The AER outlined in Better Regulation - Explanatory Statement Rate of Return Guideline (Appendices) December 2013 p.114 their method for estimating a Dividend Growth Model (DGM) for the purposes of estimating a Market Risk Premium (MRP).

This method has been subsequently altered by the AER over time. The version adopted for Regulatory Edge reflects the most recent approach (as seen in the PRELIMINARY DECISION Jemena distribution determination 2016 to 2020 Attachment 3 − Rate of return October 2015 for example) and us such, estimates generated by Regulatory Edge will not correspond with historical estimates.

Here we outline the current method and note key differences between this method and that as originally proposed in the December 2013 Guideline.

The AER use the following general specification to solve for k, the discount rate that sets the price level of the ASX200 index equal to the present value of the stream of expected dividends. (PRELIMINARY DECISION Jemena distribution determination 2016 to 2020 Attachment 3 − Rate of return October 2015, p. 328)

The AER employ two specifications of this general model:

  1. A two stage version - where (N=2) the forecast expected dividends for the current and next two financial years are discounted (the first two terms of the equation) to present value and added to the present value of the perpetuity growing at the long-term growth rate (the third term of the equation) which includes all dividends from year 3 on.
  2. A three stage version (N=9). This version sees the perpetuity growing at the long-term growth rate (the third term) beginning after ten years. The forecast expected dividends for the current and next two financial years are discounted exactly as for the two stage version. The growth rate for the next eight dividends transitions linearly from the short-term rate implied in the explicit dividend forecasts to the long-term growth rate.

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