It’s All About the (Return On) Book: An Answer to Why Implied Cost of Equity Capital Estimates Do Not Predict Stock Returns
University of Notre Dame - Mendoza College of Business
Matthew R. Lyle
Kellogg School of Management
March 12, 2015
This study shows why popular proxies for expected rates of return, implied cost of equity capital (ICC) estimates, have weak associations with future stock returns: they have weak associations with future return on book equity. We are able show this because expected rates of equity returns can be parsimoniously expressed as the book-to-market ratio (BM) plus cumulative future expected return on book equity (ROE). Thus an effective ICC metric, which is intended to proxy for a firm’s expected rate of return, should be associated with both the firm’s BM and future ROE. While we do find that all ICC estimates are positively correlated with BM, no ICC estimate has a reliable positive association with future ROE after controlling for lagged ROE. Moreover, we find no evidence that any commonly used ICC estimate contains incremental information about future stock returns that is not already contained in two easily measured variables: BM and lagged ROE.
Number of Pages in PDF File: 45
Keywords: cost of capital; expected returns; ROE
Date posted: December 22, 2013 ; Last revised: March 24, 2015
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