Removing predictable analyst forecast errors to improve implied cost of equity estimates
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Prior research documents a weak association between the implied cost of equity inferred from analyst forecasts and realized returns. It points to predictable errors in analyst forecasts as a possible cause. We show that removing predictable errors from analyst forecasts leads to a much stronger association between implied cost of equity estimates obtained from adjusted forecasts and realized returns after controlling for cash flow news and discount rate news. An estimate of implied risk premium based on the average of four commonly used methods after making adjustments for predictable errors exhibits strong correlations with future realized returns as well as the lowest measurement error. Overall, our results confirm the validity of implied cost of equity estimates as measures of expected returns. Future research using implied cost of equity should remove predictable errors from implied cost of capital estimates and then average across multiple metrics.
KeywordsImplied cost of capital Implied cost of equity Analyst forecasts Realized returns Expected returns Predictable errors
JEL ClassificationM41 G12 G31 G32
We would like to thank the editor Peter Easton, two anonymous referees, Jim Ohlson, Steve Monahan and the seminar participants at the Columbia-NYU Joint Seminar, Indian School of Business Accounting Conference, Ohio State University, and Washington University –St. Louis for their useful comments. We would like to thank Maria Ogneva for providing us with the code to estimate the measurement error variables used in the paper. Partha Mohanram would like to thank the Social Sciences and Humanities Research Council (SSHRC) of Canada for their generous financial support.
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