Implied Cost of Equity Capital Estimates as Predictors of Accounting Returns and Stock Returns
Journal of Financial Reporting, Forthcoming
50 Pages Posted: 22 Dec 2013 Last revised: 1 Aug 2017
Date Written: July 6, 2017
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: Suggested Citation