Estimating the Cost of Capital Implied by Market Prices and Accounting Data (original) (raw)
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A preliminary framework to estimate and disclose ex-ante cost of capital for (fair) valuation
International Journal of Multivariate Data Analysis, 2016
Fair-value accounting is usually seen as a rule to mark assets to market. While the market was bullish, there was little concern about the implications of a potential downside risk of fair value rules. But with the current world financial crisis triggered by US subprime loans default, pressure surged for it is simply extinction or at least for more flexibility to apply what 'fair' should really mean according to managers' judgment. Critics of fair-value (mark-to market) accounting raise the question that in some moments market prices decouple from the 'fundamentals' and using it as the value reference can distort financial statements. In other words, they posit that market are not always efficient, markets are prone to positive and negative price bubbles. This is a preliminary work that aims to estimate ex-ante cost of capital (or expected rate of return) using market data and some parameters, like expected equity market risk-premium, its volatility and an average relative risk-aversion of a representative agent. In other words, the main objective is to establish a framework of assumptions, in order to do and disclose inherently subjective estimates of equity market portfolio (or index) ex-ante expected rate of return, in a theoretical coherent manner.
Toward an Implied Cost of Capital
Journal of Accounting Research, 2001
In this study, we propose an alternative technique for estimating the cost of equity capital. Specifically, we use a discounted residual income model to generate a market implied cost‐of‐capital. We then examine firm characteristics that are systematically related to this estimate of cost‐of‐capital. We show that a firm's implied cost‐of‐capital is a function of its industry membership, B/M ratio, forecasted long‐term growth rate, and the dispersion in analyst earnings forecasts. Together, these variables explain around 60% of the cross‐sectional variation in future (two‐year‐ahead) implied costs‐of‐capital. The stability of these long‐term relations suggests they can be exploited to estimate future costs‐of‐capital. We discuss the implications of these findings for capital budgeting, investment decisions, and valuation research.
The implied cost of capital: A new approach
Journal of Accounting and Economics, 2012
We propose a new approach to estimate the implied cost of capital (ICC). Our approach is distinct from prior studies in that we do not rely on analysts' earnings forecasts to compute the ICC. Instead, we use a cross-sectional model to forecast the earnings of individual firms. Our approach has two major advantages. First, it allows us to estimate the ICC for a much larger sample of firms over a much longer time period. Second, it is not affected by the various issues that lead to the well-documented biases in analysts' forecasts. Our crosssectional earnings model delivers earnings forecasts that outperform consensus analyst forecasts. We show that, as a result, our approach to estimate the ICC produces a more reliable proxy for expected returns than other approaches. We present evidence on the implications for the equity premium and a variety of asset pricing anomalies.
Equity Valuation Approach Based on Accounting Variables
Journal of Finance and Economics, 2013
This academic paper proposed theoretically the alternative estimate of the cost of equity capital (COE) for accounting-based residual income model (RIM), which this quantity becomes an important variable for the intrinsic worth valuation model. Its format can be express interchangeably in many forms of accounting variables combining with some financial ratio. The basic assumption is relying on that the quantity of COE for an asset should reflect from its profitability and change in market price during given periods. By taking reverse-calculation into the particular RIM equation, these outcomes (alternative COE estimates) are consistent according with the fact that the investors reasonably expect to earn from investing in shares of a firm through both or either total dividends and prospective increment in market capitalization. The proposition can be eliminating the lacked explanation of existing estimates and also explainable why investors are still investing in shares of a firm that has no dividend policy. While traditional estimation methods default the explanation of this truth.
Using four academically recognized valuation models, we analyze the cost of equity capital on an implicit approach, using analysts’ forecasts for the Brazilian market, in order to complete the variables on the account-based models. The hypothesis in the present paper consists on the convergence of the models, as they have the same premises and little differences on the adjustments used by their creators. However, this hypothesis does not seem to be sustainable when observing all the market, i.e. all industry sectors, in the same sample. The results show that the models can indeed converge, but in a specific industry sector, which in the present paper is the financial sector.
The magnitude and reliability of equity capital cost estimates: A statistical approach
Managerial and Decision Economics, 1985
The purpose of this paper is to illustrate a simple technique of estimating the cost of equity capital as well as a statistical measure of its reliability. The approach specifies a probability structure that is readily estimated from company dividend data, and front that structure both the estimated cost of capital and its standard error are calculated.
Price Models and the Value Relevance of Accounting Information
SSRN Electronic Journal, 2007
Recent research in empirical accounting has raised questions about the usefulness of price models, and how this tool can be used properly given its economic and econometric problems. This paper first identifies the essential distinctions between the price and return models, and the situations in which a price model is advantageous. An alternative method of estimating price models is then developed through minimizing the symmetrized relative pricing error (LRPE); Compared to the conventional methods of deflating by BVE, Shares, lagged price, or the price itself, the LRPE regression has several advantages: (1) The estimates are economically more meaningful and substantially more accurate. Comparisons using real data show that conventional methods waste 75% of the sample relative to LRPE; (2) The predicted price from the proposed method better captures the intrinsic value of a firm. I find that a hedge portfolio based on LRPE regression gives higher returns; (3) The relative pricing error, as a measure of the value relevance of accounting information, produces intuitive conclusions, while R 2 doesn't. These results suggest that LRPE regression can contribute significant refinements to empirical research utilizing the price models.
Accruals, Accounting-Based Valuation Models, and the Prediction of Equity Values
SSRN Electronic Journal, 2000
This study uses out-of-sample equity value estimates to determine whether earnings disaggregation, imposing valuation model linear information (LIM) structure, and separate industry estimation of valuation model parameters aid in predicting contemporaneous equity values. We consider three levels of earnings disaggregation: aggregate earnings, cash flow and total accruals, and cash flow and four major components of accruals. For pooled estimations, imposing the LIM structure results in significantly smaller prediction errors; for by-industry estimations, it does not. However, by-industry prediction errors are substantially smaller, suggesting the by-industry estimations are better specified. Mean prediction errors are smallest when disaggregating earnings into cash flow and major accrual components; median prediction errors are smallest when disaggregating earnings into cash flow and total accruals. These findings suggest that (1) If concern is with errors in the tails of the equity value prediction error distribution, then earnings should be disaggregated into cash flow and the major accrual components; otherwise earnings should be disaggregated only into cash flow and total accruals.