On the Use of Modern Portfolio Theory in Public Utility Rate Cases: Comment Author(s): Stewart C.

Myers Reviewed work(s): Source: Financial Management, Vol. 7, No. 3 (Autumn, 1978), pp. 66-68 Published by: Wiley on behalf of the Financial Management Association International Stable URL: http://www.jstor.org/stable/3665014 . Accessed: 08/02/2013 07:33
Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp

.
JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org.

Wiley and Financial Management Association International are collaborating with JSTOR to digitize, preserve and extend access to Financial Management.

http://www.jstor.org

This content downloaded on Fri, 8 Feb 2013 07:33:10 AM All use subject to JSTOR Terms and Conditions

On in

the

Use

of

Modern Rate

Portfolio

Theory

Public

Utility

Cases:

Comment

Stewart C. Myers
Stewart C. Myers is Professor of Finance at the Sloan School of Management, Massachusetts Institute of Technology. He acknowledges with thanks the helpful comments of Gerald Pogue.

* Sometimes procrastination helps. In this instance it allowed me to read drafts of most of the other comments on the Brigham-Crum article [1] before writing my own. The others cover most of the specific issues I would have addressed had I started from scratch. Thus relieved, I will restrict myself to five general points that express my view of the proper role of modern portfolio theory in rate of return regulation. 1. Do not reward witnesses who bury assumptions in judgment. My first appearance as an expert witness was on behalf of the Federal Power Commission staff in 1969. I estimated the cost of equity capital for Texas Eastern Transmission Company, a gas pipeline, based on a model of the firm's stock price. During crossexamination, the company's lawyer confronted me with a list of 21 distinct assumptions that I had made in my direct testimony. I defended all of them as reasonable, but I had to admit that some of the assumptions were not literally true and that others were only "probably" or "approximately" correct. Then the lawyer gave a little speech about the 21 assumptions, arguing that, since they could not all be
1978 Financial Management Association 66

correct, my estimate of the cost of equity capital was worthless. As usual, I thought of the perfect comeback too late. I should have said: "Think of your witnesses. They only made one assumption. They assumed the answer!" Any competent witness who uses capital market data to estimate the cost of capital is forced to reveal his or her assumptions. This creates targets of opportunity for opposing lawyers or rebuttal witnesses. Anyone who uses the Capital Asset Pricing Model (CAPM) is particularly vulnerable because that model has been the focus of so much theoretical and empirical work. The CAPM's problems are well known. Who knows what secrets lurk in less formal and allegedly more realistic approaches? 2. Use simple models. The best estimates of the opportunity cost of capital are still liable to measurement error. The errors come from noise in rates of return on common stocks, and from the difficulty of inferring investors' expectations from historical data. (The so-called comparable earn-

This content downloaded on Fri, 8 Feb 2013 07:33:10 AM All use subject to JSTOR Terms and Conditions

PORTFOLIOTHEORYIN RATECASES MYERS/MODERN

67

ings method, which does not rely on capital market data, encounters equally severe measurement problems.The methodis also logicallyunsound.See Myers [3], esp. pp. 61-63.) The likelihoodof measurement erroris why honest estimates of the cost of equity capital are normally given in whole percentage points - occasionally Thatis also tenthsof a percent,but neverhundredths. economists usually stick to relatively simple why models. Many refinements,althoughthey look as if they might capture more of reality, just lead to argumentsover insignificant digits. I believethis is why the so-calledDCF modelis so widelyused in rate cases.' The modelassumesthat investors forecast a perpetualand steady growth of dividends.I doubt that investorshave that simple a view of the future.The model nevertheless seems to give reasonableanswers,at least for the traditional electricpower, publicutilitiesin telecommunications, gas pipelines,etc. Evidentlyfirms in these industries moveslowlyenough,yet at the sametime haveenough financialmomentum,for the DCF model to work. Thosewho use beta as a riskmeasuredo so because it is simple, objective,makes common sense, and is consistentwith modernportfoliotheory.They cannot say that the theoryis the wholetruth.They avoidfancier measuresof risk, not out of lazinessbut because they try to stick to a simplemeasurewhoseproperties are well understood. 3. Use more than one model when you can. the cost Becauseestimating opportunity of capitalis difficult,only a fool throwsaway usefulinformation. That meansthat you shouldnot use any one modelor measuremechanically exclusively.Beta is helpful and as one tool in a kit, to be used in parallelwith DCF models or other techniquesfor interpreting capital marketdata. 4. Modern portfolio theory is more than the CAPM. The usefulnessof beta as a measureof securityrisk does not dependon the strict validityof the CAPM. The measurecan be based on the followinglogic.
1. Portfolio risk can be measured by ap, the stan-

