Market Inefficiency and Implied Cost of Capital Models

Abstract:     
In this paper, I examine the impact of market inefficiency on the properties of implied cost of capital (ICC) estimates. Building on a model of measurement error in implied cost of capital estimates starting from the underlying primitives, investors’ and the researcher’s earnings forecasts, I show that market inefficiency will bias the relation between the ICC estimate and the future returns upwards. Using recently developed ICC estimates based on regression generated earnings forecasts, I show that, on average, between 35% and 61% of the relation between ICC estimates and one-year-ahead stock returns stems from mispricing rather than expected returns. The biases induced by mispricing are most severe for firms with significant limits to arbitrage, and less severe for firms that are larger, more liquid, and have lower transaction costs.

Number of Pages in PDF File: 57

Keywords: implied cost of capital, market inefficiency, measurement error, earnings forecasts, regression biases

JEL Classification: M41, G12, G14

working papers series