Opinion ID: 1356002
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Heading: Use of DCF Formula as Evidence of Return of Equity

Text: {15} DCF is a market-based measure of return, meaning it assumes that the current market price of the stock incorporates all relevant information about investments in general and all information regarding the particular stock. The DCF method determines the proper rate of return [on common equity] by adding to the common stock's current yield a rate of increase investors expect to occur over time. State ex rel. Utils. Comm'n v. Public Staff, 331 N.C. 215, 415 S.E.2d 354, 357 n. 1 (1992). The current price of the stock is reflective of all investment opportunities at the time. {16} Under the DCF model used by the staff witnesses, the cost of equity for the eight comparison companies was calculated using the market price of the stock of each company, dividends of each company and the projected growth in dividends. The staff witnesses applied the DCF model to generate a cost of equity for the eight companies of 8.745%. One hundred basis points were added for perceived additional risk in Zia as compared to the other companies for a cost of equity of 9.745%. Having derived the cost of equity, staff witnesses imputed debt and preferred stock components to Zia's capital structure and arrived at a composite cost of capital, including both debt and equity, of 9.15%. This percentage was applied to the rate base to produce the dollar amount of the return on the rate base of $1,142,433. {17} Throughout its case, Zia has argued for a higher rate of return on equity and the use of the book value [1] rather than the market value as the basis upon which such return should be calculated. Book value [of stock] is the net assets divided by the number of outstanding shares. Brown v. Halbert, 271 Cal.App.2d 252, 76 Cal.Rptr. 781, 785 (1969). The [m]arket value reflects the degree of confidence in potential earnings while net asset or book value disregards all but the present. Bassett v. Neeld, 23 N.J. 551, 130 A.2d 1, 4 (1957). Zia's witnesses analyzed the returns on book value. Despite the admission of Zia's expert, Robert S. Jackson, that the book value has not been equal to market value for natural gas distribution utilities for at least a decade, Zia persists with this argument on appeal. Zia contends that over [an unspecified period of] time, presumably including the disastrous year 1929, the market value of a stock will tend to decrease and equal the book value. This economic argument assumes little or no sustained growth in the long run. In the case of the expected return and the market price, the forces of the market come strongly into play in order to create the true image of what investors are doing and therefore what the fair value is. There may be an urge to protect against a sudden and complete market failure and so to use the straight book value in computing the return on equity, but this was found unrealistic in today's market. Zia's evidence attacking the DCF model lacked relevance to current economic conditions. {18} The DCF formula, which used market price and not book value, predicted dividend growth over the long run, was supported by substantial evidence and gave the Commission an indication of the appropriate rate of return on equity. The parties are in agreement that the DCF model is well-entrenched in this jurisdiction, having been in use for at least fifteen years. Also, while the rate base is calculated as the book value plus some additional adjustments, under DCF, the fair market value is used for the price of stocks. Staff witness Alan J. Girdner provided the rationale for these various facts in his testimony before the Commission: it is the return on their particular investment that concerns the individual investor and that drives the market. It is the expectation of a certain return which itself largely determines the real, current value of the stock and the company. This is what DCF, a market-based model, approximately measures. Commenting on the history of utility cases, in Mountain States 1954, 58 N.M. at 272-273, 270 P.2d at 693, we said, [t]his Court can see no reason why it should adopt as the law of this state any single formula which has been evolved out of this history of litigation.... [T]he regulatory authorities seek a formula which will adjust rates to the immediate economic situation  (emphasis added). {19} The decision whether to use the market value rather than the book value to evaluate return on equity is a decision which the Commission is capable of making. See Public Service Co. v. New Mexico Pub. Util. Comm'n, 1999-NMSC-040, ¶ 12, 128 N.M. 309, 992 P.2d 860. We hold that it is within the authority and discretion of the Commission to use the DCF formula, relying on recent economic circumstances and the data from the eight representative companies in this case. The Commission did so based on substantial evidence. See Duke City, 101 N.M. at 292, 681 P.2d at 718. The Commission's determination of cost of equity, and the resulting cost of capital, was based on substantial evidence.