a.17-04-006 cal water vilbert rebuttal testimony...

COST OF CAPITAL

REBUTTAL TESTIMONY OF MICHAEL J. VILBERT

ON BEHALF OF

CALIFORNIA WATER SERVICE COMPANY

A.17-04-006

AUGUST 22, 2017

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California Water Service Company i Rebuttal Testimony of Michael Vilbert

TABLE OF CONTENTS

I. Introduction and Summary ...............................................................................................1

II. Mr. Rothschild’s DCF Based Estimates ...........................................................................4

A. Constant Growth “Sustainable Growth Rate” DCF ................................................... 4

1. There are fundamental conceptual inconsistencies in Mr. Rothschild’s

sustainable growth methodology. ....................................................................... 6

2. Mr. Rothschild’s Sustainable Growth DCF calculations contain technical flaws

and mathematical errors. ..................................................................................... 9

B. Mr. Rothschild’s Non-constant Growth DCF .......................................................... 19

III. Mr. Rothschild’s Discussion of CAPM ..........................................................................25

IV. Mr. Rothschild’s Criticisms of My Cost of equity Recommendations ...........................26

A. Market-Based Cost of Equity Recommendations .................................................... 27

B. Interest Rate Forecasts and the Risk-Free Rate ........................................................ 32

C. Mr. Rothschild’s Criticisms of EPS Growth Rate Forecasts and of Forecasts in

General ..................................................................................................................... 34

D. Company Specific Risk ............................................................................................ 37

E. Use of Market Value Capital Structures in Cost of Equity Analysis ....................... 38

California Water Service Company ii Rebuttal Testimony of Michael Vilbert

LIST OF EXHIBITS

Rebuttal Appendix A: Rothschild External Financing Rate Error

Rebuttal Appendix B: Corrected Rothschild Sustainable Growth DCF Calculations

California Water Service Company Rebuttal Testimony of Michael Vilbert

1

I. INTRODUCTION AND SUMMARY 1

Q1. Please state your name and address for the record. 2

A1. My name is Michael J. Vilbert. My business address is The Brattle Group, 201 Mission 3

Street, Suite 2800, San Francisco, CA 94105, USA. 4

Q2. Did you submit direct testimony in this proceeding? 5

A2. Yes. My direct testimony is Exhibit E on behalf of California Water Service Company 6

(“Cal Water”, “CWS”, or the “Company”). 7

Q3. What is the purpose of your rebuttal testimony in this proceeding? 8

A3. I have been asked by Cal Water to respond to the testimony of Mr. Aaron L. Rothschild 9

(“Rothschild Testimony”) on behalf of the Office of Ratepayer Advocates (“ORA”) 10

with regard to his proposed return on equity (“ROE”) that the California Public Utilities 11

Commission (the “Commission” or the “CPUC”) should allow the Company an 12

opportunity to earn on the equity financed portion of its rate base. I also respond to Mr. 13

Rothschild’s criticisms of my own recommendations and supporting analysis presented 14

in my direct testimony dated April 3, 2017 (“Vilbert Direct Testimony”). 15

Q4. Are you sponsoring any supporting materials? 16

A4. Yes. I am sponsoring the following appendices to my rebuttal testimony: 17

• Rebuttal Appendix A – Rothschild External Financing Rate Error 18

• Rebuttal Appendix B – Corrected Rothschild Sustainable Growth DCF 19

Calculations 20


2

Q5. Were these appendices prepared by you or under your direction? 1

A5. Yes. 2

Q6. Please summarize your conclusions in rebuttal to Mr. Rothschild’s testimony. 3

A6. Mr. Rothschild’s recommended 8.22 percent ROE for Cal Water is unreasonably low 4

compared to the allowed ROE’s of other similarly situated regulated utilities as well as 5

based upon the cost of capital estimates from his own models. 6

His recommendation simply does not comport with financial market expectations and 7

regulatory norms for utility allowed returns in California and for water utilities in other 8

U.S. jurisdictions. Furthermore, Mr. Rothschild fails to justify his abnormally low 9

recommendation with supporting evidence and model results. His cost of equity 10

calculations focus on a single estimation method (his “sustainable growth” DCF 11

model), and his implementation contains fundamental conceptual inconsistencies as 12

well as technical errors that bias his results downward by at least 110 basis points. Mr. 13

Rothschild’s non-constant growth DCF calculations rely on non-standard assumptions 14

that are not justified and undermine the validity of the corresponding results. What he 15

refers to as an implementation of the CAPM is, in fact, nothing of the sort and does not 16

provide meaningful information for assessing the cost of equity for Cal Water. 17

Additionally, Mr. Rothschild falls into the trap of mechanically applying his calculation 18

methodologies without consideration of relevant context. His extensive discussion of 19

current capital market conditions and the “Goldilocks Economy” reflect a misguided 20

and unsupported view that historically low interest rates and higher-than-average P/E 21

ratios should be expected to persist throughout the period at issue in this proceeding. 22


3

Finally, Mr. Rothschild does not provide any convincing criticisms of my direct 1

testimony recommendations or analysis. His primary criticism—that my 2

recommendations are not “market-based”—is unfounded and inaccurate. And his 3

argument that my analysis is flawed because it is informed by forecasts of inputs such 4

as interest rates and EPS growth rates is undermined by his own reliance on Value Line5

forecasts for all manner of inputs, including stock returns, stock prices, dividends, book 6

value, share issuances, and return on book equity. 7

Q7. Why do you say that Mr. Rothschild’s recommendation is outside the norm? 8

A7. I say so because his recommended ROE of 8.22% for Cal Water is lower than any ROE 9

recently allowed for a water utility across the U.S. as well as below what was recently 10

allowed electric utilities in California. As my business partner and fellow Brattle 11

principal, Dr. Villadsen, details in her rebuttal testimony, Mr. Rothschild only 12

compares his recommendations to two specific water utility ROEs—9.10% in New 13

York and 9.25% in Virginia—that happen to be the lowest in the nation awarded this 14

year and are not representative of allowed ROEs for water utilities in U.S. jurisdictions. 15

As summarized in Dr. Villadsen’s rebuttal testimony, awarded water ROEs in 2016 16

and so far in 20171 have ranged from 9.0 to 10.1 percent, with an average of 9.6 percent 17

and a median of 9.8 percent. Additionally, the electric utilities subject to the 18

Commission’s jurisdiction recently were allowed ROEs in the range of 10.05% to 19

10.30% for 2018-2019, and were allowed ROEs 5 to 15 basis points higher than that 20

for 2017. 21

1 As of May 31, 2017.


4

Q8. How is the remainder of your testimony organized? 1

A8. Section II reviews Mr. Rothschild’s implementation of the DCF model, Section III 2

discusses why Mr. Rothschild did not provide any ROE estimates based upon the 3

Capital Asset Pricing Model even though he claims that he does, and Section IV 4

addresses Mr. Rothschild’s specific criticisms of my direct testimony analysis and cost 5

of equity recommendations, including a discussion of current economic conditions and 6

their likely effect on the ROE estimates from the CAPM and DCF models. 7

II. MR. ROTHSCHILD’S DCF BASED ESTIMATES 8

A. CONSTANT GROWTH “SUSTAINABLE GROWTH RATE” DCF 9

Q9. What DCF method does Mr. Rothschild rely on when recommending DCF-based 10

estimates? 11

A9. Mr. Rothschild relies primarily on the constant growth form of the DCF model, which 12

he describes as “used in determining the cost of equity when investors can reasonably 13

expect that growth of retained earnings and dividends will be constant.”2 The equation 14

for Mr. Rothschild’s sustainable growth DCF model can be expressed as 15

� =�

�+ (�� + ��)

where (br + sv) is the sustainable growth rate, as described on pages 28-29 of Mr. 16

Rothschild’s testimony. 17

2 Rothschild Testimony, p. 28.


5

Q10. How does Mr. Rothschild implement the constant growth DCF model? 1

A10. Mr. Rothschild uses historical information and forecasts from Value Line for book 2

value per share and dividends, as well as market price data from Yahoo! Finance to 3

calculate the market-to-book ratio and dividend yield for each company in the Water 4

proxy group as of 6/30/2017. He also calculates a dividend yield based on an average 5

of high and low prices over the past year.3 These values are used in the calculation of 6

the earnings retention rate (b), which Mr. Rothschild estimates by applying his assumed 7

rate of return on book equity (r) to 2017 book value per share and comparing to the 8

most recent quarterly dividend levels.4 For two of his estimates, he bases the return on 9

equity (r) on Value Line forward-looking estimates of expected returns on book equity 10

for 2020-2022. For the other half, he uses actual historical returns on book equity 11

calculated for fiscal year 2016. 512

Additionally, Mr. Rothschild uses forecasted information from Value Line to calculate 13

what he describes as the “external financing rate”. This is computed as the compound 14

annual growth between 2018 and 2021 in common shares outstanding and is used in 15

the calculation of the � × � portion of the sustainable growth calculation. He multiplies 16

the estimated external financing rate by an accretion ratio, which is estimated using the 17

market-to-book ratio that Mr. Rothschild calculates as described above.618

3 Rothschild Workpapers, Schedule ALR 3, p. 1. 4 Rothschild Workpapers, Schedule ALR 4, p. 1. 5 Rothschild Workpapers, Schedule ALR 3, p. 2. 6 Rothschild Workpapers, Schedule ALR 4, p. 1.


