Evaluating cross-sectional forecasting models for implied cost of capital

Kevin K. Li () and Partha Mohanram ()
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Kevin K. Li: University of Toronto
Partha Mohanram: University of Toronto

Review of Accounting Studies, 2014, vol. 19, issue 3, No 6, 1152-1185

Abstract: Abstract The computation of implied cost of capital (ICC) is constrained by the lack of analyst forecasts for half of all firms. Hou et al. (J Account Econ 53:504–526, 2012, HVZ) present a cross-sectional model to generate forecasts in order to compute ICC. However, the forecasts from the HVZ model perform worse than those from a naïve random walk model and the ICCs show anomalous correlations with risk factors. We present two parsimonious alternatives to the HVZ model: the EP model based on persistence in earnings and the RI model based on the residual income model from Feltham and Ohlson (Contemp Account Res 11:689–732, 1996). Both models outperform the HVZ model in terms of forecast bias, accuracy, earnings response coefficients, and correlations of the ICCs with future returns and risk factors. We recommend that future research use the RI model or the EP model to generate earnings forecasts.

Keywords: Earnings forecasts; Cross-sectional models; Implied cost of capital (search for similar items in EconPapers)
JEL-codes: G12 G31 G32 M40 M41 (search for similar items in EconPapers)
Date: 2014
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DOI: 10.1007/s11142-014-9282-y

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