Properties of Implied Cost of Capital Using Analysts’ Forecasts

26 Pages Posted: 24 Oct 2011 Last revised: 17 Aug 2012

See all articles by Wayne R. Guay

Wayne R. Guay

University of Pennsylvania - Accounting Department

S.P. Kothari

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

Susan Shu

Boston College - Carroll School of Management

Multiple version iconThere are 2 versions of this paper

Date Written: August 1, 2011

Abstract

We evaluate the influence of measurement error in analysts’ forecasts on the accuracy of implied cost of capital estimates from various implementations of the ‘implied cost of capital’ approach, and develop corrections for the measurement error. The implied cost of capital approach relies on analysts’ short- and long-term earnings forecasts as proxies for the market’s expectation of future earnings, and solves for the implied discount rate that equates the present value of the expected future payoffs to the current stock price. We document predictable error in the implied cost of capital estimates resulting from analysts’ forecasts that are sluggish with respect to information in past stock returns. We propose two methods to mitigate the influence of sluggish forecasts on the implied cost of capital estimates. These methods substantially improve the ability of the implied cost of capital estimates to explain cross-sectional variation in future stock returns, which is consistent with the corrections being effective in mitigating the error in the estimates due to analysts’ sluggishness.

Suggested Citation

Guay, Wayne R. and Kothari, S.P. and Shu, Susan, Properties of Implied Cost of Capital Using Analysts’ Forecasts (August 1, 2011). Australian Journal of Management, Vol. 36, No. 2, 2011 , Available at SSRN: https://ssrn.com/abstract=1948506

Wayne R. Guay (Contact Author)

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
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Philadelphia, PA 19104-6365
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215-573-2054 (Fax)

S.P. Kothari

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

E52-325
Cambridge, MA 02142
United States
617-253-0994 (Phone)
617-253-0603 (Fax)

Susan Shu

Boston College - Carroll School of Management ( email )

Boston College
140 Commonwealth Ave.
Chestnut Hill, MA 02167
United States
617-552-1759 (Phone)

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