6

Q11. What are your reactions to this methodology? 1

A11. While there is nothing inherently wrong with using a sustainable growth rate when 2

implementing the constant-growth version of the DCF model, Mr. Rothschild’s 3

implementation relies on several fundamental logical inconsistencies that run counter 4

to Mr. Rothschild’s statements about the benefits of the sustainable growth approach. 5

Additionally, his calculations exhibit several technical errors and flaws that lead to a 6

substantial downward bias in his results. These errors include the use of an inaccurate 7

external financing rate, and the inclusion of inputs that imply an illogical negative 8

growth rate estimate for York Water such that these inputs should not be allowed to 9

influence the cost of equity estimates for the water sample. 10

1. There are fundamental conceptual inconsistencies in Mr. Rothschild’s 11 sustainable growth methodology. 12

Q12. What are the fundamental inconsistencies in Mr. Rothschild’s calculation of the 13

sustainable growth? 14

A12. The first and most fundamental inconsistency concerns the levels of the forecasted and 15

historical return on book equity inputs (r) that Mr. Rothschild employs in his 16

calculations. The sample average forecasted value of � he employs is 12.0%, while the 17

scenarios purportedly based on “actual [historical] returns” use an � of 11.0%. 18

However, as a basis for sustainable growth rates, these assumed levels of return on 19

book equity are fundamentally incompatible with Mr. Rothschild’s recommendation 20

that CWS by allowed to earn a rate or return on equity rate base of only 8.22%. 21


7

Q13. Please explain this first inconsistency further. 1

A13. The entire premise of a sustainable growth calculation of the type Mr. Rothschild 2

proposes to calculate is that it represents a level of earnings growth that the company 3

can sustain into perpetuity. As Mr. Rothschild explains, the � × � formulation 4

recognizes that reinvesting retained earnings in its business will generate new earnings 5

at the rate of the company’s return on book equity. In applying his � × �-based growth 6

rate in the constant growth version of the DCF, Mr. Rothschild effectively assumes that 7

investors expect the water sample to be able to earn a return of 12 (or 11) percent on 8

book equity into perpetuity. At the same time, however, Mr. Rothschild recommends 9

that CWS only be allowed to earn 8.22% on the equity portion of its rate base. If his 10

position is that the cost of equity estimates for the sample are representative for the 11

subject companies in this case, he does not explain how a regulated water utility 12

company with an allowed return on equity of 8.22% could be expected to “sustainably” 13

grow earnings in a manner consistent with the much higher assumed rates of return on 14

book equity that are the basis of his calculations. 15

Q14. Did you find other inconsistencies in Mr. Rothshild’s approach? 16

A14. Yes. A second fundamental inconsistency is that Mr. Rothschild claims that using the 17

“� × �” approach eliminates the “mathematical error” caused by a non-alignment 18

between the expectations for earnings per share growth and dividends per share growth. 19

He continues by saying that because his approach employs consistent estimates of 20

expected return on book equity and retention ratios, the results of the ““� × �” approach 21


8

will be more accurate than other approaches.7 However, Mr. Rothschild contradicts 1

himself because he relies on historical dividend and book values in his calculation of a 2

sustainable growth rate instead of expected values. Return on book equity (r) and 3

growth in common shares outstanding are the only forecasts he uses, and the Value 4

Line forecasted return on book equity is only incorporated in two of his four cost-of-5

equity estimates.8 This means that two of Mr. Rothschild’s estimates are entirely based 6

on historical values, such that the only way they can reflect “what investors expect […] 7

at the time of the quantification of the stock price used in the DCF formula,” as Mr. 8

Rothschild asserts they must,9 is if investors expect the future to exactly mimic the 9

recent past. 10

A third inconsistency is that Mr. Rothschild criticizes the use of analysts’ EPS growth 11

rate forecasts as flawed and upwardly biased – yet he relies on Value Line’s forecasts 12

to drive the sustainable growth rate calculation in two of his constant growth DCF 13

scenarios. In contrast to my approach, which averages the EPS growth estimates 14

sourced from multiple independent analysts (i.e., Value Line and individual brokers 15

that contribute to IBES) Mr. Rothschild relies on a single source (Value Line) for his 16

forecasts. Importantly, he does not explain why he eschews one kind of forecast (i.e., 17

of EPS growth) but is willing to rely on a second kind (i.e., of return on book equity). 18

7 Rothschild Testimony, p. 30-32. 8 Rothschild Workpapers, Schedule ALR 4, p. 1. Forecasts of return on book equity are used in the

estimates labeled as “Based on Value Line” on Schedule ALR 4, p. 1, whereas the estimates labeled as “Based on Actual Returns” seem to rely on historical actual earnings calculated on Schedule ALR 6, columns 5, 6, and 8.

9 Rothschild Testimony, p. 31, lines 24-27 and p. 32, lines 16-17.


9

2. Mr. Rothschild’s Sustainable Growth DCF calculations contain 1 technical flaws and mathematical errors. 2

Q15. What are the technical errors and logical flaws in Mr. Rothschild’s sustainable 3

growth DCF analysis? 4

A15. First, Mr. Rothschild’s Workpaper ALR 6 shows his calculation of an external 5

financing rate. As mentioned above, he calculates this as the compound annual growth 6

rate in shares of common stock outstanding in the three years between 2018 and 2021, 7

and then calculates an average for the sample. The average compound annual growth 8

in shares for the Water Proxy Group is 0.61%. Mr. Rothschild then proceeds to round 9

this to 0.30%, which appears to be a mathematical error, as there is no logic behind this 10

rounding. 11

Second, and relatedly, the reason why the 0.61% average external financing rate that 12

Mr. Rothschild calculated for the sample is so much lower than the median rate of 13

1.36%10 is that York Water has a forecasted external financing growth rate of -1.98%. 14

Value Line forecasts a decrease in the common stock outstanding between 2018 and 15

2021, most likely due to York Water’s share buyback program as referenced in my 16

direct testimony as well as that of my Brattle partner, Dr. Villadsen.11 The impact of 17

this expected shrinkage in the number of shares outstanding on Mr. Rothchild’s 18

calculations for York Water produces a negative estimate of its sustainable growth rate. 19

10 The median of 1.36% reported on Mr. Rothschild’s Schedule ALR 6 is calculated excluding York Water, despite the fact that York is included in the average of 0.61%. Including York’s negative external financing rate in the calculation of the median results in a value of 0.92%.

11 Vilbert Direct Testimony, p. 49, and Villadsen Direct Testimony (i.e., Direct Testimony of Bente Villadsen in Application No. A.17-04-003), p. 40.


10

Negative growth is inherently not sustainable into perpetuity (since a company with 1

sustained negative earnings growth would go out of business). Therefore, in the 2

constant growth DCF model, it is not appropriate to include York Water when using 3

the negative �� + �� growth rate calculated using Mr. Rothschild’s methodology.124

Because Mr. Rothschild’s DCF estimates are all performed on the basis of sample 5

average inputs (rather than on an individual company basis), his results are substantially 6

downwardly biased by his inconsistent treatment of York Water in determining his 7

inputs. He leaves out York Water in some calculations (namely the average calculation 8

of the companies’ dividend yield and the median calculation of the companies’ external 9

financing rate) but includes it when calculating the average external financing rate as 10

well as the average and median market to book ratios and returns on book equity for 11

the sample. Mr. Rothschild’s estimates are also downwardly biased by his apparent 12

mathematical error in illogically rounding the sample average external financing rate 13

shown on Schedule ALR 6 down to 0.30%. He does not explain in his testimony why 14

0.30% is correct.1315

12 As an aside, if York Water is repurchasing its shares, then it is distributing cash to shareholders other than dividends, which, everything else equal, means its cost of equity estimate using the DCF model will increase if the additional cash distributions are considered. See Vilbert Direct Testimony at p. 49, lines 3-9.

13 In response to California Water Service Data Request # CSW-001, Question #5, Mr. Rothschild indicates that he derived this 0.30% external financing rate by observing an average change from 2018 to 2021 of 0.61%, and a slightly negative change indicated by Value Line reports from 2013 to 2018. Mr. Rothschild asserts that the 0.30% was obtained by considering both of those growth periods.


