Evaluating Methods to Estimate the Implied Cost of Equity Capital: A Simulation Study

53 Pages Posted: 2 Sep 2009 Last revised: 16 Dec 2010

See all articles by Holger Daske

Holger Daske

University of Mannheim - Accounting and Taxation

Jörn van Halteren

University of Mannheim - Department of Business Administration and Finance

Ernst G. Maug

University of Mannheim Business School; European Corporate Governance Institute (ECGI)

Date Written: December 14, 2010

Abstract

We evaluate accounting-based methods to estimate the implied cost of capital using a simulation approach. We simulate a model economy in which the true cost of capital is known and calibrate it to the CRSP-Compustat universe. We then compare the true cost of capital to the implied cost of capital estimates from ten different methods proposed in the literature in terms of bias, accuracy, and their correlation with the true cost of equity capital. Methods based on the residual income model perform better than those based on the abnormal earnings growth model. Methods that estimate the cost of capital and expected growth simultaneously work reasonably well if they rely on analyst forecasts instead of ex post realized values, even if analyst forecasts are biased. We suggest combined methods that are chosen so that the distortions from individual methods compensate each other and show that some simple combinations outperform all individual methods.

Keywords: Implied cost of capital, valuation, residual income, abnormal earnings growth, simulation

JEL Classification: C15, E37, M41

Suggested Citation

Daske, Holger and van Halteren, Jörn and Maug, Ernst G., Evaluating Methods to Estimate the Implied Cost of Equity Capital: A Simulation Study (December 14, 2010). AAA 2010 Financial Accounting and Reporting Section (FARS) Paper. Available at SSRN: https://ssrn.com/abstract=1465294 or http://dx.doi.org/10.2139/ssrn.1465294

Holger Daske (Contact Author)

University of Mannheim - Accounting and Taxation ( email )

Mannheim, 68131
Germany

Jörn Van Halteren

University of Mannheim - Department of Business Administration and Finance ( email )

D-68131 Mannheim
Germany

HOME PAGE: http://cf.bwl.uni-mannheim.de/van_halteren.html

Ernst G. Maug

University of Mannheim Business School ( email )

L9, 1-2
Mannheim, 68131
Germany
+49 621 181-1952 (Phone)

HOME PAGE: http://cf.bwl.uni-mannheim.de/de/people/maug/

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

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