Quantifying intuitive decisions on rate of return

In determining a fair rate of return for regulated industries, several standards are utilized. Those most commonly employed include the following criteria. (1) Return should be sufficient to attract new capital. (2) The allowed return should be sufficient to ensure the financial integrity of the company. (3) Return should be comparable to the returns of businesses with similar risks. (4) Return should be set at a level which is not confiscatory. Substantial empirical evidence -- i.e., past earnings-price ratios, historical market-book ratios, current difidend pay-out ratios, the dividend price-ratio and the rate of growth of dividends over time, etc. -- are all utilized to quantify rates of return. In the final analysis, however, intuition and judgement must be exercised. The author deals with the development of some empirical tools which may aid the rate-of-return specialist in forming some important judgements bearing upon the effort to assure that the rate-of-return set for any utility company is not confiscatory. In particular, he describes a method of establishing an acceptable ratio of the market value to the book value of a utility's shares of common stock which will be implicit in its cost-of-equity capital; and discusses the application of a determined rate ofmore » return to a rate base in which both original-cost and replacement-cost considerations are properly combined.« less