11

Q16. Do you have reason to believe that Mr. Rothschild’s use of 0.30% for the external 1

financing rate is the result of a mathematical error? 2

A16. Yes. In response to Golden State Water Company’s Data Request, Mr. Rothschild 3

produced “Attachment B-GSW–A.17-04-001–DR PM-1-Rothschild BXR Growth 4

Calculations.xlsx” (referred to herein as “Attachment B”). Within this workbook, Mr. 5

Rothschild calculates the external financing rate from Value Line reports over the past 6

year, used in preparation of Chart 5 of his Testimony. This includes the same April 14, 7

2017 Value Line reports used in Mr. Rothschild’s calculation of the external financing 8

rate in Schedule ALR 6. As demonstrated in Figure 1 below, the same Value Line data 9

produces very different share growth estimates in Mr. Rothschild’s Attachment B 10

calculations (column [5]) compared to his Schedule ALR 6 calculations (column [6]). 11

This is due to a mathematical error in the compound annual growth rate calculation Mr. 12

Rothschild performed in Attachment B, which assumed a growth period of five years 13

between 2018 and 2021. In Schedule ALR 6, Mr. Rothschild corrected this error to a 14

period of growth of three years between 2018 and 2021. However, the erroneous 15

Attachment B calculation results in an average external financing rate of 0.32%, which 16

rounds to 0.30%, the external growth rate used in Mr. Rothschild’s sustainable growth 17

DCF cost of equity estimation. 18


12

Figure 1 Calculation of Mr. Rothschild's External Financing Rate

Q17. In Mr. Rothschild’s response to California Water Service’s Data Request, he 1

states that the 0.30% is obtained by considering both past and future growth 2

periods.14 Is this explanation credible? 3

A17. No. Mr. Rothschild indicates that he derived the 0.30% external financing rate by 4

observing an average change from 2018 to 2021 of 0.61%, and a slightly negative 5

change indicated by Value Line reports from 2013 to 2018. Mr. Rothschild concludes 6

that the 0.30% is obtained by considering both of these growth periods.15 However, 7

Figure 1 above demonstrates that growth in common stock outstanding was only 8

“slightly “negative” for two of the eight companies over the 2013 to 2018 period—9

14 ORA response to California Water Service Data Request # CSW-001, Question #5. 15 ORA response to California Water Service Data Request # CSW-001, Question #5.

Common Stock Outstanding Compound Annual Growth

Company 2013 2018 2020-20222018-2021

(Attachment B)

2018-2021

(Schedule ALR 6)

[1] [2] [3] [4] [5] [6]

American States Water 38.7 36.7 37.0 0.16% 0.27%

American Water Works 178.3 179.0 187.5 0.93% 1.54%

Aqua America 177.9 178.5 180.0 0.17% 0.28%

California Water Serv. Grp. 47.7 48.0 50.0 0.82% 1.36%

Connecticut Water Services 11.0 11.5 12.0 0.85% 1.41%

Middlesex Water Company 16.0 16.8 17.0 0.30% 0.49%

SJW Corporation 20.2 22.0 23.0 0.89% 1.48%

York Water 13.0 12.8 12.0 -1.59% -1.98%

Average 0.32% 0.61%

Median * 0.82% 1.36%

Sources and Notes:

[2]: Value Line Company Reports, April 14, 2017.

[3]-[4]: Mr. Rothschild's Workpapers, Schedule ALR 6, p. 1.

[5]: Mr. Rothschild's Attachment B - BXR Growth Calculations, New Financing Growth. Calculated as ([4] / [3])^(1/5)-1.

[6]: Mr. Rothschild's Workpapers, Schedule ALR 6, p. 1. Calculated as ([4] / [3])^(1/3)-1.

* The Median is calculated excluding York Water, as Mr. Rothschild does in both Attachment B and his workpapers.

[3]: The common shares outstanding in 2018 for York Water is reported as 13.0 in Attachment B and as 12.75 in Mr.

Rothschild's Workpapers, Schedule ALR 6. Value Line reports this value as 12.75 in the April 14th, 2017 report.


13

American States Water and York Water. Therefore, the majority of the sample 1

experienced positive growth between 2013 and 2018, which undermines Mr. 2

Rothschild’s assertion that “the changed [sic] indicated in the Value Line reports from 3

2013-2018 [for the water sample] was slightly negative.”16 It is certainly not the case 4

that Mr. Rothschild’s assumed 0.30% external financing rate could represent any kind 5

of an average rate of growth based on both historical (i.e., starting 2013) and forecasted 6

(i.e., to 2020-2022) share balances reported in Value Line. 7

Additionally, even if the facts supported Mr. Rothschild’s statement (which they do 8

not), his explanation that he considered share growth from a historical period is at odds 9

with his repeated emphasis that inputs to the sustainable growth calculations should be 10

“what investors expect […] at the time of the quantification of the stock price used in 11

the DCF formula.”17 In my opinion, it is much more likely that Mr. Rothschild 12

corrected the mathematical error in his external financing rate calculation when 13

preparing Schedule ALR 6, but based the “rounded” 0.30% rate that he actually uses 14

in his cost of equity estimates on the mathematically erroneous Attachment B 15

calculations that underlie Chart 5 in his testimony. 16

Q18. Have you analyzed the impact of Mr. Rothschild’s errors in downwardly biasing 17

his sustainable growth DCF cost of equity estimates? 18

A18. Yes. I have replicated Mr. Rothschild’s analysis using his data sources, but on a 19

company by company basis. As shown in Figure 2 below, when Mr. Rothschild’s 20

16 ORA response to California Water Service Data Request # CSW-001, Question #5. 17 Rothschild Testimony, p. 32, lines 16-17.


14

methodological approach to the sustainable growth DCF calculation is implemented on 1

a company by company basis—which also implicitly corrects his mathematical 2

“rounding” error—it becomes clear that certain features of the data for York Water 3

company create illogical and anomalous results that downwardly bias Mr. Rothschild’s 4

results by a substantial amount. 5

Q19. Please explain how inclusion of anomalous and illogical inputs for York Water 6

downwardly biases Mr. Rothschild’s sustainable growth DCF cost of equity 7

estimates. 8

A19. As demonstrated in Figure 2 below, York Water Company has a very low retention rate 9

compared to the sample and negative financing growth due to a decrease in the forecast 10

of the shares of common stock outstanding. This results in an illogical negative 11

sustainable growth rate calculated using Mr. Rothschild’s methodology, and an 12

estimated cost of equity between -0.57% and 1.37%, depending on which versions of 13

Mr. Rothschild’s inputs are used. These results are anomalously low and cannot 14

reasonably be interpreted as meaningful estimates of York Water’s cost of equity. 15

Consequently, York Water should be excluded from all four versions of Mr. 16

Rothschild’s sustainable growth DCF analysis. 17

Figure 2 shows the results of Mr. Rothschild’s sustainable growth DCF approach on a 18

company by company basis with price and book value data as of June 30, 2017. As 19

shown in this Figure, York Water alone has a negative growth rate estimate of -0.47%, 20

as compared to the calculated sustainable growth rates for the rest of the sample, which 21

range from 5.77% to 9.33%, with an average of 7.67%. Mr. Rothschild estimates a 22


15

sustainable growth rate of 6.55% for the Water Proxy Group, which falls below the 1

sample average by approximately 110 basis points when York Water’s illogical result 2

is appropriately excluded.183

Figure 2 Mr. Rothschild’s Sustainable Growth DCF Calculations

Water Proxy Group Using 6/30/2017 Prices

18 Rothschild Workpapers, Schedule ALR 4, p. 1.

Company

Dividend

Yield on Market

Price

Market-to-book

Expected

Return on

Equity

Retention Rate

External

Financing

Rate

New

Financing

Growth

"Total Estimate

of Investor Anticipated

Growth"

Indicated

Cost of

Equity

(D/P) (M/B) (r) (b) (s x v) (br + sv)

[1] [2] [3] [4] [5] [6] [7] [8] [9]

American States Water 2.04% 3.51 14.00% 48.86% 0.27% 0.67% 7.51% 9.63%

American Water Works 1.92% 2.67 10.50% 51.14% 1.54% 2.57% 7.94% 9.94%

Aqua America 2.30% 3.19 12.50% 41.31% 0.28% 0.61% 5.77% 8.13%

California Water Serv. Grp. 1.96% 2.68 11.00% 52.40% 1.36% 2.27% 8.04% 10.07%

Connecticut Water Services 2.04% 2.65 11.00% 51.04% 1.41% 2.33% 7.94% 10.06%

Middlesex Water Company 2.13% 2.96 12.50% 49.55% 0.49% 0.96% 7.15% 9.36%

SJW Corporation 1.77% 2.39 11.50% 63.29% 1.48% 2.05% 9.33% 11.18%

York Water Company * 1.85% 3.91 12.50% 42.27% -1.98% -5.76% -0.47% 1.37%

Including York

Average 2.00% 2.99 11.94% 49.98% 0.61% 0.71% 6.65% 8.72%

Median 2.00% 2.82 12.00% 50.29% 0.92% 1.50% 7.73% 9.79%

Excluding York

Average 2.02% 2.86 11.86% 51.08% 0.98% 1.64% 7.67% 9.77%

Median 2.04% 2.68 11.50% 51.04% 1.36% 2.05% 7.94% 9.94%

Sources and Notes:

[2]: Mr. Rothschild's Workpapers, ALR 3, p. 1.



[5]: 1 - [([2] x [3]) / [4]]

[6]: Mr. Rothschild's Workpapers, ALR 6, Compound Annual Growth in Common Stock.

[7]: [6] x ([3] - 1)

[8]: [5] x [4] + [7]

[9]: [2] * (1 + 0.5 * [8]) + [8]

* York is excluded in the calculation of the Average and Median due to a negative growth rate (excluded numbers

are bold and italicized).


