
essentially equal to the expected sustainable growth rate.
21
significant element of judgment included in his assessment, it is impossible to determine
22
how this correction would change Mr. Hill's growth rate estimate for UNS. However,
When the correct data is reflected, the
As noted above, give the
161 Ibici.
162 See Direct Testimony of Stephen G. Hill, Schedule 3.
163 See Direct Testimony of Stephen G. Hill, Attachment C.
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1
given that both measures of the sustainable growth rate on which Mr. Hill relies are
2
higher than what was presented in his Direct Testimony, it is quite reasonable to conc
3
that the sustainable growth rate would be significantly increased.
4
Mr. Hill made a similar error when determining the share growth for UNS. In
5
particular, Mr. Hill stated that share growth increased at an average of 4.78 percent over
6
the past five years, due to an equity issuance in 2009.
7
number of shares is expected to increase at an annual rate of 0.30 percent through 2 15-
8
17 164 Both of those statements, however, are incorrect. From 2007 through 2011 share
9
growth for UNS averaged 1.12 percent. Value Line estimates that the number of shares
10
outstanding will increase by over 12.00 percent in 2012 and remain relatively flat
11
thereafter. 165 Again, it is unclear how the corrected information would affect Mr. ill's
12
assessment of the projected share growth for UNS.
13
WHAT ARE YOUR CONCLUSIONS REGARDING MR. HILL'S CONST.
Q.
GROWTH DCF ANALYSIS?
14
15
Mr. Hill also stated that the
The critical input to Mr. Hill's Constant Growth DCF analysis, projected growth i
A.
16
are highly subjective, cannot be replicated, and essentially represent the substituti4
17
Mr. Hill's judgment for that of the market. Consequently, it is very difficult to see
18
those results weigh in his 9.00 percent ROE recommendation. In my view, there
19
those results should be given no weight in determining the Company's Cost of Equit.
164
of
Ibid
165 The most recent SEC Form 10-Q for the quarter ending September 30, 2012 for UNS states that the :
shares outstanding for the company is 41.38 million. Value Line reported that the number of shares o
in 2011 was 36.92 million.
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C. CAPM Analysis
1
2
Q.
3
4
PLEASE SUMMARIZE THE VARIOUS INPUTS TO MR. HILL'S
ANALYSIS.
A.
Mr. Hill relies on his estimate of the long-term trend in Treasury bond yields (i.e., ^.70
5
percent), the average Value Line Beta coefficient for his proxy group (0.70),
6
Morningstar's arithmetic mean long-term Market Risk Premium (6.00 percent, based on
7
the total return of Long-Term Government Bonds). Those parameters produce a
8
result of 7.93 percent.166
9
Q.
DO YOU AGREE WITH MR. HILL'S APPLICATION OF THE CAPM?
10
A.
No, I do not. As a practical matter, Mr. Hill's results are unreasonably low and
L be
11
reconciled with any reasonable measure of investors' equity return requirements. In
12
regard, Mr. Hill's 7.93 percent result is far below even the lowest return ever
13
for an electric utility. 167 In addition, Mr. Hill relied on data from the Ibbotson
14
Valuation Yearbook in developing his Market Risk Premium of 6.00 percent, not the
15
more recent edition.168 If he relied on the 2012 Valuation Yearbook, his Market isk
16
Premium would be 5.70 percent,169 which would have the effect of decreasing Mr. Hill's
17
CAPM result to 7.69 percent. On its face, a CAPM result that low is far belom
18
reasonable estimate of the Company's ROE and should be given no weight.
166
167
168
169
See Direct Testimony of Stephen G. Hill, Schedule 7.
That return, 8.75 percent, was awarded to a distribution utility in Connecticut.
See Direct Testimony of Stephen G. Hill, at 48 - 49.
Morningstar, Inc., 2012 Ibbotson Stocks Bonds, Bills and Inflation Valuation Yearbook, at 23. Mr. ill's
Market Risk Premium based on data through 2011 equals the arithmetic mean of total returns for large company
stocks (11.80 percent) minus the arithmetic mean of total returns for long-term government bonds 6.10
percent). 11.80 percent - 6.10 percent = 5.70 percent.
