Removing predictable analyst forecast errors to improve implied cost of equity estimates

Partha Mohanram () and Dan Gode ()
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Partha Mohanram: Rotman School of Management, University of Toronto
Dan Gode: New York University

Review of Accounting Studies, 2013, vol. 18, issue 2, No 6, 443-478

Abstract: Abstract 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.

Keywords: Implied cost of capital; Implied cost of equity; Analyst forecasts; Realized returns; Expected returns; Predictable errors (search for similar items in EconPapers)
JEL-codes: G12 G31 G32 M41 (search for similar items in EconPapers)
Date: 2013
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DOI: 10.1007/s11142-012-9219-2

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