Ebook Estimating The Expected Cost Of Equity Capital Using Analysts’ Consensus Forecasts
Sound estimates of the cost of capital are crucial for evaluating investments and for corporate valuation. Current state-of-the-art methods of estimating the cost of equity capital, such as the CAPM or the Fama and French Three-Factor Model, have not only produced disappointing results empirically (Fama and French (1997, 2004)). They are also questionable in that they use average realized returns instead of measures of expected returns for which the underlying theories on asset pricing call for.
Recently, Claus and Thomas (2001), Gebhardt, Lee, and Swaminathan (2001) and Easton, Taylor, Shroff, and Sougiannis (2002) have proposed an alternative approach to estimating a firm’s expected cost of equity capital that does not rely on realized returns. Their idea uses a model of corporate valuation to generate a market-implied cost of equity capital. These studies define this implied cost of equity capital as the internal rate of return that equates the current stock price of a firm to the present value of the market’s expected future residual flows to common shareholders as approximated by observable financial analysts’ consensus forecasts.
Gebhardt, Lee, and Swaminathan (2001) and Easton (2003) propose these estimates of implied cost of equity capital for application in investment decisions. However, both investors and firms should then be able to estimate their expected cost of equity capital at any date of their own choice. The approach taken in related papers allows estimation only at a specific point in time that is predetermined by the disclosure of financial results once a year (typically April or June). In addition, input variables that reflect information at different points in time have been matched to that estimation date. For example, Claus and Thomas (2001) use share prices and book values of equity as of December 31 but earnings forecasts as of April 30 of the following year, which means that information flows into the estimation as of December 31 which will be available only at the end of April.
We extend previous approaches by applying the residual income valuation framework in a way that allows estimation on any day in the fiscal year, using only data concurrently and publicly available. We calculate the book value of equity at the estimation date by adding to last year’s book value the intra-year profit accumulated until that date, utilizing the expected return on equity (ROE) of the next period implied in one-year-ahead analysts’ earnings forecasts. We also adjust that period’s earnings forecast and use daily discounting (Actual/365) for discounting future residual income to the estimation date. We implement daily estimation both in the estimation method assuming long-term growth in terminal value estimation (method I; Gebhardt, Lee, and Swaminathan (2001)) and in the portfolio-approach estimating expected cost of equity capital and infinite growth simultaneously (method II; Easton, Taylor, Shroff, and Sougiannis (2002)).
International evidence for market-implied cost of equity capital estimates is available only for the market risk premium (Claus and Thomas (2001)), but not at the industry or individual firm level. We estimate the expected cost of equity capital and risk premia at the market, industry, and individual firm level by using our method and German companies’ historical data from 1989-2002. We also examine firm characteristics that have been systematically related to our estimates of expected returns. This research supplements prior findings in the U.S. for a major European financial market that has been characterized as distinct from the U.S. in its institutional setting (Franke, Gebhardt, and Krahnen (2002)).
We find that during the 1989-2002 period in Germany the average expected cost of equity capital under estimation method I (II) is 10% (11.2%), and the average expected market risk premium is 3.9% (5.2%). Under both methods, we observe a clear trend of a rising market risk premium over time that has not been documented by the corresponding U.S. literature covering only periods before 1999. We also find significant industry effects, as the market assigns higher discount rates to the information technology and service sectors and lower rates to sectors such as utilities, real estate, or the food and beverage industries. At the firm level, we find reasonable results for individual companies and present the distribution of expected cost of equity capital estimates.
When we examine the cross-sectional relation between expected risk premia and several firm characteristics, the book-to-market ratio and the industry category prove to be the most important factors. In a multifactor model, the traditional beta factor seems to be important only in the Fama and French (1992) Three-Factor Model context, but looses explanatory power as soon as we include additional factors.
The paper is organized as follows: Section 2 presents our motivation for this new approach and explains our residual income based estimation procedures. In Section 3 we summarize the findings of our empirical analysis of the expected cost of equity capital and its determinants. Section 4 concludes.
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