16

Q20. How do the sustainable growth rates calculated under Mr. Rothschild’s approach 1

compare to the growth rates used in your January 31, 2017 DCF analysis? 2

A20. When Mr. Rothschild’s sustainable growth rate calculation is performed on a company 3

by company basis, the resulting growth rates are very much in line with those used in 4

my January 31, 2017 DCF analysis, where I calculated a weighted average growth rate 5

using both growth rates implied by Value Line’s EPS forecasts and Thomson Reuters 6

IBES’s consensus estimates for 5-year EPS growth rates. Figure 3 below compares the 7

estimates used in my single and multi-stage DCF approach with the sustainable growth 8

rates calculated here under Mr. Rothschild’s constant growth DCF methodology. 9


17

Figure 3

Comparison of EPS Growth Rates Use in My Direct Testimony and Sustainable Growth Rates Calculated Using Mr. Rothschild’s Data and Methodology

Q21. What is the numerical impact of correcting the technical errors and other 1

technical flaws in Mr. Rothschild’s sustainable growth DCF analysis, but 2

otherwise replicating his approach exactly? 3

A21. After correcting the technical errors and logical flaws in Mr. Rothschild’s sustainable 4

growth DCF analysis, cost of equity estimates increase by approximately 110 basis 5

points in every scenario as compared to Mr. Rothschild’s original estimates, as 6

demonstrated in Figure 4 below. Since Mr. Rothschild’s “Indicated Cost of Equity” 7

for the proxy group of 8.25% is clearly based heavily, if not primarily, on his constant 8

Vilbert Approach Rothschild Approach

Company

Value Line Growth

Rate as of

1/31/2017

Weighted Growth

Rate as of

1/31/2017

Sustainable Growth

Rate as of

6/30/2017

[1] [2] [3] [4]

American States Water 8.90% 5.87% 7.51%

American Water Works 9.59% 7.88% 7.94%

Aqua America 6.70% 5.57% 5.77%

California Water Serv. Grp. 15.47% 10.32% 8.04%

Connecticut Water Services 3.25% 4.85% 7.94%

Middlesex Water Company 5.38% 5.38% 7.15%

SJW Corporation * 0.00% 0.00% 9.33%

York Water Company ** 6.82% 6.82% -0.47%

Average 8.02% 6.67% 7.67%

Sources and Notes:

[2],[3]:

[4]: Mr. Rothschild's calculation of sustainable growth rate = br + sv, as of June 30, 2017.

* SJW was excluded from the sample average in [2] and [3] due to its estimated cost of equity

not exceeding the cost of debt by 100 basis points.

** York Water was excluded from the sample average in [4] due to its negative growth rate.

Vilbert Workpapers, Table No. MJV-WATER-5, Estimated Growth Rates as of January 31,

2017. Weighted average includes both Thomson Reuters and Value Line LT EPS estimates.

Thomson Reuters estimates were missing for MSEX, SJW, and YORW at the time of analysis.

Therefore, the weighted average is based solely on Value Line for these companies.


18

growth DCF cost of equity estimates19 that are logically inconsistent and downwardly 1

biased due to technical flaws as demonstrated herein, it is reasonable to conclude that 2

Mr. Rothschild’s recommendation should have been substantially higher (by as much 3

as 118 basis points) absent these flaws. 4

Figure 4 Downward Bias in Mr. Rothschild’s Sustainable Growth DCF Estimates

Due to Technical Flaws and Errors in His Calculations

Furthermore, less weight should be given to Mr. Rothschild’s DCF estimates “Based 5

on Actual Returns” because these estimates disregard the significance of forward-6

looking investor expectations and rather assume that the future is going to exactly 7

mimic the recent past. In summary, Mr. Rothschild’s constant growth DCF model, 8

implemented using his recommended inputs and formulas, but correcting mathematical 9

errors and excluding illogical and anomalous inputs in a manner consistent with Mr. 10

Rothschild’s stated principles that cost of equity estimates should reflect investors’ 11

19 Rothschild Testimony, p. 5 and Schedule ALR 2.

Rothschild Price and Book Value Timing Scenario

Average for Year Ending 6/30/2017 As of 6/30/2017

Rothschild Return on Book

Equity Input AssumptionAs Filed Corrected

Downward

BiasAs Filed Corrected

Downward

Bias

[1] [2] [3] [4] [5] [6]

"Based only on Value Line Future

Expected Growth"8.49% 9.67% -1.18% 8.63% 9.77% -1.13%

"Based on Actual Returns" 7.48% 8.61% -1.13% 7.62% 8.71% -1.09%

Sources and Notes:

[1],[4]: Mr. Rothschild's Workpapers, ALR 4, p. 1.

[2],[5]: Vilbert Rebuttal Appendix B, Workpapers #1-4.

[3]: [1] - [2]

[6]: [4] - [5]


19

forward looking expectations, produces estimates in the range of 9.7% to 9.8%, which 1

exceed his cost of equity recommendations by approximately 150 basis points. 2

B. MR. ROTHSCHILD’S NON-CONSTANT GROWTH DCF 3

Q22. How does Mr. Rothschild implement his “non-constant growth” DCF model? 4

A22. As explained on pages 38-39 of Mr. Rothschild’s testimony and illustrated on page 2 5

of Schedule ALR 4, Mr. Rothschild computes the internal rate of return (“IRR”) 6

associated with a stream of estimated cash flows for each company in the water utility 7

sample. The estimated cash flows assume an investor purchases the company’s stock 8

at its 6/30/2017 market price, and holds the stock for four years, selling it on 7/1/2021. 9

During the assumed holding period, Mr. Rothschild assumes the investor expect to 10

receive the annual dividends forecasted by Value Line,20 with the first one (2017) 11

modeled as arriving on the original purchase date (i.e., 6/30/2017), and the last one 12

arriving on the date of sale (i.e., 7/1/2021). To calculate his assumed terminal price 13

(i.e., the price at which the investor sells the stock at the end of the holding period), 14

Mr. Rothschild multiplies the company’s 2017 market-to-book ratio (calculated based 15

on the 6/30/2017 price and Value Line’s 2017 book value per share estimate) by Value 16

Line’s forecasted book value per share for 2020-2022. 17

20 The Value Line data utilized by Mr. Rothschild includes forecasted annual dividends for 2017, 2018, and 2020-2022. As indicates in his testimony and schedules, Mr. Rothschild attributes the 2020-2022 dividend forecast to 2021, and interpolates 2019 and 2020 dividends based on the 3-year compound annual growth rate implied by the 2018 and 2020-2022 forecasts.


20

Mr. Rothschild computes his non-constant growth DCF cost of equity estimate of 1

7.26%21 as the average of the calculated IRRs for all the water sample companies 2

excluding York Water.22 He does not explain why he excludes York from the average 3

in deriving his non-constant growth DCF estimate despite including the inputs leading 4

to its illogical negative sustainable growth rate and anomalously low indicated cost of 5

equity in his constant-growth DCF calculations. 6

Q23. In your opinion, is a DCF model that assumes a non-constant pattern of growth 7

in dividends a valid way to estimate the cost of equity? 8

A23. Yes. I routinely perform a multi-stage growth version of the DCF model, and have 9

done so in this proceeding. My multi-stage DCF analysis assumes that a company’s 10

dividends grow at a company-specific growth rate for 5 years and then transition 11

gradually over the next 5 years toward an estimate of the expected growth rate of the 12

overall economy (i.e., GDP growth). At the 10-year mark in my model, a terminal 13

value is calculated based on the assumption that dividends are projected to grow at the 14

rate of GDP from that point into perpetuity. This component of the model is necessary 15

to reflect the fundamental principle of finance that any future value of the stock (such 16

as the price it would sell for in 10 years) is itself a reflection of the dividends investors 17

expect to receive from that date forward—into perpetuity—discounted back to that 18

point in time at the cost of equity.2319

21 Rothschild Testimony, p. 5 and Schedule ALR 2. 22 Mr. Rothschild’s Schedule ALR 4, page 2 workpapers. 23 Vilbert Direct Testimony, pp. 46-47.


