Implied Cost of Equity Capital Estimates as Predictors of Accounting Returns
University of Notre Dame - Mendoza College of Business
Matthew R. Lyle
Kellogg School of Management
June 3, 2014
Numerous influential finance and accounting studies describe how to reverse-engineer cost of equity capital (COEC) estimates. A key motivation of these studies is that the COEC is important for capital budgeting and investment. Indeed, theory suggests that there must be a relation between the COEC, market-to-book, and future return on equity (ROE). Given this relation, one would expect future firm accounting returns to be correlated with cost of equity capital estimates after controlling for the market-to-book ratio.
We find that, after controlling for market-to-book, very few of the implied COEC estimates which are commonly employed in academic studies are positively associated with future ROE; in fact some implied COEC estimates are significantly negatively correlated with future ROE. A subset of COEC estimates based on the residual income model are positively associated with future ROE, as is the earnings-to-price ratio; however, contrary to intuition and theoretical predictions, all the COEC estimates based on the abnormal earnings growth model are negatively associated with future ROE. Factor analysis suggests that the strong weight that abnormal earnings growth-based COEC estimates place on earnings growth is one of the key reasons for their negative association with future ROE.
Number of Pages in PDF File: 52
Keywords: cost of equity capital; expected returns; ROEworking papers series
Date posted: December 22, 2013 ; Last revised: June 4, 2014
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