Implied Cost of Capital in the Cross-Section of Stocks

39 Pages Posted: 29 Apr 2015 Last revised: 3 May 2017

See all articles by Namho Kang

Namho Kang

Bentley University - Department of Finance

Ronnie Sadka

Boston College - Carroll School of Management

Date Written: April 30, 2017

Abstract

Recent research shows that the implied cost of capital (ICC), measured from analyst forecasts and current stock prices, positively predicts returns at the aggregate level. In contrast, there is a strong negative relation between ICC and future returns in the cross-section. We hypothesize that mispricing due to optimistic analyst forecasts and earnings uncertainty renders ICC a poor proxy for expected returns, leading to the negative cross-sectional relation. Consistent with this hypothesis, we find that (1) high-ICC firms tend to have more optimistic analyst forecasts; (2) the underperformance of high-ICC firms is pronounced for firms with a high predictable analyst bias; and (3) mispricing due to earnings uncertainty further strengthens the negative relation between ICC and future returns. The findings suggest that not only bias in analyst forecasts but also mispricing may significantly affect the estimation of ICC at the firm level.

Suggested Citation

Kang, Namho and Sadka, Ronnie, Implied Cost of Capital in the Cross-Section of Stocks (April 30, 2017). Available at SSRN: https://ssrn.com/abstract=2600147 or http://dx.doi.org/10.2139/ssrn.2600147

Namho Kang (Contact Author)

Bentley University - Department of Finance ( email )

175 Forest Street
Waltham, MA 02154
United States

Ronnie Sadka

Boston College - Carroll School of Management ( email )

140 Commonwealth Avenue
Chestnut Hill, MA 02467
United States

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