21

In my direct testimony, I noted that while I considered the results of the multi-stage 1

DCF in making my recommendation, I note that several factors—including the 2

presence of expected stock repurchases among the proxy group members and very low 3

current estimates of long-term GDP growth—may cause a mechanical implementation 4

of the multi-stage DCF in particular to underestimate the cost of equity.245

Q24. Do you have any concerns about the assumptions underlying Mr. Rothschild’s 6

implementation of the non-constant growth DCF? 7

A24. Yes. His method of calculating his assumed 2021 sale price for each stock reflects a 8

non-standard approach that is inconsistent with fundamental finance principles 9

underlying the DCF. 10

As explained above, any financially sound DCF model must be consistent with the 11

fundamental assumption that the observed market price of a stock at any point in time 12

is equal to the expected value of all dividends or cash flows that investors will receive 13

from that time forward, discounted back to the relevant time at the cost of equity. This 14

is why the “terminal value” price in my multi-stage DCF model reflects the final 15

“stage” of dividend growth occurring into perpetuity at the rate of GDP growth, 16

according to the same formula that is the foundation of the single-stage DCF model. 17

Mr. Rothschild, however, does not calculate his terminal price in this manner. Rather 18

he calculates it based on a Value Line forecast of what each company’s book value per 19

share will be in 2020-2022, coupled with an assumption that the market-to-book ratio 20

24 Vilbert Direct Testimony, p. 56.


22

at that time will be the same as it is now (or more precisely, the same as it is according 1

to Value Line’s 2017 book value estimate). Mr. Rothschild does not justify his 2

assumption that the market-to-book ratio will remain constant (as opposed to applying 3

a constant P/E ratio for example), nor does he explain why he is comfortable employing 4

Value Line forecasts of book value despite his repeated general objections to my own 5

use of forecasts. 6

More importantly, however, Mr. Rothschild does not reconcile his assumed terminal 7

prices with the fundamental underlying assumption of all DCF models that these prices 8

must equal the discounted value of expected cash flows from that time forward. 9

Q25. Why do you say Mr. Rothschild has not reconciled his assumed terminal prices 10

with the fundamental finance principle that these prices must equal the 11

discounted value of cash flows from that time forward? 12

A25. When asked in data requests whether he agreed that “the fundamental value of a 13

company’s stock at a given point in time reflects the discounted present value of all 14

expected future cash flows that investors expect to receive form that point forward,” 15

Mr. Rothschild responded as follows. 16

Yes. Other than the right to vote, the only reason investors purchase 17 stock is for the right to future dividends, including the “liquidating 18 dividend” that obtain upon sale.2519

The “liquidating dividend” Mr. Rothschild refers to is of course the price at which a 20

given investor sells the stock. Despite acknowledging this principle, Mr. Rothschild’s 21

25 Mr. Rothschild’s response to CWS Data Request # CSW-001, Question #6.


23

analysis ignores the fact that the purchasing party will only agree to the sale if the price 1

reflects the market value of the right to receive dividends from that point forward, (and 2

so on for any subsequent sales of the stock). Mr. Rothschild’s non-constant growth 3

DCF implementation makes no explicit assumptions about what these dividends will 4

be, or how they will grow. Thus his analysis does not reconcile the assumed terminal 5

prices with the fundamental finance theory underlying all DCF models. 6

Q26. Have you attempted to reconcile the terminal price assumptions in Mr. 7

Rothschild’s non-constant growth DCF model with finance theory? 8

A26. Yes. I have done so by calculating the implied perpetual growth rate for each company 9

that—if applied to Mr. Rothschild’s forecasted 2021 dividend and discounted back to 10

2021 at his estimated cost of equity for that company—gives a value equal to his 11

assumed terminal price. As illustrated in Figure 5 below, these implied growth rates 12

vary widely, from a low of 2.74% for Connecticut Water Services Inc. (CWTS) to a 13

high of 8.11% for Aqua America (WTR). Mr. Rothschild provides no explanation for 14

why investors would expect such disparate rates of growth for the companies in the 15

water sample from 2021 forward, nor does he ground the assumed perpetual growth 16

rates in economic principles, as I do by linking perpetual company growth to the rate 17

of broader economic growth. These variable and unjustified implicit growth rates 18

reveal that Mr. Rothschild’s terminal price assumptions are not well grounded in 19

finance principles, casting doubt on the theoretical validity of his non-constant growth 20

DCF cost of equity estimates. 21


24

Figure 5 Implied Terminal Growth Rates of Mr. Rothschild’s Non-constant DCF Model

Q27. Do you have any other comments about Mr. Rothschild’s non-constant growth 1

DCF results? 2

A27. Yes. An examination of Mr. Rothschild’s individual company IRRs from the non-3

constant growth DCF reveals that some of them are simply too low to form credible 4

estimates for the cost of equity of those companies. Specifically, Mr. Rothschild’s 5

estimates of 5.72% for California Water Services Group (CWT), 5.11% for 6

Connecticut Water Services (CTWS), and 5.51% for SJW Group (SJW) are barely 7

higher than the cost of debt for the companies in this proceeding, and only 100-150 bps 8

higher than the prevailing yield on an A-rated utility bond index. Given that equity is 9

CompanyStock Price

(2021)

Dividend

(2021)"DCF Result"

Implied Terminal

Growth Rate

[1] [2] [3] [4] [5]

American States Water $56.09 $1.35 7.18% 4.66%

American Water Works $99.84 $2.35 9.35% 6.83%

Aqua America $44.55 $1.15 10.91% 8.11%

California Water Serv. Grp. $41.32 $0.99 5.72% 3.25%

Connecticut Water Services $60.61 $1.40 5.11% 2.74%

Middlesex Water Company $46.70 $1.02 7.03% 4.75%

SJW Corporation $55.44 $1.12 5.51% 3.42%

York Water Company $41.94 $0.90 7.52% 5.26%

Sources and Notes:

[2]-[4]: Mr. Rothschild's Workpapers, Schedule ALR 4, p. 2.

[3]: Value Line projected dividend for 2020-2022 (midpoint 2021) as of April 14, 2017.

[4]: Internal rate of return based on cash flows from 2017 to 2021.

[5]: ([2] x [4] - [3]) / ([2] + [3])

[2]: Forecasted 2021 stock price calculated under the assumption that stock price will grow at

the same rate as book value per share.


25

riskier than corporate debt, it does not make sense that investors would invest in stocks 1

with the expectation of earning returns that barely exceed what they could earn buying 2

a bond from the same (or a similar) company. 3

III.MR. ROTHSCHILD’S DISCUSSION OF CAPM 4

Q28. Have you reviewed the section of Mr. Rothschild’s testimony titled “Capital Asset 5

Pricing Model”? 6

A28. Yes. In conjunction with my Brattle partner and fellow Brattle principal, Dr. Villadsen, 7

I have reviewed Mr. Rothschild’s statements about the Capital Asset Pricing Model 8

(“CAPM”) and the accompanying calculations. In her rebuttal testimony, Dr. Villadsen 9

provides a detailed summary of what Mr. Rothschild refers to as his “implement[ation 10

of] the CAPM” and explains why it is not truly a CAPM analysis and why it does not 11

provide any meaningful information about the cost of equity capital in this proceeding. 12

Q29. Would you please summarize the conclusions you and Dr. Villadsen reached with 13

respect to Mr. Rothschild’s discussion of the CAPM? 14

A29. Yes. As Dr. Villadsen’s rebuttal testimony explains, Mr. Rothschild does not select 15

inputs for the risk-free rate of interest or the market risk premium, and thus has no basis 16

from which to criticize our own methodological approach to the CAPM. Additionally, 17

Mr. Rothschild’s calculation of the average mid-point Value Line forecast of total 18

returns for the 30 companies included in the Dow Jones Industrial Average (“DJIA” or 19

“Dow 30”) does not provide a meaningful benchmark, either for the expected return on 20

the market as a whole or for the comparison Mr. Rothschild undertakes of average betas 21

for the water sample versus the Dow 30. As Dr. Villadsen’s rebuttal testimony explains, 22


26

the Value Line return forecasts that Mr. Rothschild relies on (despite arguing repeatedly 1

in his testimony that such forecasts are unreliable) do not exhibit any correlation with 2

the Value Line betas, and thus Mr. Rothschild’s attempt to use the 7.85% average Value 3

Line forecast as a “check” on his recommendations is invalid. Dr. Villadsen’s rebuttal 4

testimony also points out that Mr. Rothschild failed to consider financial leverage, 5

operating leverage, and other factors that prevent valid apples-to-apples comparisons 6

among levered equity betas for the Dow 30 companies and those of the water sample 7

companies or between the Dow 30 betas and those that should properly apply to the 8

California Class A Water Companies. 9

IV. MR. ROTHSCHILD’S CRITICISMS OF MY COST OF EQUITY 10 RECOMMENDATIONS 11

Q30. What are Mr. Rothschild’s primary criticisms of your cost of equity 12

recommendations? 13

A30. Mr. Rothschild’s testimony makes a general claim that my cost of equity 14

recommendation for Cal Water and those of the other companies’ witnesses in this 15

proceeding “cannot be considered market based.”26 This criticism stems from his belief 16

that forecasted Treasury bond yields, such as those I employ in my risk positioning 17

analysis do not constitute valid market indicators of what the risk free rate of interest 18

will be during the period rates are in effect.27 Mr. Rothschild also explicitly criticizes 19

me and my Brattle partner, Dr. Villadsen, for interpreting our DCF based cost of equity 20

results in the context of current financial market conditions. He further criticizes my 21

26 Rothschild Testimony, p. 49. 27 Rothschild Testimony, p. 49.


27

caution against relying on the current results from mechanical implementation of cost 1

of equity models as the best indicators of what the cost of equity will be over the entire 2

2018-2020 period. 283

Beyond his claim that my cost of equity recommendations are not “market based”, Mr. 4

Rothschild lists as additional “concerns” about my and Dr. Villadsen’s analyses that 5

we (i) employ analyst estimates of EPS growth rates—which Mr. Rothschild asserts 6

are upwardly biased—in our DCF calculations and (ii) “combine [our] cost of equity 7

estimates with market value capital structures.”29 Much of my rebuttal in this section 8

is duplicative of material in Dr. Villadsen’s rebuttal testimony, in part because Mr. 9

