Implied Cost of Capital versus Fundamental Valuation Efficiency: A Clarification and Empirical Implications

Abstract

As the proxy for expected return, the implied cost of capital (ICC) is subject to a mispricing-driven measurement error. For undervalued stocks, the mispricing-driven measurement error is positive and increases with the degree of undervaluation while for overvalued stocks, the mispricing-driven measurement error is negative and decreases with the degree of overvaluation. That is, ceteris paribus, lower ICC is equivalent to smaller undervaluation and thus higher fundamental valuation efficiency for undervalued stocks while lower ICC is equivalent to larger overvaluation and thus lower fundamental valuation efficiency for overvalued stocks. Fundamental valuation efficiency (FVE) refers to the extent to which the price of a stock deviates from the intrinsic value. We show that the estimated relation of an FVE-associated variable with ICC is a potentially biased estimate of its relation with expected return due to the mispricing-driven measurement error. Moreover, existing methods do not seem able to address the bias.

Keywords: implied cost of capital, fundamental valuation efficiency, measurement error, bias

JEL Classification: C13, G12, G14, M41