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1
Q.
ANALYSIS?
2
3
A.
Mr. Hill asserts that I have overstated two of the components of the CAPM model: the
Beta coefficient and the Market Risk Premium.
4
5
WHAT CONCERNS HAS MR. HILL EXPRESSED REGARDING YOUR CA
Q.
TURNING FIRST TO THE BETA COEFFICIENT, DO YOU AGREE THAT YC UR
6
CALCULATED BETA IS NOT RELEVANT TO AN ANALYSIS OF THE COST OF
7
EQUITY FOR SWEPCO?
8
A.
No. As stated in my Direct Testimony, I used a twelve-month calculated Beta coeffic
(in addition to the 60 and 24 month Betas calculated by Value Line and Bloomt
9
10
respectively) to provide a more current view as to investors' perspectives with respe, ;t to
11
that
the systematic risk represented by the proxy group companies.170 While he argues
12
my calculated Beta is not relevant to an estimate of the Cost of Equity because it doe; not
13
represent, "information that is widely available to the investing public," 171 I perfoi med
14
my calculation in order to address concerns similar to those expressed by Mr. Hill
15
regarding the use of the CAPM in general:
16
17
18
19
20
[T]he beta of a particular company, because it is usually derived with five
years of historical data, is slow to change to current (i.e., forward-looking)
conditions, and some price abnormality that may have happened four
years ago could substantially affect beta while, currently, being of little
actual concern to investors.172
21
Moreover, although Mr. Hill asserts that my Beta estimate is not availal;
to
22
investors, he relies on a Beta coefficient that he acknowledges reflects data tl
is
23
sufficiently dated as to be "of little actual concern to investors."173 In fact, wherea Mr.
170 See Direct Testimony of Robert B. Hevert, at 27.
171 See Direct Testimony of Stephen G. Hill, at 66.
172 Ibid., at 46. Emphasis added.
173
Ibid.
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1
Hill states that his CAPM is a "check of the DCF Cost of Equity estimate," 174 his C
2
result is 113 basis points lower than his DCF result and 107 basis points below his
3
recommended ROE. As such, Mr. Hill's CAPM result does little to corroborate his
4
analytical results.
M
5
Lastly, in response to the notion that Beta estimates relying on twelve month of
6
data are not available to investors, there is no question that financial services such as
7
Bloomberg enable analysts to specify the analytical period (e.g., six, twelve, twenty-
ur,
8
sixty months), the holding period (e.g., daily, weekly, monthly), and the index (e.g.,
&P
9
500, Dow Industrial) used to calculate Beta coefficients. That is, Bloomberg recogn zes
10
that investors require the ability to calculate Beta coefficients over varying periods and
11
with respect to differing indices. Given that (on average) Mr. Hill's proxy companies are
12
over 71.00 percent institutionally owned,175 it is difficult to imagine that those inve stors
13
would not have such resources available to them. In any event, Mr. Hill's concern with
14
anything other than "default" estimates of Beta coefficients is misplaced. Even ab ent
15
services such as Bloomberg, it is possible (as I have done) to calculate Beta coeffici nts
16
using publicly available data. It is clear, therefore, that market practitioners are not
17
resigned to rely on financial metrics that do not reflect prevailing and expected m arket
18
conditions, when the data to produce more relevant analyses are readily available.
19
Q
20
21
22
WHAT ARE MR. HILL'S CONCERNS WITH YOUR MARKET RISK PREMIUM
ESTIMATES?
A.
Mr. Hill asserts that: (1) I have made an "apples-to-oranges" comparison of the expe ted
earned return on the S&P 500 to current 30-year Treasury bond yield (as opposed to the
174 Ibid., at 45.
175 Source: SNL Financial.
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1
total return on Treasuries) and have done the same in my derivation of the Sharpe
2
derived Market Risk Premium;176 (2) my estimates are "outside the mainstream of c
3
economic thought" because they do not reflect certain "discussion in the literat
4
financial economics over the past decade," which Mr. Hill fails to document; 177 and (3)
5
the CAPM analysis I performed in my Direct Testimony uses different inputs than th e se I
6
used approximately seven years ago in a Minnesota proceeding. 178 Finally, Mr. ill
7
comments on my use of the VIX stating that there is no empirical nexus between the IX
8
and historical volatility.179
9
Q.
