54 Pages Posted: 6 Aug 2010 Last revised: 16 Jun 2017
Date Written: June 3, 2017
We argue, from an extensive literature review, that in the vast majority of research settings, biases in alternative expected-return proxies (ERPs) are irrelevant. Therefore, in most settings, the choice between alternative ERPs should be based on an evaluation of their relative measurement-error variances. We develop a parsimonious evaluation framework that empirically estimates a given ERP’s cross-sectional and time-series measurement-error variances. We then apply this framework to five classes of firm-level ERPs nominated by recent studies, including factor-based ERPs from finance and implied costs of capital (ICC) estimates from accounting. Our analyses show ICCs are particularly useful in tracking time-series variations in expected returns. We also find broad support for a “fitted” or “characteristic-based” approach to ERP estimation.
Keywords: Implied Cost of Capital, Expected Returns
JEL Classification: G10, G11, G12, G14, M41
Suggested Citation: Suggested Citation
Lee, Charles M.C. and So, Eric C. and Wang, Charles C. Y., Evaluating Firm-Level Expected-Return Proxies (June 3, 2017). 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
By Charles Wang