When I was working at the Surface Transportation Board, I often felt trapped in a game of “Whack a Mole.” That was because STB rarely had time or staff to do more than react to the latest rate case, stakeholder petition or Congressional request. There is a sense of Whack a Mole in some of the flurry of STB regulatory reform proposals, particularly STB’s tinkering with the industry Cost of Capital calculation.
STB develops industry Cost of Capital by estimating an industry cost of debt and an industry cost of equity. The debt estimate is straightforward because it is simply the weighted average interest rate of all outstanding industry debt. Those are observable in the financial markets.
Equity is tougher because it is not observable and depends on investor expectations of future stock prices and dividend payouts. STB uses two models to estimate what these expectations are: Capital Asset Pricing Model (CAPM) and a Multi-Stage Discounted Cash Flow (MSDCF) model.
An MSDCF model estimates the value of an investment today based on predictions of how much money it will generate in the future, and then adjusts (discounts) that cash flow to its present dollar value to show its future worth today. And, in multi-stage, there is a short-term five-year growth period, a transition period over the next five years, and a long-term growth period continuing into perpetuity.
CAPM combines the return on a risk-free government bond with a return accounting for risk. This risk measure is based on how the stock or group of stocks’ return compares to the overall market. In finance texts it is known as “beta.”
Risk is an important consideration in investment analysis. The riskier an investment, i.e., the more volatile, the higher the return required by investors. This is often known as the risk premium.
MSDCF and CAPM have different orientations. CAPM uses past data to develop its estimates. It is backward-looking. MSDCF, because it uses analysts’ forecasts, is forward-looking.
In response to shipper criticism, STB proposes to tweak the second stage of MSDCF. According to STB, the tweak will slightly reduce MSDCF’s estimate and its volatility. The question is whether this is the right mole to whack, or whether STB should step back and look much more broadly at the industry’s condition and prospects when reforming its Cost of Capital calculation.
Just consider these couple of facts about the industry. In October 2010, the industry moved 1.2 million carloads and 44% of those were coal. In October 2019, the industry still moved 1.2 million carloads but only 31% were coal. The U.S. is more than 10 years into an economic recovery, but railroad traffic is flat. In fact, railroads have never recovered to pre-recession levels; and, importantly, the coal business is disappearing.
Loss of coal is a major blow to industry prospects. Coal was a great business for rail. It was largely independent of the business cycle and was predictable because it generally moved under contract. The service was low cost because it comprised unit trains moving in loop service.
One chief advantage of the railroads’ coal business has been its lack of intermodal competition. The remaining railroad traffic base is not so tied to rail. It is more subject to intermodal competition. That increases uncertainty and risk for the industry’s future.
To deal with this change and to position carriers to best grab new opportunities, railroad executives are embarking on new operating practices, i.e., scheduled service. These practices aim to increase productivity and lower operating cost.
The industry is changing. The future is more uncertain. Under these circumstances, investors will expect an increased risk premium. We should expect the industry cost of capital to increase.
Instead of simply playing Whack a Mole, STB should consider how the industry is evolving, and how that affects the industry cost of capital. In particular, STB should question whether it has the correct models to estimate the industry’s cost of capital.
Of its two models, MSDCF is less of a concern. MSDCF aims to be a forward-looking model because it incorporates Wall Street analyst forecasts of dividend and stock price trends.
CAPM is another matter. CAPM uses past data to develop its estimate. In a stable situation, past data can be a good proxy of the future, but that is not the situation for today’s railroad industry. STB should consider other options, perhaps real options.
In a most perceptive 2002 article, MIT professors Jerry Hausman and Stewart Myers criticized STB for not incorporating real options theory in its regulation (“Regulating the United States Railroads: The Effects of Sunk Costs and Asymmetric Risk,” Journal of Regulatory Economics: 22:3 287, 2002). Real options theory is based on the concept that there is value in delaying investment decisions until there is more information, information that reduces uncertainty.
Hausman and Myers argue that this analysis is important for the railroad industry. Railroads make large investments that, once made, are often sunk, meaning these investments cannot be repurposed or sold to others. Gathering more information is vitally important for railroad executives as they consider committing billions of investment dollars.
What could be the impact on the industry’s cost of capital from a real options perspective? Hausman and Myers write: “Modern real options theory demonstrates that the expected return for a sunk investment must exceed that of fixed investment by a factor typically around 2.0 or higher.” (p. 304).
For a back-of-the-envelope estimate of what a real options analysis might mean for the industry cost of capital, I assume that a real options estimate produces a cost of equity that is twice the 2018 STB estimate of 13.86%, meaning I use 27.72%. I then assume STB adds this to its MSDCF and CAPM estimates and gives each a one-third weight. That yields 18.48 cost of equity (not quite 5 percentage points higher). Recalculating the Cost of Capital yields a 16.06% (not quite 4 percentage points higher than STB’s estimate of 12.22%).
Including a real options component in STB’s Cost of Capital calculation could significantly increase STB’s industry Cost of Capital. That would be absolutely appropriate as the industry watches its coal franchise dry up and transitions into a riskier and more uncertain future. This time, STB can’t default to playing Whack a Mole.
Dr. William Huneke is the former Director & Chief Economist at the Surface Transportation Board. He has more than 40 years’ experience in economics, transportation, railroad regulatory policy, management consulting, business analysis and teaching in the commercial and government sectors. He provides economic consulting on regulatory and arbitration matters. At the STB, Dr. Huneke led the Board’s analytical work and oversaw the collection of economic and financial data. Since leaving the STB, he has provided economic and litigation support to Class I railroads and other private-sector clients. He worked with the OECD (Organisation for Economic Co-operation and Development) to advise the Mexican government on its future rail regulatory policy. He represented the United States at an OECD conference on railroad industry structure. His private-sector experience included executive and management positions at UUNET, Freddie Mac and the Association of American Railroads. Dr. Huneke has taught graduate business courses at the University of Maryland, Robert H. Smith School of Business. He holds a doctorate from the University of Virginia and a B.A. from Swarthmore College.