Types of Investor Uncertainty and Cost of Equity
43 Pages Posted: 30 Aug 2013 Last revised: 17 May 2017
Date Written: April 1, 2017
Asset pricing theory notes that different types of investor uncertainty can have directionally different effects on cost of equity. Empirical studies of costs of equity, however, generally assume that different types of uncertainty are independent or have the same directional effect. We relax this assumption and jointly test the effects of two types of investor uncertainty, one related to future firm performance and unrelated to accruals (cash flow uncertainty) and one directly related to accrual estimation errors (information quality uncertainty). Distinct from prior studies, our uncertainty estimates are based on a matched-firm design that minimize the mechanical relation between the two uncertainty variables. We find a strong negative relation between cash flow uncertainty and multiple estimates of cost of equity. With respect to information quality uncertainty, we find a strong positive association with both expected stock returns and implied costs of equity, but only in settings that control for cash flow uncertainty. Collectively, our study suggests the need to consider different types of investor uncertainty when examining how investor uncertainty affects cost of equity.
Keywords: earnings quality, earnings uncertainty, earnings management, information uncertainty
JEL Classification: G14, M41
Suggested Citation: Suggested Citation