Accounting-Based Estimates of the Cost of Capital: A Third Way
69 Pages Posted: 9 Oct 2017 Last revised: 12 Oct 2017
Date Written: February 1, 2017
This paper estimates the cost of capital from observed accounting information and compares the resulting estimates with so-called implied cost of capital (ICC) calculations and those from asset pricing models. The estimates are based on the idea that buying earnings growth is risky, and accounting numbers inform about that risk under accounting principles. First, accounting principles determine how much earnings are recognized currently or deferred to the future; that is accounting principles generate earnings growth. Second, these same principles connect the resulting growth to risk. Thus, an accounting number generated under these principles potentially indicates of the cost of capital, the required return for risk borne. The estimates perform well in validation tests, in contrast to the alternatives that are the current standards.
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