An Evaluation of the Reliability of Accounting Based Measures of Expected Returns: A Measurement Error Perspective

University of Notre Dame and INSEAD Working Paper

62 Pages Posted: 15 Sep 2003  

Peter D. Easton

University of Notre Dame - Department of Accountancy

Steven J. Monahan

INSEAD

Date Written: August 2003

Abstract

We develop and implement a method for comparing the measurement error in estimates of the expected rate of return on equity. We combine the Campbell [1991] and Vuolteenaho [2002] return decomposition with the econometric method described in Garber and Klepper [1980] and Barth [1991] to infer cross-sectional measurement error variances. We evaluate a variety of estimates of expected returns that are discussed in the extant accounting literature (e.g., Gebhardt, Lee, and Swaminathan [2001], Easton [2002], and Gode and Mohanram [2002]). Our results show that the estimate that is based on the simplest model (i.e., price-to-forward earnings) is as reliable as more sophisticated proxies. This result is also observed when the analyses are repeated for portfolios of observations. Predicted values based on instrumental variables that are, a priori, expected to be correlated with the true expected return but uncorrelated with the measurement error have considerably lower measurement error variances. Nonetheless, the crudest proxy still performs at least as well as more sophisticated proxies.

Keywords: expected returns, cost of capital

JEL Classification: C53, E43, G11, G12, G31, M41

Suggested Citation

Easton, Peter D. and Monahan, Steven J., An Evaluation of the Reliability of Accounting Based Measures of Expected Returns: A Measurement Error Perspective (August 2003). University of Notre Dame and INSEAD Working Paper. Available at SSRN: https://ssrn.com/abstract=433801 or http://dx.doi.org/10.2139/ssrn.433801

Peter D. Easton

University of Notre Dame - Department of Accountancy ( email )

Mendoza College of Business
Notre Dame, IN 46556-5646
United States
574-631-6096 (Phone)
574-631-5127 (Fax)

Steven J. Monahan (Contact Author)

INSEAD ( email )

Boulevard de Constance
PMLS 1.24
F-7705 Fontainebleau Cedex, 77305
France
+33 1 60 72 92 14 (Phone)
+33 1 60 72 92 53 (Fax)

HOME PAGE: http://www.insead.edu/facultyresearch/faculty/profiles/smonahan/

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