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Evaluating Firm-Level Expected-Return Proxies

54 Pages Posted: 6 Aug 2010 Last revised: 16 Jun 2017

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: June 3, 2017

Abstract

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

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

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 )

100 Main Street
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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