is 3. Of course ,jp differentfor each possiblecombination of portfolio and security. But the returns on any well-diversifiedportfolio are highly correlatedwith returns on the market portfolio. The bulk of capital invested in securitiesis invested via diversifiedportfolios. Thus we take the market (portfolio M) as a "standard" portfolioto proxy for investors'actual portfolios, and
/jp. #j =

ajM/aM2to proxy for

The CAPM goes further.It says that /j is a complete and sufficientrisk measure,that the expected riskpremium demanded investors zerowhen/j is is by and that this risk premiumis linearlyrelatedto zero, fj. Roll shows how difficultthese statementsare to the proveor disprove[5]. Therefore, CAPM remains controversial. The general, qualitative tenets of modernportfoliotheory are more widely accepted. 5. Beta is most useful for qualitativerisk comparisons;the CAPM is also useful. Thereis an unfortunate to tendency referto any use of beta as "an applicationof the CAPM." Actually, one canget a good dealof mileageout of modern portfolio theorywithouteverusingthe CAPM formulafor cost of equity capital estimates. My testimony in two cases before the FCC illustrates point [4,6]. In the 1971AT&Tcase, beta this was used to confirm 1) that AT&T stock was less risky than the marketportfolioor a sampleof large industrialcompanies,and 2) that AT&T's stock was just aboutas riskyas a sampleof electricutilities.The cost of equity capital estimates were obtained from DCF modelsappliedto AT&T and to primarily the utility and industrialsamples. In the Comsatcase, GeraldPogueandI arguedthat Comsat common stock was significantly riskierthan riskierthan AT&T. Comsathad alreadyrequested a 12%equity rate of return,above the 10.5% FCC the had allowedin the priorAT&Tcase. The extrareturn had to be justified by showing that Comsat was riskier.Pogue and I showedthat Comsat'sbeta was morethandoubleAT&T'sandthat the difference was significant. We did not attempt to translate this differenceinto a numericalestimate of the cost of equity capital. (In both cases, the risk comparisons wererepeatedin termsof standard deviationsof stock rates of return. The conclusions were unchanged, whichI think will be the typicalresultin rate cases.) As these examplesillustrate,there are many ways to use betas that do not dependon the CAPM formula.Incidentally, FCC reliedon my approach the in
the typical stock in the market portfolio and afortiori

dard deviationof portfolioreturn. 2. The risk of any securityis its marginal contribution to ap. For security the marginalcontribuj,
tion is proportional to ojp or to /jp, j's beta with

respectto portfolio p.
1The model states that stock price equals D,, next year's dividend, capitalized at k-g, the difference between the opportunity cost of equity capital and the growth trend of dividends. Thus k can be estimated at dividend yield plus growth: k = D,/P + g.

