Evaluating Cross-Sectional Forecasting Models for Implied Cost of Capital
47 Pages Posted: 7 Mar 2014
Date Written: March 5, 2014
The computation of implied cost of capital (ICC) is constrained by the lack of analyst forecasts for half of all firms. Hou, van Dijk, and Zhang (2012, HVZ) present a cross-sectional model to generate forecasts in order to compute ICC. However, the forecasts from the HVZ model perform worse than those from a naïve random walk model and the ICCs show anomalous correlations with risk factors. We present two parsimonious alternatives to the HVZ model: the EP model based on persistence in earnings and the RI model based on the residual income model from Feltham and Ohlson (1996). Both models outperform the HVZ model in terms of forecast bias, accuracy, earnings response coefficients, and correlations of the ICCs with future returns and risk factors. We recommend that future research use the RI model or the EP model to generate earnings forecasts.
Keywords: earnings forecasts, cross-sectional models, implied cost of capital
JEL Classification: G12, G31, G32, M40, M41
Suggested Citation: Suggested Citation