Estimating the Cost of Equity: Why Do Simple Benchmarks Outperform Factor Models?

62 Pages Posted: 29 Jul 2012 Last revised: 6 Nov 2014

See all articles by Nishad Kapadia

Nishad Kapadia

Tulane University - Finance & Economics

Bradley S. Paye

Virginia Polytechnic Institute & State University - Department of Finance, Insurance, and Business Law

Date Written: October 28, 2014

Abstract

We compare the accuracy of cost of equity estimates based on leading factor models to two simple alternatives: the asset mean and the market mean. The market mean proves to be a serious competitor to traditional implementations of factor models even if the underlying factor model is true. Pricing errors (alphas) that are negatively correlated with firm and industry market betas further improve the performance of the market mean relative to model-based approaches. We propose Bayesian estimators that address key weaknesses in standard plug-in approaches. These estimators outperform plug-in methods and the market mean in simulations and out-of-sample.

Keywords: Cost of equity, CAPM, Fama-French three factor model, estimation error, mispricing, Bayesian

JEL Classification: G12, C13, G31

Suggested Citation

Kapadia, Nishad and Paye, Bradley S., Estimating the Cost of Equity: Why Do Simple Benchmarks Outperform Factor Models? (October 28, 2014). Available at SSRN: https://ssrn.com/abstract=2118920 or http://dx.doi.org/10.2139/ssrn.2118920

Nishad Kapadia (Contact Author)

Tulane University - Finance & Economics ( email )

A.B. Freeman School of Business
7 McAlister Drive
New Orleans, LA 70118
United States
504-314-7454 (Phone)

Bradley S. Paye

Virginia Polytechnic Institute & State University - Department of Finance, Insurance, and Business Law ( email )

1016 Pamplin Hall (0221)
Blacksburg, VA 24060-0221
United States

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