Terminal Valuations, Growth Rates and the Implied Cost of Capital
47 Pages Posted: 18 Dec 2010 Last revised: 12 Oct 2012
Date Written: December 18, 2010
We develop a model based on the notion that prices lead earnings, allowing for a simultaneous estimation of the implied growth rate and the cost of equity capital for US industrial sectors. The major difference between our approach and that in prior literature is that ours avoids the necessity to make assumptions about terminal values and consequently about future growth rates. In fact, growth rates are an endogenous variable, which is estimated simultaneously with the implied cost of equity capital. Since we require only one-year-ahead forecasts of earnings and no assumptions about dividend payouts, our methodology allows us to estimate ex ante aggregate growth and risk premia over a larger sample of firms than has previously been possible. Our estimate of the risk premium being between 3.1% and 3.9% is at the lower end of recent estimates, reflecting the inclusion of these short-lived companies. Our estimate of the long run growth is from 4.2% to 4.7%.
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