Market Inefficiency and Implied Cost of Capital Models

Abstract

In this paper, I examine the impact of market inefficiency on the properties of implied cost of capital (ICC) estimates. I show that market inefficiency will bias the relation between the ICC estimate and future returns upwards. Utilizing recently developed ICC estimates formed using regression based earnings forecasts, I show that a substantial portion of the returns to an ICC trading strategy stem from mispricing rather than expected returns. The biases induced by mispricing are most severe for firms with significant limits to arbitrage and less severe for firms that are larger, more liquid, and have lower transaction costs, and for ICC estimates based on adjusted analyst forecasts. In addition, I find that controlling for earnings and discount rate news is not an effective control for mispricing, but that controlling for earnings announcement returns is at least partially effective.

Keywords: implied cost of capital, market inefficiency, measurement error, earnings forecasts, regression biases

JEL Classification: M41, G12, G14