10
11
of
IS MR. HILL CORRECT THAT COMPARING THE OVERALL STOCK MARKET
RETURN TO BOND YIELDS PRESENTS A "MIS-MATCH"?
A.
No. As discussed in my response to Mr. Parcell, the income return (i.e., the yield on
. 180
12
government issued securities is the only "riskless" component of the total retu rn
13
Consequently, it is the income-only portion of the return, as opposed to the total re turn,
14
that should be used in calculating the risk premium.
15
Mr. Hill relies to develop his Market Risk Premium, defines the Equity Risk Premiu
16
"calculated by subtracting the arithmetic mean of the government bond income re rn
17
from the arithmetic mean of the stock market total return." 181 It is that value (.60
18
percent) on which I have relied in my calculation of the Sharpe Ratio.
Morningstar, the source on w hich
as
16 See Direct Testimony of Stephen G. Hill, at 67.
17 Ibid., at 67-68.
178 Ibid., at 69.
179 Ibid., at 71-72.
180 Morningstar, Inc., 2012 Ibbotson Stocks Bonds. Bills and Inflation Valuation Yearbook, at 55
tsl Ibid., at 54
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86
1
Q.
2
3
PLEASE COMMENT ON MR. HILL'S ASSERTIONS REGARDING C
NT
INVESTOR EXPECTATIONS CONCERNING THE MARKET RISK PREMIUM.
A.
Mr. Hill's position that "investors expect the market risk premium to be lower than it has
4
been historically" appears to be based, in large measure, on unspecified discussions "in
5
the literature of financial economics over the past decade." 1 82 It is important to note
6
general discussions of the market risk premium that may have occurred over the past
7
decade do not necessarily reflect current market conditions.
8
significant question as to whether discussions of the Market Risk Premium, which may
9
have been based on fundamentally different capital market conditions, would be rele vant
at
Consequently, there is a
to the current market environment.
10
11
Mr. Hill further suggests that certain pension funding assumptions corroborat e: his
12
position regarding the expected return on the overall market and, therefore, the Market
13
Risk Premium.183
14
assumptions are relevant to determining the Company's required Return on Equity is
15
misplaced.
16
Q.
As discussed below, however, Mr. Hill's position that such
WHY ARE THE CAPM INPUTS YOU USED IN A 2005 PROCEEDING IN
17
MINNESOTA, AS POINTED OUT BY MR. HILL,184 NOT RELEVANT TO
18
PROCEEDING?
19
A.
IS
As a practical matter, market conditions are significantly different from those that existed
20
in 2005, which was prior to the recent financial crisis. As Mr. Hill points out, "[i]nv stor
21
expectations regarding the strength of the U.S. economy, the direction of interest rates
22
and the level of inflation (factors that are determinative of capital costs) are key buil ding
182 Direct Testimony of Stephen G. Hill, at 67.
... Ibid., at 10.
'&' Ibicl., at 69.
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1
blocks in the investment decision." 185 Nonetheless, his CAPM analysis does not
2
for those factors. My CAPM specification in this proceeding, however, specifically
3
into account current investor sentiments to incorporate current expectations
4
requirements for market performance.
5
Although my 2005 testimony included a calculation of the ex post Equity
6
Premium, as I explained above, it is counter-intuitive to assume that the increm
7
return required by investors to accept equity risk would decrease even as visible mea
8
of market volatility increase. As such, it is reasonable and appropriate to use forv
9
looking estimates of the Equity Risk Premium in the current market environment.
10
Q.
11
12
IS THERE AN "EMPIRICAL NEXUS,, 18' BETWEEN THE VIX AND HISTORI
MARKET VOLATILITY?
A.
