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Removing predictable analyst forecast errors to improve implied cost of equity estimates

Author

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  • Partha Mohanram

    (Rotman School of Management, University of Toronto)

  • Dan Gode

    (New York University)

Abstract

Prior research documents a weak association between the implied cost of equity inferred from analyst forecasts and realized returns. It points to predictable errors in analyst forecasts as a possible cause. We show that removing predictable errors from analyst forecasts leads to a much stronger association between implied cost of equity estimates obtained from adjusted forecasts and realized returns after controlling for cash flow news and discount rate news. An estimate of implied risk premium based on the average of four commonly used methods after making adjustments for predictable errors exhibits strong correlations with future realized returns as well as the lowest measurement error. Overall, our results confirm the validity of implied cost of equity estimates as measures of expected returns. Future research using implied cost of equity should remove predictable errors from implied cost of capital estimates and then average across multiple metrics.

Suggested Citation

  • Partha Mohanram & Dan Gode, 2013. "Removing predictable analyst forecast errors to improve implied cost of equity estimates," Review of Accounting Studies, Springer, vol. 18(2), pages 443-478, June.
    • Handle: RePEc:spr:reaccs:v:18:y:2013:i:2:d:10.1007_s11142-012-9219-2
    DOI: 10.1007/s11142-012-9219-2
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    2. Mei Feng, 2014. "Discussion of “Evaluating cross-sectional forecasting models for implied cost of capital”," Review of Accounting Studies, Springer, vol. 19(3), pages 1186-1190, September.
    3. Kevin K. Li & Partha Mohanram, 2014. "Evaluating cross-sectional forecasting models for implied cost of capital," Review of Accounting Studies, Springer, vol. 19(3), pages 1152-1185, September.

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    JEL classification:

    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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