Using Earnings Forecasts to Simultaneously Estimate Firm-Specific Cost of Equity and Long-Term Growth
64 Pages Posted: 15 Dec 2010 Last revised: 9 Mar 2011
Date Written: March 3, 2011
A growing body of literature in accounting and finance relies on implied cost of equity (COE) measures. Such measures are sensitive to assumptions about terminal earnings growth rates. In this paper we develop a new COE measure that is more accurate than existing measures because it incorporates endogenously estimated long-term growth in earnings. Our method extends Easton, Taylor, Shroff, and Sougiannis’ (2002) method of simultaneously estimating sample average COE and growth. Our method delivers COE (growth) estimates that are significantly positively associated with future realized stock returns (future realized earnings growth). Moreover, the predictive ability of our COE measure subsumes that of other commonly used COE measures and is incremental to commonly used risk characteristics. Our implied growth measure fills the void in the earnings forecasting literature by robustly predicting earnings growth beyond the five-year horizon.
Keywords: Cost of equity, expected return, expected earnings growth, residual income model
JEL Classification: G12, G14, G17, G31, M41
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