Industry cost of equity capital: European evidence for multifactor models

We estimate the costs of equity capital for 117 industries from 16 European countries employing the CAPM and 8 multifactor asset pricing models as well as a variety of different econometric techniques. In doing so, we extend previous research on cost of equity estimation in mainly two ways. First, our study involves European instead of US or UK industries, which are investigated in previous research, and we find that cost of equity estimates obtained from the CAPM or multifactor asset pricing models are as imprecise for European industries as for US and UK industries. Second, in addition to the CAPM, the Fama and French [1993. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics 33: 3–56] three-factor model, and the Carhart [1997. “On Persistence in Mutual Fund Performance.” The Journal of Finance 52 (1): 57–82] four-factor model, which are usually employed, our study includes six multifactor models that have not yet been examined on their ability to provide precise estimates of the costs of equity: the five-factor model of Fama and French [1993. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics 33: 3–56] as well as the multifactor models of Pástor and Stambaugh [2003. “Liquidity Risk and Expected Stock Returns.” Journal of Political Economy 111 (3): 642–685]; Campbell and Vuolteenaho [2004. “Bad Beta, Good Beta.” American Economic Review 94 (5): 1249–1275]; Hahn and Lee [2006. “Yield Spreads as Alternative Risk Factors for Size and Book-To-Market.” Journal of Financial & Quantitative Analysis 41 (2): 245–269]; Petkova [2006. “Do the Fama–French Factors Proxy for Innovations in Predictive Variables?” The Journal of Finance 61 (2): 581–612]; and Koijen, Lustig, and van Nieuwerburgh [2010. “The Cross-Section and Time-Series of Stock and Bond Returns.” Working Paper, University of Chicago, University of California at Los Angeles, New York University]. Our results suggest that these models provide even more imprecise cost of equity estimates. One main reason for these inaccurate estimates is the large temporal variation of the risk loadings on the non-traded factors in these models.