The application of proxy methods for estimating the cost of equity for unlisted companies: evidence from listed firms

Julio Sarmiento, Mehdi Sadeghi, Juan S. Sandoval () and Edgardo Cayon
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Julio Sarmiento: Pontificia Universidad Javeriana
Mehdi Sadeghi: Macquarie University
Juan S. Sandoval: Colegio de Estudios Superiores de Administración (CESA)
Edgardo Cayon: Colegio de Estudios Superiores de Administración (CESA)

Review of Quantitative Finance and Accounting, 2021, vol. 57, issue 3, No 7, 1009-1031

Abstract: Abstract The Campbell and Vuolteenaho (Am Econ Rev 94(5):1249–1275, 2004) two–beta model decomposes the systematic risk in the sensitivity of cash flow and discount rate change. We employed this model, which we call the Two Beta Decomposition Model (TBDM) and found that this model is useful to compute the cost of capital for unlisted companies (UCs) via a proxy from listed companies. This model includes not only the accounting return reaction to long-term changes in consumption, but also links fundamental reactions to temporal changes in risk aversion. We test this model along with three traditional alternatives that are potentially useful in computing the cost of equity for UCs: accounting betas (AB), unlevered betas (UB), and operational betas (OB). Our results show that AB, UB and TBDM can partially explain the cross-sectional variations of stock returns. Additionally, using a series of non-parametric ranking test along with several statistics of goodness of fit, we found that the TBDM is the model that produces the best fit among competing models followed by the UB which is currently the most used among proxy methods.

Keywords: Unlisted companies; Cost of equity; Accounting betas; Unlevered betas; Operational betas; Two beta decomposition model (search for similar items in EconPapers)
JEL-codes: G30 (search for similar items in EconPapers)
Date: 2021
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DOI: 10.1007/s11156-021-00968-3

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