Properties of implied cost of capital using analysts' forecasts

We evaluate the influence of measurement error in analysts’ forecasts on the accuracy of implied cost of capital estimates from various implementations of the ‘implied cost of capital’ approach, and develop corrections for the measurement error. The implied cost of capital approach relies on analyst...

Full description

Saved in:
Bibliographic Details
Published in:Australian journal of management 2011-08, Vol.36 (2), p.125-149
Main Authors: Guay, Wayne, Kothari, SP, Shu, Susan
Format: Article
Language:English
Subjects:
Accuracy
Capital
Cost estimates
Cost of capital
Costs
Discount rates
Earnings
Economic forecasting
Efficient markets
Estimates
Forecasts
Growth models
Measurement errors
Present value
Proxies
Rates of return
Stock prices
Studies
Valuation
Citations: Items that this one cites
Items that cite this one
Online Access:Get full text
Tags: Add Tag
No Tags, Be the first to tag this record!
Description
Summary:We evaluate the influence of measurement error in analysts’ forecasts on the accuracy of implied cost of capital estimates from various implementations of the ‘implied cost of capital’ approach, and develop corrections for the measurement error. The implied cost of capital approach relies on analysts’ short- and long-term earnings forecasts as proxies for the market’s expectation of future earnings, and solves for the implied discount rate that equates the present value of the expected future payoffs to the current stock price. We document predictable error in the implied cost of capital estimates resulting from analysts’ forecasts that are sluggish with respect to information in past stock returns. We propose two methods to mitigate the influence of sluggish forecasts on the implied cost of capital estimates. These methods substantially improve the ability of the implied cost of capital estimates to explain cross-sectional variation in future stock returns, which is consistent with the corrections being effective in mitigating the error in the estimates due to analysts’ sluggishness.
ISSN:0312-8962
1327-2020
DOI:10.1177/0312896211408624