Internal consistency of risk free rate and MRP in the CAPM

the cost of equity directly (ie, the cost of equity that would result from application of the
CAPM if we could accurately estimate each parameter separately). 52 .
155. The downside of the first methodology is that it is only possible if there is listed equity
with comparable risk to the reference services and there is some methodology for
arriving at an estimate of the future dividends that investors expect that equity to pay.
In the US, regulators rely in part on a relatively deep pool of analyst forecasts for this
purpose. Arguably, the level of analyst coverage for individual regulated businesses,
and certainly the pool of regulated businesses, is not as deep in Australia as in the US.
156. Of course, having regard to comparables in other countries, such as the US regulated
businesses and US regulatory determinations, is one way to address any perceived
lack of depth in Australian data.
157. A further potential objection to this approach is that the estimates of the cost of equity
are sensitive to the level of stock prices at the time that the estimate is made. The
volatility in equity prices (relative to long run dividend forecasts) means that the DGM
estimate of the cost of equity will also be volatile.
158. Once more, this can reasonably be argued to be a ‘feature’ rather than a ‘bug’ to the
extent that the volatility in equity prices is driven by volatility in prevailing conditions in
equity markets (ie, volatility in equity investor’s required return on equity). However, at
least part of the volatility in equity prices is likely to be driven by illiquidity in the market
for a particular equity. Consequently, part of the volatility in DGM estimates may
simply reflect movements driven by lopsided buy or sell side activity. However, this
can potentially be addressed by using a longer average of equity prices (e.g.
measured over a month or several months).
7.1.1. Application
159. I have used the dividend growth model to forecast a cost of equity for Australian
regulated utilities of between 10.87% and 14.59%. This is based on analyst dividend
forecasts sourced from Bloomberg on 24 February 2012 and 9 March 2012 and the
average price of equities for these firms over the period 24 February 2012 to 9 March
2012. The range for the cost of equity is based on a range for long term dividend
growth from zero growth in real terms (2.5% nominal) to growth in line with long term
average GDP growth (6.6% nominal).
7.2. Methodology ii)
160. As with the first methodology, the second methodology relies on a DGM estimate of
prevailing returns but instead of being only for comparable firms the DGM is applied to
the market as a whole. However, one still needs to separately analyse comparable
52 Note that if the CAPM actually describes how investors arrive at required returns then a well implemented DGM analysis
will estimate the CAPM cost of capital in the market place. If the CAPM does not describe how investors assess risk then
this will not be the case. Of course, that is a another ‘feature’ of the DGM rather than a ‘bug’.
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