Yes, there is., As Mr. Hill points out, the VIX is a measure of market volatility, "as i the
13
long-term historical standard deviation of returns." 187 Since its inception in 1990, the
14
VIX188 has averaged 20.46, suggesting annual market volatility of 20.46 perc ent.
15
Morningstar, a source relied upon by Mr. Hill, 189 reports the long-term standard devi ation
16
in returns on large company stocks to be 20.30 percent. 190
17
course, are quite similar and as such, I disagree that there is no "empirical
18
between the two.
Those two estimates, of
19
As to the relationship between the VIX and the expected equity risk premi , a
20
recent article by Graham and Harvey (the authors of the article noted by Mr. Hill on age
iss
Ibid., at 12.
116
Ibid., at 72.
187 Ibid.
188 As noted in my Direct Testimony (at 27), the VIX is the Chicago Board Options Exchange Volatility Inde
189
See Direct Testimony of Stephen G. Hill, at 48.
190 See Morningstar, Inc., 2012 Ibbotson SBBI Risk Premia Over Time Report Estimates for 1926-2011, at 6.
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1
77 of his Direct Testimony), also found a direct, empirical relationship between
2
Market Risk Premium and volatility, in particular, the VIX. As Graham and
3
noted:
4
5
6
7
8
9
10
11
12
13
Finally, we consider two measures of risk and the risk premium. Figure 5
shows that over our sample there is evidence of a strong positive
correlation between market volatility and the long-term risk premium. We
use a five-day moving average of the implied volatility on the S&P index
option (VIX) as our volatility proxy. The correlation between the risk
premium and volatility is 0.52. If the closing day of the survey is used, the
correlation is roughly the same. Asset pricing theory suggests that there is
a positive relation between risk and expected return. While our volatility
proxy doesn't match the horizon of the risk premium, the evidence,
nevertheless, is suggestive of a positive relation. 191
14
As Graham and Harvey point out, basic asset pricing theory suggests "a posih
15
relation between risk and expected return." That, of course, is the relationship thatl my
16
approach is intended to reflect. Given the equivalence of the historical VIX and the
17
standard deviation in large company returns, and knowing that Graham and Harvey poi
18
to the relationship between the VIX and risk premium, I disagree with Mr. Hill that t
19
is no "empirical nexus" between the two.
D. MEPR and MBR Models
20
21
Q.
HIS ROE RECOMMENDATION?
22
23
DOES MR. HILL PERFORM ANY ADDITIONAL ANALYSES IN ARRIVING AT
A.
Yes, Mr. Hill includes what he refers to as Modified Earnings to Price Ratio
24
and Market-to-Book Ratio (MBR) analyses to assess the reasonableness of his
25
CAPM results.
and
19' John R. Graham, Campbell R. Harvey, The Equity Risk Premium in 2012, March 11, 2012 (emphasis
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89
1
Q.
PLEASE DESCRIBE MR. HILL'S MEPR ANALYSIS.
2
A.
Mr. Hill's MEPR analysis involves the simple averaging of two data points for e ch
3
company in his proxy group: the earnings-price ratio and the expected earned return on
4
equity.192
5
Q.
AS A PRELIMINARY MATTER, WHAT IS THE EARNINGS-PRICE RATIO?
6
A.
The earnings-price ratio is the ratio of expected earnings to the current market price of a
The ratio relies on earnings as a measure of expected cash flow, under the
7
security.
8
theory that the ownership claim of a shareholder includes both dividends and retai ned
9
earnings, with the latter being redeployed within the enterprise and contributing the
10
future dividend payments.193 The earnings-price ratio differs from the discount rate ('.e.,
11
the Cost of Equity) in that it assumes no growth beyond that incorporated in the expected
12
cash flow. In that sense, it is a "capitalization rate." While capitalization rates suc h as
13
the earnings-price ratio rarely are used for the purpose of equity valuation in regul ted
14
utility ratemaking proceedings, they sometimes are used in the valuation of real es ate
15
investments, for which the cash flows are expected to remain constant.194
16
capitalization rates may be used in practice for the valuation of annuities, they are hig
17
inappropriate for equity investments for which there is an expectation of long-ti
18
growth.