Rothschild addresses our direct testimony recommendations and analyses essentially 10

as if they were one and the same, and in part because Dr. Villadsen and I worked jointly 11

on the non-company specific portions of the rebuttal. 12

A. MARKET-BASED COST OF EQUITY RECOMMENDATIONS13

Q31. How do you respond to Mr. Rothschild’s characterization of your 14

recommendations as not market-based? 15

A31. Mr. Rothschild’s characterization is inaccurate and unsupported by evidence. All of 16

the data and model inputs I employ are market-based, derived either from trading 17

platforms or from publications such as Blue Chip Economic Indicators, Thomson 18

Reuters IBES, and Value Line that aggregate financial market measurements and 19

28 Rothschild Testimony, p. 49-50. 29 Rothschild Testimony, p. 52.


28

consensus economic forecasts of investment brokerage analysts who are themselves 1

participants in and influencers of the markets. 2

Mr. Rothschild’s real disagreement with my recommendation relates to my use of 3

forecasts to inform my implementation of the models and my interpretation of the 4

results in context of current conditions rather than relying on mechanical 5

implementations of the models using the specific inputs he recommends. 6

Q32. Why is it important to rely on forward-looking information when using and 7

interpreting cost of capital models? 8

A32. The cost of equity is a forward-looking concept—the expected rate of return that market 9

participants require to take on the risk of investing in a particular stock. It is not directly 10

observable, and estimating it requires the application of judgment on the part of the 11

analyst—both in selecting the inputs to estimation methodologies such as the CAPM 12

and DCF models, and in interpreting the results of the models as indicators of the 13

forward-looking expected returns investors require. The models require estimates of 14

what capital market conditions will prevail at the times market participants consider 15

whether to buy the stock. In the context of this proceeding, it is important to consider 16

not only the expected returns required by potential investors right now, but also 17

investors who may decide to invest (or not) at any time during the period rates will be 18

in effect (i.e., 2018-2020). 19

Mr. Rothschild admits in his testimony, “[i]f the cost of equity and overall cost of 20

capital is [sic] set too low, the California Class A Water Companies will not be able to 21


29

access the capital needed to provide safe and reliable service.”30 However, he restricts 1

his recommendations for the cost of capital to what he can measure using a mechanical 2

implementation of his models based on current capital market conditions. This decision 3

necessarily reflects one of two views. Either Mr. Rothschild believes that the cost of 4

capital throughout the 2018-2020 period is not relevant, or he believes that estimates 5

made using mechanical implementations of the models in current capital market 6

conditions are the best estimates of what the cost of capital will be throughout that 7

period. Both of these views are misguided. 8

Q33. Why do you say that Mr. Rothschild implements his models mechanically? 9

A33. As I noted above in the discussion of Mr. Rothschild’s implementation of the DCF 10

model, he does not consider whether the estimates from the model make sense. Recall 11

that results of Mr. Rothschild sustainable growth rate DCF model estimate of York 12

Water Company’s ROE is 1.37%, which is less than the cost of debt, or the fact that 13

the implied terminal growth rate of dividends in his non-constant growth rate model 14

varied substantially among the sample companies without explanation. Dr. Villadsen 15

and I carefully consider the inputs and results of our models in the context of current 16

economic conditions and available forward-looking indicators when arriving at our 17

recommended ROEs. Mr. Rothschild mischaracterizes this practice as relying on our 18

“opinions” about what will happen in capital markets and inaccurately concludes that 19

our recommendations are not market based. On the contrary, our recommendations are 20



30

informed by economic and market context to a degree lacking in Mr. Rothschild’s 1

analysis. 2

Q34. What is Mr. Rothschild’s general assessment of current capital market 3

conditions? 4

A34. Mr. Rothschild places a great deal of emphasis on his view that the U.S. is currently 5

experiencing a “Goldilocks economy” in which interest rates and volatility are low and 6

demand for stocks (as indicated by P/E ratios) is high.31 He asserts repeatedly—7

without or against evidence—that markets expect these conditions to continue,32 and 8

all of his recommendations are based on his view that mechanical implementations of 9

his models based on prevailing market interest rates, prices, and other model inputs 10

produce results that are representative of the cost of capital going forward. 11

Q35. Do you agree with Mr. Rothschild’s view that these conditions are likely to 12

continue? 13

A35. No. The recent past is a poor guide to the future as dramatic changes in the stock 14

market have repeatedly revealed. (For example, between January 2003 and July 2007, 15

the S&P 500 increased by more than 50% and then declined by almost 40% between 16

July 2008 and April 2009.33) Even the article Mr. Rothschild cites for the “Goldilocks 17

Economy” reference notes that “[t]he fact that everything's been awesome recently is 18

31 Rothschild Testimony, pp. 7-9. 32 See, for example, Rothschild Testimony, p. 17. 33 Yahoo Finance.


31

little guide to the future of the economy or inflation – and the rise in stocks makes it 1

less likely the general awesomeness will continue.”342

While current government bond yields are near historically low levels, this is the result 3

of unprecedented global capital market events such as the financial crisis of 2008-2009, 4

as well as the effects of ongoing policies of central banks since the financial crisis that 5

were and are explicitly designed to bring down interest rates, particularly on long-term 6

securities. The Federal Reserve currently holds a substantial inventory of treasury 7

securities and mortgage backed bonds, which it expects to unwind. Statements by the 8

U.S. Federal Reserve indicate a gradual unwinding of these policies that will lead to 9

higher rates in the future.35 As noted above, credit spreads remain elevated relative to 10

their long-term historical levels—indicating either that risk premiums are elevated or 11

that risk-free rates are artificially depressed, or both.36 All indications are that interest 12

rates will not remain at historically low levels forever, and market participants expect 13

them to increase modestly in the near future as reflected in the forecasts I rely on in 14

selecting the inputs to my risk positioning models. 15

With respect to stock price levels, my direct testimony presented evidence that P/E 16

ratios vary inversely to interest rates, such that if interest rates rise in the coming years, 17

P/E ratios will likely fall. This in turn means dividend yields and/or expected growth 18

34 “Everything Is Awesome! Now Is the Time to Sell”, Wall Street Journal, July 6, 2017. 35 Federal Reserve Press Release, “Addendum to the Policy Normalization Principles and Plans,” June 14,

2017. 36 Vilbert Direct Testimony, p. 29.


32

rates would rise, such that DCF-based measurements of the cost of equity would be 1

higher than they are when mechanically applied at current market prices.372

B. INTEREST RATE FORECASTS AND THE RISK-FREE RATE3

Q36. Is your analysis based on your “opinion” that interest rates are likely to increase? 4

A36. No. My analysis is based on market evidence that interest rates are expected to 5

increase. This evidence includes the current levels of credit spreads as well as 6

consensus estimates of U.S. Treasury bond yields for 2018. 7

Q37. Is it inappropriate to rely on interest rate forecasts such as those provided by Blue 8

Chip as Mr. Rothschild suggests? 9

A37. No. While neither economic forecasts nor indications of future expectations inferred 10

from securities prices are perfect predictors of the future, the relevant question is not 11

whether they are perfectly accurate all of the time, but rather whether they can be 12

expected to be unbiased predictors on average. While Mr. Rothschild purports to show 13

in his testimony that Blue Chip forecasts have tended to over-predict interest rates, his 14

analysis is limited to a small number of very long-range projections made in 2010.3815

This is hardly conclusive evidence, especially with respect to the shorter range 16

(approximately 1-year) projections of Treasury yields I relied on in my direct 17

testimony. In data responses, Mr. Rothschild admits he has not analyzed such closer-18

37 Vilbert Direct Testimony, pp. 22-23. 38 Rothschild Testimony, p. 21-22.


33

range projections, nor has he conducted a systematic study of the accuracy of interest 1

rate forecasts in rising as well as falling interest rate environments.392

Q38. What does academic evidence say about the accuracy of interest rate projections? 3

A38. Research shows that while it is certainly true that expert forecasts of interest rates do 4

not always precisely predict eventual spot yields, such forecasts generally exhibit a 5

conservative “status quo bias”—tending to over-predict eventual spot yields during 6

falling interest rate environments and under-predict actual yields when interest rates 7

are on the rise.40 Unlike Mr. Rothschild, the Federal Reserve economists who 8

conducted this research considered evidence from historical periods where interest 9

rates were generally increasing as well as from periods of generally declining rates. 10

Since interest rates have generally followed a downward trajectory since the financial 11

crisis (and indeed, as Mr. Rothschild notes, since the early 1980s for long-term yields), 12

it is then not surprising that the handful of forecasts Mr. Rothschild analyzed—made 13

very close on the heels of the crisis itself—have tended to predict higher yields than 14

were eventually realized. However, when interest rates do rise, the academic evidence 15

suggests they may well do so more dramatically or at a faster pace than anticipated by 16

market participants. 17

39 Mr. Rothschild’s response to CWS Data Request # CWS-001, Question #8. 40 R.W. Hafer and Scott Hein, “Comparing Futures and Survey Forecasts of Near-Term Treasury Bill

Rates,” Federal Reserve Bank of St. Louis, May/June 1989.


