Measurement Errors of Expected Returns Proxies and the Implied Cost of Capital
Charles C. Y. Wang
Harvard Business School
May 21, 2013
Harvard Business School Accounting & Management Unit Working Paper No. 13-098
This paper presents a methodology to study implied cost of capital's (ICC) measurement errors, which are relatively unstudied empirically despite ICCs' popularity as proxies of expected returns. By applying it to the popular implementation of ICCs of Gebhardt, Lee, and Swaminathan (2001) (GLS), I show that the methodology is useful for explaining the variation in GLS measurement errors. I document the first direct empirical evidence that ICC measurement errors can be persistent, can be associated with firms' risk or growth characteristics, and thus confound regression inferences on expected returns. I also show that GLS measurement errors and the spurious correlations they produce are driven not only by analysts' systematic forecast errors but also by functional form assumptions. This finding suggests that correcting for the former alone is unlikely to fully resolve these measurement-error issues. To make robust inferences on expected returns, ICC regressions should be complemented by realized-returns regressions.
Number of Pages in PDF File: 54
Keywords: Expected returns, implied cost of capital, measurement errors
JEL Classification: D03, G30, O15, P34working papers series
Date posted: December 5, 2011 ; Last revised: May 21, 2013
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