Estimating Firm-specific Long-term Growth Rate and Cost of Capital (original) (raw)

We use the residual income valuation model to simultaneously estimate firm-specific implied long-term growth rate in abnormal earnings and cost of capital by relating earnings-to-price and book-to-market ratios in a linear fashion. This provides a simple framework to estimate the investors' consensus beliefs with respect to long-term growth rate of abnormal earnings and the corresponding cost of capital embedded in stock price. Empirical results show that the firm-specific long-term growth rate in abnormal earnings and cost of capital estimates obtained from the model exhibit desirable properties. Specifically, both of the estimates are persistent over the years and they are related to various previously documented firm-specific factors in the predicted directions. The cost of capital estimate is also shown to be positively related to one-year-ahead and two-yearahead returns (see Guay, Kothari and Shu (2003)). We apply the firm-specific long-term growth and cost of capital estimates to examine the value-glamour anomaly and find evidence that is consistent with the notion that the market overestimates (underestimates) the long-term growth rate of glamour (value) stocks.