A forecast evaluation of expected equity return measures

Michael Chin and Christopher Polk

No 520, Bank of England working papers from Bank of England

Abstract: Recent studies find evidence in favour of return predictability, and argue that their positive findings result from their ability to capture expected returns. We assess the forecasting performance of two popular approaches to estimating expected equity returns, a dividend discount model (DDM) commonly used to estimate `implied cost of capital', and a vector autoregression (VAR) model commonly used to decompose equity returns. In line with recent evidence, in-sample tests show that both estimates generate substantially lower forecast errors compared to traditional predictor variables such as price-earnings ratios and dividend yields. Out-of-sample, the VAR and DDM estimates generate economically and statistically significant forecast improvements relative to a historical average benchmark. Our results tentatively suggest that the VAR approach better captures expected returns compared to the DDM.

Keywords: Expected returns; implied cost of capital; dividend discount model; return predictability; forecasting (search for similar items in EconPapers)
JEL-codes: G10 G11 G12 G17 (search for similar items in EconPapers)
Pages: 48 pages
Date: 2015-01-16
New Economics Papers: this item is included in nep-fmk and nep-for
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Citations: View citations in EconPapers (4)

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Persistent link: https://EconPapers.repec.org/RePEc:boe:boeewp:0520

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