Analysts’ Optimism in Earnings Forecasts and Biases in Estimates of Implied Cost of Equity Capital and Long-Run Growth Rate

Abstract

Using a value-weighted rather than an equally weighted regression, Easton and Sommers (2007) show that the upward bias in the risk premium implied by analysts’ earnings forecasts falls to 1.6%, but remains statistically and economically significant. In this paper, we argue that any estimation of a forward risk premium implies a joint test of analysts’ optimism and the implied cost of capital model applied. Employing the recent model developed by Ashton and Wang (2010), we first find that the impact of any bias attributable to analysts’ forecasts can be reduced to a statistically insignificant 0.4%. Second, we show that our estimates of the implied equity risk premium after removing the effect of this bias are between 3.57% and 3.62%. Third, we show that the real estimates of earnings growth from their model seem more plausible.

Keywords: Implied Cost of Capital, Analysts’ Bias

JEL Classification: G12