Evaluating Accounting-Based Measures of Expected Returns: Easton and Monahan and Botosan and Plumlee Redux

Abstract:     
We respond to questions and comments we have received from numerous colleagues on the approach we developed for evaluating the reliability of accounting-based measures of the expected rate of return (i.e., ERR) on equity capital. First, we clarify the two implicit assumptions underlying the use of accounting-based ERR proxies: (1) firm- and portfolio-level realized returns are not reliable ERR proxies; and, (2) the factors that determine expected returns are unknown and/or they cannot be reliably estimated. Second, we discuss the approach developed by Botosan and Plumlee [2005]; and, we explain that this approach is logically inconsistent with the second implicit assumption. Third, we elaborate on our approach (i.e., Easton and Monahan [2005]) and we explain how it, and the proxies we use, follows logically from: (1) the first implicit assumption; and, (2) the analytical model developed by Vuolteenaho [2002]. Finally, we explain the importance of analyzing measurement error variances, and we answer some frequently asked questions about how to conduct and interpret these analyses.

Number of Pages in PDF File: 36

Keywords: Expected rate of return, equity capital, ERR, realized returns, expected returns

JEL Classification: G12, M41

working papers series