Evaluating Firm-Level Expected-Return Proxies

61 Pages Posted: 6 Aug 2010 Last revised: 9 Nov 2015

Charles M.C. Lee

Stanford University - Graduate School of Business

Eric C. So

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Charles C. Y. Wang

Harvard Business School

Date Written: October 23, 2015

Abstract

We develop and implement a rigorous analytical framework for empirically evaluating the relative performance of firm-level expected-return proxies (ERPs), based on the premise that superior proxies should closely track true expected returns both cross-sectionally and over time (that is, the proxies should exhibit lower measurement-error variances). We then compare five classes of ERPs nominated in recent studies to demonstrate how researchers can easily implement our two-dimensional evaluative framework. Overall, our findings support the trend towards characteristic-based ERPs. We also document a tradeoff between time-series and cross-sectional ERP performance, indicating the optimal choice of proxy may vary across research settings. Our results illustrate how researchers can use our framework to critically evaluate and compare a growing body of ERPs.

Keywords: Implied Cost of Capital, Expected Returns

JEL Classification: G10, G11, G12, G14, M41

Suggested Citation

Lee, Charles M.C. and So, Eric C. and Wang, Charles C. Y., Evaluating Firm-Level Expected-Return Proxies (October 23, 2015). Harvard Business School Accounting & Management Unit Working Paper No. 15-022; Rock Center for Corporate Governance at Stanford University Working Paper No. 197; Stanford University Graduate School of Business Research Paper No. 15-57. Available at SSRN: https://ssrn.com/abstract=1653940 or http://dx.doi.org/10.2139/ssrn.1653940

Charles M.C. Lee (Contact Author)

Stanford University - Graduate School of Business ( email )

Stanford Graduate School of Business
655 Knight Way
Stanford, CA 94305-5015
United States
650-721-1295 (Phone)

Eric C. So

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

77 Massachusetts Ave.
E62-416
Cambridge, MA 02142
United States

Charles C. Y. Wang

Harvard Business School ( email )

Soldiers Field Road
Morgan 270C
Boston, MA 02163
United States

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