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Evaluating Accounting-Based Measures of Expected Returns: Easton and Monahan and Botosan and Plumlee Redux

36 Pages Posted: 19 Apr 2010 Last revised: 25 May 2010

Steven J. Monahan

INSEAD

Peter D. Easton

University of Notre Dame - Department of Accountancy

Date Written: March 31, 2010

Abstract

We respond to questions and comments we have received from numerous colleagues on the approach we developed for evaluating the reliability of accounting-based measures of the expected rate of return (i.e., ERR) on equity capital. First, we clarify the two implicit assumptions underlying the use of accounting-based ERR proxies: (1) firm- and portfolio-level realized returns are not reliable ERR proxies; and, (2) the factors that determine expected returns are unknown and/or they cannot be reliably estimated. Second, we discuss the approach developed by Botosan and Plumlee [2005]; and, we explain that this approach is logically inconsistent with the second implicit assumption. Third, we elaborate on our approach (i.e., Easton and Monahan [2005]) and we explain how it, and the proxies we use, follows logically from: (1) the first implicit assumption; and, (2) the analytical model developed by Vuolteenaho [2002]. Finally, we explain the importance of analyzing measurement error variances, and we answer some frequently asked questions about how to conduct and interpret these analyses.

Keywords: Expected rate of return, equity capital, ERR, realized returns, expected returns

JEL Classification: G12, M41

Suggested Citation

Monahan, Steven J. and Easton, Peter D., Evaluating Accounting-Based Measures of Expected Returns: Easton and Monahan and Botosan and Plumlee Redux (March 31, 2010). Available at SSRN: https://ssrn.com/abstract=1592518 or http://dx.doi.org/10.2139/ssrn.1592518

Steven J. Monahan

INSEAD ( email )

Boulevard de Constance
PMLS 1.24
F-7705 Fontainebleau Cedex, 77305
France
+33 1 60 72 92 14 (Phone)
+33 1 60 72 92 53 (Fax)

HOME PAGE: http://www.insead.edu/facultyresearch/faculty/profiles/smonahan/

Peter D. Easton (Contact Author)

University of Notre Dame - Department of Accountancy ( email )

Mendoza College of Business
Notre Dame, IN 46556-5646
United States
574-631-6096 (Phone)
574-631-5127 (Fax)

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