34

Q39. What about Mr. Rothschild’s assertion that “[a]ny expected rise or decline in 1

interest rates is already incorporated in the current market yield”?412

A39. It is unclear precisely what Mr. Rothschild means by this. If he means that future rates 3

cannot be expected to rise above the level of current yields, this is simply untrue and 4

contradicted by Mr. Rothschild’s own testimony with respect to the yield curve.425

Additionally, the yield curve itself is not static; rather it changes over time. At any 6

point in time, the market is evaluating the probability of a change in interest rates and 7

the yield curve changes as the probability of the magnitude and likelihood of changes 8

in interest rates change. The fact that the market is aware of possible interest rate 9

changes does not mean that interest rates cannot change more (or less) than anticipated 10

by the current yield curve. 11

C. MR. ROTHSCHILD’S CRITICISMS OF EPS GROWTH RATE FORECASTS AND OF 12 FORECASTS IN GENERAL13

Q40. How do you respond to Mr. Rothschild’s claims that the EPS growth rate forecasts 14

you employ in your DCF analysis are upwardly biased? 15

A40. I find Mr. Rothschild’s arguments on this point unconvincing. For one thing, Mr. 16

Rothschild has not presented any academic evidence that an upward or “optimistic” 17

bias in the earnings forecasts of equity analysts currently applies in the context of 18

regulated utilities. Importantly, more recent academic research has not only found that 19

41 Rothschild Testimony, p. 9. 42 Rothschild Testimony, p. 17. The fact that the yield curve is upward sloping such that longer-term bond

yields are higher than yields on 1-year T-bills means—according to the expectation hypothesis—that the market expects rates to by higher 1-year from now than today. This is true both for T-bill yields themselves as demonstrated in Mr. Rothschild’s footnote 41, as well as for longer-term Treasury bonds such as the 20-yr and 30-yr.


35

“the median forecast bias [has] essentially disappeared,”43 but also studied how 1

industry characteristics impact analysts’ forecasts. The findings of several academic 2

studies44 show that analyst earnings forecasts turn out to be too optimistic for stocks 3

that are more difficult to value, for instance, stocks of smaller firms, firms with high 4

volatility or turnover, younger firms, or firms whose prospects are uncertain. These 5

are not characteristics of water utilities. 6

More directly, however, I find Mr. Rothschild’s criticisms inconsistent with the fact 7

that, as shown in Figure 3 above, his own calculations of forward-looking sustainable 8

growth rates for the water sample companies are completely in line—and even higher 9

on average—than the analyst EPS growth forecasts I employed in my direct testimony 10

analysis. 11

Q41. Do you have any other reactions to Mr. Rothschild’s repeated criticisms of 12

financial forecasts in general? 13

A41. As mentioned above, Mr. Rothschild is critical of my use of consensus forecasts for 14

both interest rates and company growth rates, and he makes repeated reference to the 15

notion that financial forecasting in general tends to be inaccurate or unreliable. For 16

example, he references research indicating that “predicting capital markets (e.g. interest 17

43 A. Hovakimian and E. Saenyasiri, “Conflicts of Interest and Analyst Behavior: Evidence from Recent Changes in Regulation,” Financial Analysts Journal, vol. 66, 2010.

44 These studies include the following: (i) Hribar, P, McInnis, J. “Investor Sentiment and Analysts’ Earnings Forecast Errors,” Management Science Vol. 58, No. 2 (February 2012): pp. 293-307; (ii) Scherbina, A. (2004), “Analyst Disagreement, Forecast Bias and Stock Returns,” downloaded from Harvard Business School Working Knowledge: http://hbswk.hbs.edu/item/5418.html; and (iii) Michel, J-S., Pandes J.A. (2012), “Are Analysts Really Too Optimistic?” downloaded from http://www.efmaefm.org.


36

rates, stock prices) is not done well.”45 However, I find Mr. Rothschild’s criticisms 1

disingenuous given that he relies heavily and repeatedly on capital market forecasts to 2

inform his own analysis and recommendations. For example, after stating that capital 3

market predictions are “not done well”, Mr. Rothschild references capital market 4

predictions by Charles Schwab and McKinsey Global Institute in support of his 5

recommendations on the very next page of his testimony.46 Additionally, as discussed 6

above, Mr. Rothschild relies on Value Line predictions of total returns for the Dow 30 7

companies to inform his so-called CAPM analysis. Similarly, Mr. Rothschild relies 8

heavily on Value Line forecasts for his DCF calculations, including medium term 9

predictions of dividends, returns on book equity, price appreciation, book value, and 10

shares outstanding.47 Nowhere in his testimony does Mr. Rothschild explain how or 11

why the extensive capital market predictions he relies upon are any better or more 12

reliable than the limited projections and estimates I use to inform my cost of equity 13

analysis. 14

45 Rothschild Testimony, p. 5. In response to data requests, Mr. Rothschild indicated that the specific types and categories of capital market prediction were those he referred to in that quote: i.e., interest rates and stock prices. See Mr. Rothschild’s response to CWS Data Request # CWS-001, Question #4.

46 Rothschild Testimony, p. 6, Table 6. 47 Rothschild Testimony Schedules ALR 3, ALR 4, and ALR 6. See also Section II.A of this rebuttal

testimony.


37

D. COMPANY SPECIFIC RISK1

Q42. Have you determined that the company specific risks mentioned by the cost of 2

capital witnesses for the California Class A Water utilities are all diversifiable? 3

A42. No. It is difficult to specify which risks are diversifiable and which are not in part 4

because a portion of a specific risk may be systematic (i.e., non-diversifiable) and a 5

portion may be diversifiable. Mr. Rothschild claims that the witnesses did not 6

demonstrate that the company specific are systematic,48 which is true, but of course, it 7

is equally true that Mr. Rothschild has not demonstrated that they are diversifiable 8

either. In any case, the point is that the risks exist and should be considered in a 9

regulatory proceeding. 10

Q43. Are you saying that diversifiable risks affect the Company’s cost of capital? 11

A43. No. According to financial theory, diversifiable risks do not affect a company’s cost 12

of capital, but that does not mean that they should not be considered in a regulatory 13

proceeding. This is because the ability of a regulated company to earn its allowed ROE 14

depends in part on company specific risks and how the regulator chooses to address 15

those risks. For example, the fact that the California Class A Water Companies earn a 16

90-day commercial paper rate on their outstanding WRAM balances means that the 17

companies will expect to earn less than their allowed ROE if every other cost and 18

revenue projection is perfectly accurate because the companies have to finance the 19

WRAM balances at a cost greater than 90-day commercial paper rates. Moreover, it is 20

possible and even likely that a portion of the company specific risks identified are 21



38

systematic. The company specific risks should not be simply dismissed as irrelevant 1

as Mr. Rothschild has done. 2

E. USE OF MARKET VALUE CAPITAL STRUCTURES IN COST OF EQUITY 3 ANALYSIS4

Q44. What is your reaction to Mr. Rothschild’s “concern” about your use of market 5

value capital structures in deriving your cost of equity estimates? 6

A44. While Mr. Rothschild does not say what in particular concerns him about this aspect of 7

my analysis, I find it inconsistent of Mr. Rothschild to criticize me for such a thing in 8

the same section of his testimony that he also claims my recommendations are not 9

“market-based”. The dividends yields and betas that are inputs to my cost of equity 10

estimation methods for the publicly traded companies in the water sample are based on 11

market values (i.e., market stock prices determine the dividend yield and market stock 12

returns are used to estimate betas), so it should be intuitive to rely on the corresponding 13

market-value measures of capital structure, which is what I have done. 14

As to my use of market value capital structures in computing the overall weighted 15

average cost of capital and assets beta estimates for the water sample companies, I do 16

so because this is the standard textbook approach taught in every corporate finance 17

textbook of which I am aware.49 The fact that financial risk is a function of market 18

value financial leverage and that a company’s weighted average cost of capital is based 19

49 See, for example Richard A. Brealey, Stewart C. Myers, and Franklin Allen, Principles of Corporate Finance,12th Edition, 2017, pp. 505-507; Jonathan Berk and Peter DeMarzo, Corporate Finance, 3rd Edition, 2014, pp. 492-494; Stephen Ross, Randolph W. Westerfield, and Jeffrey E. Jaffe, Corporate Finance, 10th Edition, 2013, pp. 571-574; Leonardo R. Giacchino and Jonathan A. Lesser, Principles of Utility Corporate Finance, 2011, pp. 229-232.


39

on its market value capital structure is not a matter of any academic controversy or 1

debate. 2

Q45. Do you, as Mr. Rothschild asserts, “add a leverage adjustment to account for the 3

difference between market value and book value capital structures?”504

A45. No. This is a mischaracterization of the role financial leverage plays in my approach to 5

estimating the cost of equity. My calculation of the overall after tax weighted average 6

cost of capital for the sample companies and my application of the standard Hamada 7

adjustment procedure for betas in my CAPM analysis are designed to account for 8

differences in financial leverage and corresponding financial risk levels inherent in the 9

market beta and cost of equity estimates among the sample companies and between 10

those estimates and the level of financial risk inherent in the regulatory capital structure 11

of Cal Water. 12

Q46. Does this conclude your testimony? 13

A46. Yes. 14

50 Rothschild Testimony, p. 50, lines 12-13.

Figu

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Application No. A.17-04-006 Vilbert Rebuttal Appendix A

Page 1 of 5

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Application No. A.17-04-006 Vilbert Rebuttal Appendix B

Page 1 of 6

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.86%

12.7

2%Y

ork

Wat

er C

ompa

ny *

1.85

%3.

