Properties of implied cost of capital using analystsâ€™ forecasts
We evaluate the influence of measurement error in analystsâ€™ forecasts on the accuracy of implied cost of capital estimates from various implementations of the â€˜implied cost of capitalâ€™ approach, and develop corrections for the measurement error. The implied cost of capital approach relies on analystsâ€™ short- and long-term earnings forecasts as proxies for the marketâ€™s expectation of future earnings, and solves for the implied discount rate that equates the present value of the expected future payoffs to the current stock price. We document predictable error in the implied cost of capital estimates resulting from analystsâ€™ forecasts that are sluggish with respect to information in past stock returns. We propose two methods to mitigate the influence of sluggish forecasts on the implied cost of capital estimates. These methods substantially improve the ability of the implied cost of capital estimates to explain cross-sectional variation in future stock returns, which is consistent with the corrections being effective in mitigating the error in the estimates due to analystsâ€™ sluggishness.