Empirical Estimation of the Term Structure of Implicit Discount Rates in Security Valuation

Abstract:     
In this paper we use a reformulation of the residual income (RI) valuation model to generate estimates of the term structure of discount rates (cost of capital) implicit in security prices. We use future realisations of residual income as proxies of their present day expectations and reduce the impact of measurement error in the forecast values by transforming them into a current value plus a series of change variables. Different lengths of the forecast window lead to the coefficients on the current realisations of earnings and book value incorporating different combinations of implicit discount rates. By comparing the coefficients on these two variables for different forecast windows estimates of implicit discount rates can be generated. Terminal values are incorporated within the coefficients on current realisations of earnings and book value. As our estimates of cost of capital are made from comparisons of the earnings and book value coefficients from valuation models of different forecast length we are able to eliminate the impact of terminal value assumptions from our cost of capital estimates. The results indicate no specific pattern to implicit discount rates that would indicate either short termism or excessive optimism about future earnings growth.

Number of Pages in PDF File: 39

Keywords: Residual income model; Discount rates; Term structure; Forecasting

JEL Classification: C31, C32, E43, G12, G31

working papers series