A buyer paying exactly the RAB earns exactly the allowed return. Every point of premium has to be traced to a line, and this is how to build those lines.
The premium to RAB is the present value of every return the buyer expects above its own required return on the regulatory asset base, so it is calculated as a bridge: the gap between the allowed WACC and the buyer's required return, plus retained cost outperformance, plus financing outperformance, each discounted over the years it will last. On an illustrative 1,000 RAB with a 4.0 per cent allowed real WACC and a 3.5 per cent required return, those three lines justify a value of 1,089.82, a premium of 8.98 per cent, or 1.090 times RAB.
Worked in full in The Infrastructure Investment Analyst by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A regulator sets allowed revenue so that an efficient company, financed at the assumed cost of capital, earns exactly the allowed return on its RAB: the building blocks are worked in how allowed revenue is calculated under a RAB model. It follows that a buyer paying exactly the RAB and discounting at exactly the allowed WACC gets a net present value of zero. Any premium paid must therefore rest on something the building blocks leave out. Listing those things one by one, and pricing each, is the only defensible way to bid above 1.0 times.
| Input | Value |
|---|---|
| Opening RAB, held flat in real terms | 1,000 |
| Allowed real WACC | 4.0% |
| Buyer's required real return | 3.5% |
| Horizon: two five-year price controls | 10 years |
| Totex outperformance retained after sharing, a year | 4.0 |
| Gearing assumed by the regulator | 60% |
| Actual cost of debt below the allowance | 0.30% |
| Exit value | 1.00x RAB |
The RAB is kept flat by assuming capital spending equals regulatory depreciation, so the cash flow each year is the allowed return of 40.0 plus whatever outperformance is retained. Everything is in real terms, because the RAB is indexed: a nominal discount rate against a real allowed return is the error dissected in real vs nominal discount rates. Tax is treated as passed through by the allowance. All figures are illustrative.
Value = Σ (allowed return + outperformance) / (1 + k)t + exit multiple × RAB / (1 + k)n
WACC line = (allowed WACC − k) × RAB × annuity factor
Premium = value / RAB − 1
In Excel, with the inputs in B1:B8 in the order of the assumptions table above: =PV(B3,B4,-(B1*B2+B5+B1*B6*B7),-B1*B8)/B1-1
Step 1, the discount factors. At 3.5 per cent over ten years the annuity factor is 8.3166 and the terminal discount factor 0.70892.
Step 2, the WACC line. The allowed return of 40.0 a year is worth 332.66, and the RAB returned at exit 708.92: together 1,041.58, a premium of 41.58 or 4.16 per cent. The shortcut gives the same figure: 0.5 point × 1,000 × 8.3166 = 41.58. This is the buyer accepting a lower return than the regulator allows, and it is the line most exposed to the next determination.
Step 3, totex outperformance. Beating the cost allowance by 4.0 a year after the customer's share, for ten years: 4.0 × 8.3166 = 33.27.
Step 4, financing outperformance. Debt of 600 at 30 basis points below the allowed cost of debt saves 1.80 a year, worth 14.97.
| Line | Value | Share of premium |
|---|---|---|
| RAB | 1,000.00 | |
| Allowed WACC above required return | 41.58 | 46.3% |
| Totex outperformance | 33.27 | 37.0% |
| Financing outperformance | 14.97 | 16.7% |
| Justified value | 1,089.82 | 8.98% |
Nearly half the premium is the buyer's lower cost of capital, which is a statement about the buyer rather than the asset. If the buyer also assumes it can sell at 1.05 times RAB in year ten, a further 35.45 appears and the premium rises to 12.53 per cent, but that line is a bet on the next buyer's cost of capital and should be shown separately, never folded into the base case.
| Required return | No outperformance | With outperformance |
|---|---|---|
| 3.0% | 8.53% | 13.48% |
| 3.5% | 4.16% | 8.98% |
| 4.0% | 0.00% | 4.70% |
| 4.5% | -3.96% | 0.63% |
The middle column is the identity at work: at a required return equal to the allowed WACC the premium is exactly zero. Each half point of required return moves the premium by about four to four and a half points, almost as much as all the operational outperformance put together. That is why auctions for regulated assets are usually won on cost of capital, and why the winning bidder's premium tells you more about its return target than about the network.
Capitalising outperformance in perpetuity. Regulators reset cost and financing allowances at every price control, usually sharing part of the saving with customers and resetting the baseline to the revealed cost. Outperformance therefore has a life, typically one or two controls. Treated as permanent, the 5.8 a year in this case is worth 165.71; over the two controls modelled here it is worth 48.24, and over one control 26.19. The perpetual version values the business at 1,207.30, a premium of 20.73 per cent, and overpays by 117.48, or 10.8 per cent of the justified value.
Model each line with its own end date and its own evidence: a totex saving supported by a credible plan for the current control, a financing saving locked by debt already issued. A premium line with no end date and no evidence is a price, not a valuation.
The regulated utility behind chapter 6, with all seven of the chapter's quantitative claims computed, is in the free valuation workbook for this case.
Because buyers expect to earn more than the allowed return, or accept less. If the allowed real WACC is 4.0 per cent and a buyer needs 3.5, the gap alone is worth 41.58 on a 1,000 RAB over ten years. Retained cost and financing outperformance add 48.24, for a premium of 8.98 per cent. With no gap and no outperformance the premium is zero.
There is no fixed level; it is the output of the buyer's assumptions. In this illustration it runs from 0.63 per cent at a 4.5 per cent required return to 13.48 per cent at 3.0 per cent, with the same outperformance. Ask which line of the bridge each point of a quoted premium rests on, and how long that line is assumed to last.
No. Regulators reset cost allowances at each price control and pass part of the saving to customers, so outperformance has a life. Capitalising 5.8 a year in perpetuity adds 165.71 against 48.24 over two controls and 26.19 over one, enough to turn an 8.98 per cent premium into 20.73 per cent.
The valuation of a regulated utility is worked in the valuation workbook that accompanies chapter 6 of The Infrastructure Investment Analyst. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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