This content downloaded on Fri, 8 Feb 2013 07:33:10 AM All use subject to JSTOR Terms and Conditions

68

FINANCIALMANAGEMENT/AUTUMN 1978

their AT&T decisionbut dismissedthe Myers-Pogue study with essentiallyno explanation. The CAPM could have been used to generatecost of equitycapitalestimatesfor both AT&T andComsat. That would have requiredstrongerassumptions, ones: althoughnot necessarilyunreasonable we have to accept the CAPM. This is First, naturally controversial. I neverthelessbelieve the CAPM is a reasonable theoryso long as the numbers it generates not treatedas exactor conclusive. is are It a rule of thumb- somethingworthleaningon if you don't have to lean too hard. Second, we do not knowexactlywhatthe expected rate of returnon the marketportfoliois, althoughrecent researchgives an improvedpictureof "normal" ratesof returnin the U.S. economy.(See Hollandand Myers [2] for evidenceon "normal"rates of return and also for referencesto other work in this area.) Third, standarderrorsof beta estimatesare large for individual securities.For example,Comsat'sbeta was estimatedat 1.69 from 6 years of monthlydata, with a standard errorof .30. A confidence intervalin 2 standard errors would be 1.09 < d cluding
2.29.2 Estimates of industry betas are more ac-

(See Myers [3], pp. 70-71.) Fourth,beta may not be stable.It can be dangerous to projectit from historicaldata. However,I believe much of the concernabout instabilityis misplaced. Assuming a stable beta is usually no worse than assuminga constantcompound growthrate for future
earnings.

Conclusion
Risk comparisonsare inevitablein rate of return testimony.So far, beta is the only risk measurewe have that is sensible, objective,and consistentwith modern portfolio theory. Clearly it should be used carefully;but so what? Any applicationof finance theory should be careful.

References
1. E. F. Brighamand R. L. Crum, "On the Use of the CAPM in Public Utility Rate Cases," Financial
Management (Summer 1977), pp. 7-15.

that it is possibleto obtaina sample curate,providing of reasonablysimilar firms. The distinctionbetweenindustryand firm betas is important in rate cases. It is hard to estimate a regulatedfirm'scost of equitycapitalif data on only that firm are available.This is true regardlessof the the taken. It is necessary broaden sample. to approach
2YetComsat's betawasso farabove1.0or AT&T'sbetathatPogue andI wereableto establish pointdespite highstandard our the error of the estimate.The Comsatcase was a rareopportunity because therewas such a dramaticspreadbetweenits risk and AT&T's.

2. D. M. Hollandand S. C. Myers,"Trendsin Corporate and Profitability CapitalCosts,"Working Paper999-78, Sloan School of Management, M.I.T., 1978. 3. S. C. Myers, "The Applicationof FinanceTheory in Public Utility Rate Cases," Bell Journalof Economics and Management Science (Spring 1972),pp. 58-97. 4. S. C. Myers and G. A. Pogue, "An Evaluationof the Risk of ComsatCommonStock,"in U.S. FederalCommunicationsCommission, PreparedTestimony S. C. Myers, F.C.C. Docket 16070, 1973. of 5. R. Roll, "A Critique the Asset PricingTheory's Tests, Part I," Journalof FinancialEconomics(March 1977), pp. 129-76. 6. U.S. FederalCommunications Commission,American Telephone and Telegraph Company, Prepared TestimonyS. C. Myers, F.C.C. Docket 19129, 1971.

Announcing FACTS

The National InformationClearinghouse of FinancialApplicationsUsing ComputerTechniquesand Simulations

FACTS has been established to facilitate the flow of information about computer applications in broad areas of finance (managerial, securities, real estate, international, for instance). Its purpose is threefold: 1) to provide source information on both academic and business applications; 2) to provide listings of recently printed, delivered, or accepted papers or articles; and 3) to generate questions, answers, and comments on computer applications in finance. FACTS is neither an association nor a journal, but a resource. If you are currently using the computer in your finance offerings or in solving your finance problems; if you have an interest in establishing a specific finance application; or, if you are simply interested in what others are doing, we would like to know about it. For further information about FACTS, write Richard T. Nyerges, Editor, FACTS: The Information Clearinghouse, School of Management, The University of Michigan-Flint, Flint, Michigan 48503, (313) 762-3160.

This content downloaded on Fri, 8 Feb 2013 07:33:10 AM All use subject to JSTOR Terms and Conditions