Thus, While
'y` See Direct Testimony of Stephen G. Hill, at 51.
193 See, e.g., Ro er A. Morin New Regulatory Finance, Public Utility Reports, Inc., 2006, at 260.
,
g
194
See, for example, Pratt, Shannon P., and Roger J. Grabowski, Cost of Capital, Applications and
Third Edition, 2008, at 564-565.
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1
Q.
GROWTH DCF FORMULA?
2
3
CAN THE EARNINGS-PRICE RATIO BE DERIVED FROM THE CONSTANT
A.
Yes, provided that the analyst assumes that ( 1) all earnings will be paid in dividends, and
4
(2) future growth is zero. An intuitive derivation of the earnings-price ratio from the
5
Constant Growth DCF model is as follows:
As Mr. Hill points out, the fundamental expression of the Constant Growth
6
7
CF
model is:
k= ^ + g [2]i95
8
of
9
As Mr. Hill also points out, dividends may be expressed as the produc
10
earnings ("E") and the payout ratio ("b"). As such, D = E x (1 - b)196 [3]. Finally,
11
Hill notes that growth ("g") may be expressed as the product of the retention ratio ani the
12
expected earned return on common equity ("r"), such that g = b x r.197 Combining t
13
terms, the model states that:
14
k = 'ri b) + (h X T`) [4] 198
15
Thus, if the subject company were to pay out all of its earnings in dividend; i.e.,
P
16
the retention ratio equals zero), the model would reduce to k= 1^^I + 0X r, or
17
clear, therefore, that the Constant Growth DCF model reduces to the earnings-price
It is
195 See Direct Testimony of Stephen G. Hill, at 28. Please note that this form of equation does not
expected dividends.
196
Ibid. , at 55.
197
Ibid.
198 For the sake of this discussion I have assumed that the sv component of the sustainable growth rate (i.e.
associated with the issuances of equity) is zero.
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91
1
as a measure of the Cost of Equity when the payout ratio is 100.00 percent, and ;
2
0.00 percent.199
1 is
3
Q.
DO ANY OF MR. HILLS' PROXY COMPANIES MEET THOSE CRITERIA?
4
A.
No, they do not. In fact, Mr. Hill's Schedule 3 demonstrates that all of his proxy
5
companies have expected retention ratios greater than 0.00 percent (i.e., have payout
6
ratios less than 100.00 percent) and all have internal growth estimates (i.e., "b x r")
7
greater than 0.00 percent. Consequently, the basic premise of Mr. Hill's earnings-p ice
8
ratio approach is highly impractical and inconsistent with his own data.
9
Q.
IS MR. HILL'S APPLICATION OF THE CONSTANT GROWTH DCF MODEL
10
CONSISTENT WITH THE 0.00 PERCENT PAYOUT RATIO AND GROWTH RATE
11
ASSUMPTIONS IMPLICIT IN THE EARNINGS/PRICE METHOD?
12
A.
No, it is not. The Constant Growth DCF results presented on Schedule 6 of Mr. H 11's
13
testimony are based, at least in part, on the "DCF growth" estimate developed in his
14
Schedule 4, page 1 of 2. That schedule assumes a "b x r" estimate greater than .00
15
percent for every company in his proxy group.
16
fundamentally flawed and inconsistent with the underlying assumptions of the earnings-
17
price ratio approach.
18
Q.
Here again, Mr. Hill's approach is
MOVING NOW TO MR. HILL'S "MODIFIED" EARNINGS-PRICE RA
19
APPROACH, PLEASE SUMMARIZE HOW THAT APPROACH DIFFERS
20
THE EARNINGS-PRICE RATIO METHOD DISCUSSED ABOVE.
21
22
A.
The modified model is identical to the earnings-price ratio approach with the
that the "modified" model includes a term that represents the ratio of the expected
199 Please note that the formulation discussed above is supported by the discussion contained in the text cited by
Mr. Hill in footnote 38 of his Direct Testimony.
