The Relation Between Expected Returns, Realized Returns, and Firm Risk Characteristics

Abstract:     
Existing literature employs two approaches to assess the validity of alternative proxies for firm-specific cost of equity capital. One approach relies on the theoretical link between future realized returns and cost of equity capital, while the second approach relies on the theoretical link between cost of equity capital and priced risk. The results of these two streams of literature are conflicting. The first approach provides no support for the construct validity of any of the cost of equity capital proxies examined, while the second approach provides strong support for certain proxies. In this paper, we assess the construct validity of twelve alternative proxies, and realized returns before and after controlling for news. Using both approaches, we find support for the construct validity of two proxies (rDIV and rPEG), and show that prior research fails to demonstrate the theoretical link between several of the proxies and future realized returns due to empirical misspecification. Based on our evidence, we recommend that researchers requiring a valid proxy for cost of equity capital employ either rDIV or rPEG, and we caution against the use of realized returns to proxy for cost of equity capital before or after controlling for cash flow news.

Keywords: implied cost of capital, expected returns, realized returns, cash flow news

JEL Classification: M41, G12, G31

Accepted Paper Series