Properties of Implied Cost of Capital Using Analysts' Forecasts

26 Pages Posted: 15 Sep 2003 Last revised: 17 Aug 2012

See all articles by Wayne R. Guay

Wayne R. Guay

University of Pennsylvania - Accounting Department

S.P. Kothari

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Susan Shu

Boston College - Carroll School of Management

Date Written: August 25, 2011

Abstract

We evaluate the influence of measurement error in analysts' forecasts on the accuracy of implied cost of capital estimates from various implementations of the 'implied cost of capital' approach, and develop corrections for the measurement error. The implied cost of capital approach relies on analysts' short- and long-term earnings forecasts as proxies for the market's expectation of future earnings, and solves for the implied discount rate that equates the present value of the expected future payoffs to the current stock price. We document predictable error in the implied cost of capital estimates resulting from analysts' forecasts that are sluggish with respect to information in past stock returns. We propose two methods to mitigate the influence of sluggish forecasts on the implied cost of capital estimates. These methods substantially improve the ability of the implied cost of capital estimates to explain cross-sectional variation in future stock returns, which is consistent with the corrections being effective in mitigating the error in the estimates due to analysts' sluggishness.

Keywords: Cost of Capital, Implied Cost of Capital, Analysts' Forecasts, Discount Rate

JEL Classification: G12, M41, G29, G31, G32

Suggested Citation

Guay, Wayne R. and Kothari, S.P. and Shu, Susan, Properties of Implied Cost of Capital Using Analysts' Forecasts (August 25, 2011). Australian Journal of Management, Vol. 36, p. 125, 2011; MIT Sloan Working Paper No. 4422-03. Available at SSRN: https://ssrn.com/abstract=426560 or http://dx.doi.org/10.2139/ssrn.426560

Wayne R. Guay (Contact Author)

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
1329 Steinberg-Dietrich Hall
Philadelphia, PA 19104-6365
United States
215-898-7775 (Phone)
215-573-2054 (Fax)

S.P. Kothari

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

E52-325
Cambridge, MA 02142
United States
617-253-0994 (Phone)
617-253-0603 (Fax)

Susan Shu

Boston College - Carroll School of Management ( email )

Boston College
140 Commonwealth Ave.
Chestnut Hill, MA 02167
United States
617-552-1759 (Phone)

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