Costs of Equity from Factor-Based Models

Abstract

Equity costs of capital for individual firms are estimated using several models that relate expected returns to betas on one or more pervasive factors. A Bayesian approach incorporates prior uncertainty about an asset's mispricing as well as uncertainty about betas and factor means. Substantial prior uncertainty about mispricing results in an estimated cost of equity close to that obtained with mispricing ruled out. Uncertainty about which pricing model to use appears to be less important, on average, than within-model parameter uncertainty. In the absence of mispricing uncertainty, uncertainty about factor means is generally the most important source of overall uncertainty about a firm's cost of equity, although uncertainty about betas is nearly as important.

JEL Classification: G12, G31, C11