Costs of Capital and Earnings Attributes
43 Pages Posted: 23 Jun 2003
Date Written: May 2003
We examine the relation between the cost of equity capital and seven attributes of earnings: quality, persistence, predictability, smoothness, value relevance, timeliness and conservatism. We refer to the first four attributes as accounting-based because measures of these constructs are typically based on accounting information only. We refer to the last three attributes as market-based because proxies for these constructs are typically based on relations between market data and accounting data. Our analysis of the cost of capital effects of these attributes is based on two distinct approaches to measuring the cost of capital: a cross-sectional approach which uses ex ante cost of capital estimates derived from analyst forecast data, and a time-series approach that uses realized returns and asset pricing regressions. Across both sets of tests, we find that firms with the most favorable values of each attribute, viewed individually, enjoy significantly lower costs of capital than firms with the least favorable values. The largest cost of capital effects are found for the accounting-based attributes; within this set, earnings quality has the strongest effects. Among the market-based attributes, value relevance dominates timeliness and conservatism. Considering all attributes together, the results show that investors consistently price earnings quality and earnings persistence, and to a lesser extent, value relevance.
Keywords: cost of capital, earnings quality, persistence, predictability, smoothness, value relevance, timeliness, conservatism
JEL Classification: M41, M44, G12, G29
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