Implied Cost of Equity Capital Estimates as Predictors of Accounting Returns and Stock Returns

51 Pages Posted: 22 Dec 2013 Last revised: 22 Dec 2016

Date Written: December 22, 2016

Abstract

Using a popular return decomposition, we show that expected returns should on average be positively associated with future return on equity (ROE), controlling for the book-to-market ratio (BM). However, we find that none of the commonly-used implied cost of equity capital estimates (ICCs), which proxy for expected returns, are positively associated with future ROE. This lack of association with future accounting returns appears to affect the ability of ICCs to forecast future stock returns: ICCs do not provide information about future stock returns incremental to that contained in a linear combination of current ROE and BM. Our findings suggest that tractable accounting-based models that linearly combine BM and ROE, or other accounting-based variables, offer improvements on extant ICCs as expected returns proxies.

Keywords: cost of capital; expected returns; ROE

JEL Classification: M41, G3

Suggested Citation

Larocque, Stephannie and Lyle, Matthew R., Implied Cost of Equity Capital Estimates as Predictors of Accounting Returns and Stock Returns (December 22, 2016). Available at SSRN: https://ssrn.com/abstract=2370686 or http://dx.doi.org/10.2139/ssrn.2370686

Stephannie A. Larocque (Contact Author)

University of Notre Dame - Mendoza College of Business ( email )

Mendoza College of Business
Notre Dame, IN 46556-5646
United States

Matthew R. Lyle

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

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