Estimating Firm-Specific Long-Term Growth Rate and Cost of Capital

Abstract

We use the residual-income valuation model to simultaneously estimate firm-specific implied long-term growth rate in abnormal earnings and cost of capital by relating earnings-to-price and book-to-market ratios in a linear fashion. This simple framework estimates investors' consensus beliefs with respect to the long-term growth rate of abnormal earnings and the corresponding cost of capital embedded in the stock price. Empirical results show that the growth rate and cost of capital estimates obtained from this model and that of Easton [2004] exhibit desirable properties. Specifically, both cost of capital estimates, controlled for growth, are predictably related to various previously documented firm-specific factors. The cost of capital estimates using this and the Easton [2004] procedure are also positively related to one-year-ahead returns, especially when the change in cost of capital and growth are controlled. Overall, we show the importance of considering return decomposition as well as controlling for growth when assessing the relationship between cost of capital and various risk factors.

Keywords: Cost of capital, risk premium, implied growth rate, residual-income

JEL Classification: C53, G12, G31, M41