9110

.58%

31.8

0%-1

.98%

-5.7

6%-2

.39%

-0.5

7%

Incl

udin

g Y

ork

Ave

rage

2.00

%2.

9910

.78%

43.2

1%0.

61%

0.71

%5.

50%

7.55

%M

edia

n2.

00%

2.82

10.5

7%42

.81%

0.92

%1.

50%

6.09

%8.

24%

Excl

udin

g Y

ork

Ave

rage

2.02

%2.

8610

.81%

44.8

4%0.

98%

1.64

%6.

62%

8.71

%M

edia

n2.

04%

2.68

10.5

6%43

.72%

1.36

%2.

05%

6.33

%8.

54%

Sour

ces a

nd N

otes

:[2

]:M

r. R

oths

child

's W

orkp

aper

s, A

LR 3

, p. 1

.[3

]:M

r. R

oths

child

's W

orkp

aper

s, A

LR 3

, p. 1

.[4

]:M

r. R

oths

child

's W

orkp

aper

s, A

LR 3

, p. 2

.[5

]:1

- [([

2] x

[3])

/ [4

]][6

]:M

r. R

oths

child

's W

orkp

aper

s, A

LR 6

, Com

poun

d A

nnua

l Gro

wth

in C

omm

on S

tock

.[7

]:[6

] x ([

3] -

1)[8

]:[5

] x [4

] + [7

][9

]:[2

] * (1

+ 0

.5 *

[8])

+ [8

]*

Yor

k is

exc

lude

d in

the

calc

ulat

ion

of th

e A

vera

ge a

nd M

edia

n du

e to

a n

egat

ive

grow

th ra

te (e

xclu

ded

num

bers

are

bol

d an

d ita

liciz

ed).


Page 4 of 6

Wor

king

Pap

er #

4 to

Fig

ure

4C

onst

ant G

row

th D

iscou

nted

Cas

h Fl

ow (D

CF)

Indi

cate

d C

ost o

f Equ

ity W

ater

Pro

xy G

roup

Bas

ed o

n A

ctua

l Ret

urns

for

Yea

r E

ndin

g 6/

30/2

017

Com

pany

Div

iden

d Y

ield

on

Mar

ket

Pric

e

Mar

ket-t

o-bo

ok

His

toric

al

Ret

urn

on

Equi

ty

Ret

entio

n R

ate

Exte

rnal

Fi

nanc

ing

Rat

e

New

Fi

nanc

ing

Gro

wth

"Tot

al E

stim

ate

of In

vest

or

Ant

icip

ated

G

row

th"

Indi

cate

d C

ost o

f Eq

uity

(D/P

)(M

/B)

(r)

(b)

(s x

v)

(br +

sv)

[1]

[2]

[3]

[4]

[5]

[6]

[7]

[8]

[9]

Am

eric

an S

tate

s Wat

er2.

19%

3.36

12.3

2%40

.25%

0.27

%0.

63%

5.59

%7.

85%

Am

eric

an W

ater

Wor

ks1.

94%

2.69

9.11

%42

.75%

1.54

%2.

61%

6.50

%8.

51%

Aqu

a A

mer

ica

2.40

%3.

1613

.06%

42.0

3%0.

28%

0.60

%6.

09%

8.56

%C

alifo

rnia

Wat

er S

erv.

Grp

.2.

10%

2.53

7.44

%28

.71%

1.36

%2.

07%

4.21

%6.

35%

Con

nect

icut

Wat

er S

ervi

ces

2.11

%2.

6210

.15%

45.6

7%1.

41%

2.29

%6.

92%

9.10

%M

iddl

esex

Wat

er C

ompa

ny2.

20%

2.93

10.5

6%38

.77%

0.49

%0.

95%

5.04

%7.

30%

SJW

Cor

pora

tion

1.84

%2.

4013

.03%

66.1

5%1.

48%

2.07

%10

.69%

12.6

2%Y

ork

Wat

er C

ompa

ny *

1.90

%3.

8810

.58%

30.3

5%-1

.98%

-5.7

1%-2

.50%

-0.6

3%

Incl

udin

g Y

ork

Ave

rage

2.08

%2.

9510

.78%

41.8

3%0.

61%

0.69

%5.

32%

7.46

%M

edia

n2.

10%

2.81

10.5

7%41

.14%

0.92

%1.

51%

5.84

%8.

18%

Excl

udin

g Y

ork

Ave

rage

2.11

%2.

8110

.81%

43.4

8%0.

98%

1.60

%6.

43%

8.61

%M

edia

n2.

11%

2.69

10.5

6%42

.03%

1.36

%2.

07%

6.09

%8.

51%

Sour

ces a

nd N

otes

:[2

]:M

r. R

oths

child

's W

orkp

aper

s, A

LR 3

, p. 1

.[3

]:M

r. R

oths

child

's W

orkp

aper

s, A

LR 3

, p. 1

.[4

]:M

r. R

oths

child

's W

orkp

aper

s, A

LR 3

, p. 2

.[5

]:1

- [([

2] x

[3])

/ [4

]][6

]:M

r. R

oths

child

's W

orkp

aper

s, A

LR 6

, Com

poun

d A

nnua

l Gro

wth

in C

omm

on S

tock

.[7

]:[6

] x ([

3] -

1)[8

]:[5

] x [4

] + [7

][9

]:[2

] * (1

+ 0

.5 *

[8])

+ [8

]*

Yor

k is

exc

lude

d in

the

calc

ulat

ion

of th

e A

vera

ge a

nd M

edia

n du

e to

a n

egat

ive

grow

th ra

te (e

xclu

ded

num

bers

are

bol

d an

d ita

liciz

ed).

** A

mer

ican

Sta

tes W

ater

and

Con

nect

icut

Wat

er h

igh

and

low

stoc

k pr

ices

from

Yah

oo F

inan

ce a

re c

orre

cted

to a

ccou

nt fo

r err

or in

Mr.

Rot

hsch

ild's

Atta

chm

ent D

.


Page 5 of 6

Figu

re 3

Com

pari

son

of E

PS G

row

th R

ates

Use

in M

y D

irec

t Tes

timon

yan

d Su

stai

nabl

e G

row

th R

ates

Cal

cula

ted

Usi

ng M

r. R

oths

child

'sD

ata

and

Met

hodo

logy

Vilb

ert A

ppro

ach

R

oths

child

App

roac

h

Com

pany

Val

ue L

ine

Gro

wth

R

ate

as o

f 1/

31/2

017

Wei

ghte

d G

row

th

Rat

e as

of

1/31

/201

7

Sust

aina

ble

Gro

wth

R

ate

as o

f 6/

30/2

017

[1]

[2]

[3]

[4]

Am

eric

an S

tate

s Wat

er8.

90%

5.87

%7.

51%

Am

eric

an W

ater

Wor

ks9.

59%

7.88

%7.

94%

Aqu

a A

mer

ica

6.70

%5.

57%

5.77

%C

alifo

rnia

Wat

er S

erv.

Grp

.15

.47%

10.3

2%8.

04%

Con

nect

icut

Wat

er S

ervi

ces

3.25

%4.

85%

7.94

%M

iddl

esex

Wat

er C

ompa

ny5.

38%

5.38

%7.

15%

SJW

Cor

pora

tion

*0.

00%

0.00

%9.

33%

Yor

k W

ater

Com

pany

**

6.82

%6.

82%

-0.4

7%

Ave

rage

8.02

%6.

67%

7.67

%

Sour

ces a

nd N

otes

:[2

],[3]

:

[4]:

Mr.

Rot

hsch

ild's

calc

ulat

ion

of su

stai

nabl

e gr

owth

rate

= b

r + sv

, as o

f Jun

e 30

, 201

7.*

SJW

was

exc

lude

d fr

om th

e sa

mpl

e av

erag

e in

[2] a

nd [3

] due

to it

s est

imat

ed c

ost o

f equ

ity

not

exc

eedi

ng th

e co

st o

f deb

t by

100

basi

s poi

nts.

** Y

ork

Wat

er w

as e

xclu

ded

from

the

sam

ple

aver

age

in [4

] due

to it

s neg

ativ

e gr

owth

rate

.

Vilb

ert W

orkp

aper

s, Ta

ble

No.

MJV

-WA

TER

-5, E

stim

ated

Gro

wth

Rat

es a

s of J

anua

ry 3

1,

2017

. Wei

ghte

d av

erag

e in

clud

es b

oth

Thom

son

Reu

ters

and

Val

ue L

ine

LT E

PS e

stim

ates

.

Thom

son

Reu

ters

est

imat

es w

ere

mis

sing

for M

SEX

, SJW

, and

YO

RW

at t

he ti

me

of a

naly

sis.

Ther

efor

e, th

e w

eigh

ted

aver

age

is b

ased

sole

ly o

n V

alue

Lin

e fo

r the

se c

ompa

nies

.


Page 6 of 6

a.17-04-006 cal water vilbert rebuttal testimony...

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