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1
Return on Common Equity to the Cost of Equity ("c"),200 and reflects the simple average
2
of the earnings-price ratio (including the effect of "c") and the Expected Return on
3
Common Equity. In support of that approach, Mr. Hill presents a table of hypothetical
4
returns and retention ratios that, he suggests, "produces an MEPR estimate of the co of
5
common equity capital of sufficient accuracy to serve as a check of other analyses..." 01
6
Q.
7
8
DO THE HYPOTHETICAL DATA PROVIDED IN MR. HILL'S TABLE I SUPPORT
THAT CONCLUSION?
A.
No, they do not. Mr. Hill neglects to point out that the average Cost of Equity in his
9
Table I(10.00 percent) equals the average Return on Equity (also 10.00 percent). Si ply
10
by virtue of the model, the average MEPR therefore is 10.00 percent. Given Mr. H 11's
11
decision to present hypothetical data for which the average Cost of Equity equals the
12
average Return on Equity, it simply is a truism that the average earnings-price ratio lso
13
will equal 10.00 percent.
14
about the model's "accuracy"; it is only "accurate" to the extent that the average Cost of
15
Equity equals the average Return on Equity (see EXHIBIT RBH-19R).
Consequently, Mr. Hill's hypothetical example tells us 1 ttle
on
16
In fact, it is easily shown that if the Cost of Equity equals the expected Re
17
Equity, the Constant Growth DCF formula reduces to the earnings-price ratio. Agai n, an
18
intuitive derivation of that relationship is as follows. If the Cost of Equity (k) equals the
19
Return on Equity (r), the Constant Growth DCF formula can be expressed as
20
k= ^ + h X :^ , where ( 1 - b)El is the expected dividend (i.e., earnings times the
®
21
payout ratio) and b x k is the "internal" growth estimate. Re-arranging and simpli ing
200 See Direct Testimony of Stephen G. Hill, at 52.
201 Ibid., at 53.
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1
the equation renders k(i - b) = t1-ON, , and therefore, .il- L . That assumes, of
pe
pe
2
that the Cost of Equity will equal the expected Return on Equity at all time in
3
perpetuity.202 As discussed above, even Mr. Hill's data show that not to be the case.
4
Q.
PLEASE NOW COMMENT ON MR. HILL'S POSITION THAT THE MARKET-TO-
5
BOOK RATIO WILL EXCEED UNITY WHEN THE RETURN ON
6
EXCEEDS THE COST OF EQUITY.
7
A.
Other than his general observation regarding the prevailing level of Market-to-Book
8
ratios, Mr. Hill provides no empirical basis grounded in current market data for his
9
conclusion.
As shown in Mr. Hill's Schedule 10, the Market-to-Book ratio exceeds
10
100.00 percent for each company in his proxy group. That Market-to-Book ratios
11
unity is not unusual, as demonstrated in EXHIBIT RBH-20R. Mr. Hill therefore
12
to suggest that each company in his proxy group is earning more than its authorized ost
13
of Equity, and has been for some time. Mr. Hill also has assumed that the only variable
14
affecting the Market-to-Book ratio is the earned return on equity.
15
shortcomings in Mr. Hill's position regarding the relevance of the Market-to-Book Ratio
16
in the context of his analysis of the ROE for SWEPCO. As discussed in my respon e to
17
Mr. Parcell, the Market-to-Book ratio equals the market value (or stock price) per share,
18
divided by the total common equity (or the "book equity") per share. Book value: per
19
share is an accounting construct, which reflects historical costs, whereas market value per
20
share is forward-looking, and is a function of many variables.
21
surprising that the two would not be equal.
There are several
Consequently, it i not
202 See Roger A. Morin, New Regulatory Finance, Public Utility Reports, Inc., 2006, at 261,262. See also
Testimony of Stephen G. Hill, at 54.
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1
As also discussed in my response to Mr. Parcell, no rational investor would invest
2
in utility stocks if they believed that utility commissions would set rates in an effort to
3
move the Market-to-Book ratio toward unity.
