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
Date Written: August 2003
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  and Vuolteenaho  return decomposition with the econometric method described in Garber and Klepper  and Barth  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 , Easton , and Gode and Mohanram ). 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: Suggested Citation