Is the Discounted Cash Flow Model a Biased Estimator of Stock Returns?

The Discounted Cash Flow Model (DCF) and the Capital Asset Pricing Model (CAPM) are often used to determine an appropriate return on equity for regulated utilities. However, both the CAPM and the DCF will sometimes produce unrealistically high or low results during times of excess market volatility.In the 40 years since the initial publication of the CAPM, there have been numerous criticisms of the model in the financial literature. Studies have suggested that future returns on stocks with a high earnings/price ratio are higher than predicted by the CAPM (Basu, 1977); that average returns on stocks with a low market capitalization are higher than predicted by the CAPM (Banz, 1981); that high debt-equity ratios are associated with returns higher than their market betas (Bhandari, 1988); that stocks with high book-to-market equity ratios have high average returns which are not captured by their betas (Statman, 1980 and Rosenberg, Reid, and Lanstein, 1985); that non-systematic risk has a significant effect on excess returns (Lintner, 1965b); and that the expected return-beta relationship is not fully consistent with empirical observations (Fama and MacBeth, 1973).We review the literature concerning the CAPM and DCF models and briefly discuss the arguments of the proponents of each model.We use data from 70 electric, natural gas, and water utility stocks and separately estimate a one-year forward market price for the years 2001-2011. We estimate the expected return for each stock using the following models: the CAPM; two single-stage DCF models (one based on dividend growth estimates and one based on earnings growth estimates); two three-stage DCF models (one based on dividend growth estimates and one based on earnings growth estimates); and the Capital Appreciation plus Income (CA I) (stock price change plus dividends) model.We then evaluate the CAPM, DCF, and CA I models using a sum of the squared differences method