4
utility stock at the long-term average Market-to-Book ratio of 1.39 (i.e., Mr. Hill's pr xy
5
group average as noted in his Schedule 10), that investor would incur a loss of over 2 .00
6
percent if the Market-to-Book ratio reached 100.00 percent. Again, the prospect of near-
7
certain capital losses would inhibit the Company's ability to access external capital. In
8
any event, the Market-to-Book ratio has exceeded unity for many years, over the course
9
of many rate proceedings.
10
Q
DOES MR. HILL'S MEPR ANALYSIS ASSUME A DIFFERENCE BETWEEN HE
COST OF EQUITY AND THE EXPECTED RETURN ON EQUITY?
11
12
Assuming that an investor purchased a
A.
No, it does not. Rather, Mr. Hill's Schedule 9 simply calculates the earnings-price i
13
without an adjustment factor. That is, Mr. Hill has assumed that all earnings will be
14
in dividends and growth will equal zero for all of his proxy companies.
15
assumptions are inconsistent with the data presented in the following page o his
16
testimony (i.e., Schedule 10 page 1 of 2).
17
Q.
PR
APPROACH?
18
19
WHAT ARE YOUR CONCLUSIONS REGARDING MR. HILL'S
Those
A.
Mr. Hill's use of the MEPR approach is premised on the assumption that either (1 all
20
earnings are paid in dividends and expected growth equals zero, or (2) at all times in
21
perpetuity the Cost of Equity will equal the expected Return on Equity.
22
assumptions are fundamentally incompatible with the data and assumptions that underlie
23
Mr. Hill's DCF analysis. Even if one accepts that the Cost of Equity will fall somewhere
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1
between the earnings-price ratio and the projected earned ROE, Mr. Hill has provide no
2
support for his simple averaging of the two data points. In fact, nowhere in the text c ted
3
by Mr. Hill in support of his approach do the authors indicate that a simple average or
4
any average of the earnings-price ratio and the expected Return on Equity somehow
5
improves the "accuracy" of his estimate.
6
with no empirical or theoretical support for that assumption.
Here again, Mr. Hill relies on his judgm nt,
7
Q.
PLEASE NOW DESCRIBE MR. HILL'S MBR ANALYSIS.
8
A.
As Mr. Hill points out, his MBR analysis is derived from his Constant Growth
CF
9
model. The growth component of his "market-to-book" approach is the sum of internal
10
and external sources of growth.203 In that regard, the growth component is the same as
11
the "br + sv" method contained in the "Sustainable Growth" model discussed by Mr. Hill
12
in developing his company-by-company growth estimates.204 The difference between
13
Mr. Hill's "market-to-book" model and the "Sustainable Growth" model, then, lies i the
14
calculation of the dividend yield component. Whereas my application of the Con tant
15
Growth DCF model relies on actual dividend and stock price data to calculate the
16
dividend yield, the "market-to-book" model estimates the dividend yield on the basis of
17
several parameters, all of which are provided by Value Line. Therefore, the "market-to-
18
book" method introduces a significant element of estimation risk, even though the
19
parameter being estimated (the dividend yield) is readily observable from market data.
203 See Direct Testimony of Stephen G. Hill, at 55.
204 See Attachment C and Schedule 3 to Mr. Hill's Direct Testimony.
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1
Q.
PLEASE ELABORATE ON THAT POINT.
2
A.
As noted in Mr. Hill's testimony, the "market-to-book" method is specified as:
3
K^
P7R
4
#, fbr + syl [51
where:
5
b = Retention Ratio;
6
r = Return on Book Equity;
7
P/B = Price/Book ratio; and
8
sv = growth in the number of shares outstanding. 205
9
10
As noted above, the second bracketed term is the "br + sv" component of the ,
"Sustainable Growth" model. The first bracketed term,^ ^^ ^^ can be re-arranged as:
11
[(1-b) x r x B)]lP [6].
12
Equation [6], which is the product of the payout ratio (1 - b), the earned returr on
13
book equity (r) and the book value of equity per share (B), simply is an expression o the
14
expected dividend per share. The expected dividend per share divided by the market
15
price (P) is the expected dividend yield.
