Validating Implied Cost of Capital With Realized Returns by Using Alternative Measures of Cash-Flow News

Abstract

We outline analytically that when testing different implied cost of capital (ICC) measures for validation by employing the Vuolteenaho (2002) framework, the cash-flow news in the validation framework should be defined in a way that considers the model specific assumed sequence of future cash flows. This is based on market’s expectations, as proxied by analysts’ forecasts. We then propose adjusting the cash-flow news proxies accordingly and implement these adjustments empirically. Consistent with the theoretical predications, the results from these tests show that ICC estimates are significantly positively related to realized returns. Informed by these findings, we employ the adjusted proxies in the validation framework and compare the correlation between adjusted and unadjusted for analysts’ bias ICC proxies with realized returns. These tests show no difference in these correlations. This suggests that it is not the analysts’ bias that weakens the validity of ICC measures, as argued by prior literature. It is the proxies in the validation framework that leads to the suggestion in removing analysts’ optimism from ICC measures. Overall, our proposed alternative framework not only unlocks the gate for extensive use of the existing ICC measures but also enables future researchers to develop more reliable and meaningful ICC measures.

Keywords: Expected returns, realized returns, cash-flow news, implied cost of capital.

JEL Classification: M41, G12, G31, G32