16
In essence, the "market-to-book" method combines the "Sustainable Growth" ate
17
with an algebraic expression of the dividend yield. Consequently, its application depends
18
on estimates of the expected payout ratio, the expected earned return on equity, and the
205 See Direct Testimony of Stephen G. Hill, at 55. Please note that the brackets included in Equation 5 have 1
added for the purpose of clarification.
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1
expected price/book ratio.206 Because the dividend yield is observable, the market-to-
2
book method introduces an additional element of potential estimation error.
3
To illustrate that point, I calculated the dividend yield using data provided in
r.
4
Hill's schedules along with Equation [6]. As shown in EXHIBIT RBH-21R, the mean
5
yield under this approach is 4.18 percent, compared to the 4.28 percent dividend yield
6
used by Mr. Hill in his Constant Growth DCF analysis, a difference of 0.12 percent (.e.,
7
10 basis points). Moreover, the individual proxy company expected dividend
8
differ by up to 38 basis points demonstrating the potential estimation error
9
above.
10
11
E. Risk Premium Analysis
Q.
12
13
PLEASE BRIEFLY SUMMARIZE MR. HILL'S RESPONSE TO YOUR
PREMIUM ANALYSIS.
A.
Mr. Hill discusses what he perceives to be three flaws in my risk premium analysis: (1)
14
that the analysis does not capture the potential lag that may exist between the data
15
incorporated into authorized equity returns by regulatory bodies and market conditio s at
16
the time rates are authorized; (2) that "the allowed return can overstate the cos of
17
capital", since the utility market values exceed book values; and (3) that my data set may
18
include outlying observations.207 Mr. Hill also challenges my conclusion, reached from
19
an analysis of nearly 1,350 rate decisions from January 1980 through May 2012, that
20
there is an inverse relationship between bond yields and the Market Risk Premium. In
21
support of that last point, Mr. Hill cites a recent poll of Chief Financial Officers (C Os)
22
that, he claims, proves there is a direct (as opposed to inverse) relationship between
206 Note, for purposes of his analysis, Mr. Hill uses the actual market-to-book ratio, thus combining expected
actual data in his formulation of the dividend yield.
207 See Direct Testimony of Stephen G. Hill, at 74-75.
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1
interest rates and the Market Risk Premium.208 Finally, Mr. Hill discusses a hypothet ical
2
"dramatic international event" that he believes supports his position that there is no
3
inverse relationship between the two.
4
Q.
WHAT IS YOUR RESPONSE TO MR. HILL'S CLAIM THAT THE ANALYSIS
5
DOES NOT CAPTURE THE LAG BETWEEN THE DATA INCORPORATED TO
6
AUTHORIZED EQUITY RETURNS BY REGULATORY BODIES AND MARKET
7
CONDITIONS AT THE TIME RATES ARE AUTHORIZED.
8
A.
Mr. Hill is incorrect. As noted in my Direct Testimony the analysis considers such a lag
9
by calculating the average period between the filing of the case and the date of the nal
10
order (the lag period). In order to reflect the prevailing level of interest rates during the
11
pendency of the proceedings, I calculated the average 30-year Treasury yield over the
12
average lag period (approximately 202 days).209
13
account the difference that may exist between the data incorporated into
14
equity returns by regulatory bodies and market conditions at the time rates are
15
Q.
That method specifically takes
WHAT IS YOUR RESPONSE TO MR. HILL'S ASSERTION THAT )
16
RETURNS CAN OVERSTATE THE ROE, AS EVIDENCED BY MARKET VAL
17
IN EXCESS OF BOOK VALUES?
18
A.
to
As discussed in my response to Mr. Parcell, the Market-to-Book ratio is
19
numerous factors other than the authorized ROE, and as such the fact that ma
20
ratios exceed 100.00 percent does not provide conclusive evidence that authorized re
21
are overstated. If that were to be the case, all of the regulatory commissions that
20s Ibid., at 77.
209 See Direct Testimony of Robert B. Hevert, at 31. Mr. Hill, on page 74 of his Direct Testimony, i
described my Bond Yield Plus Risk Premium analysis as comparing "historical allowed equity
quarterly average T-bond yields."
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