Using earnings forecasts to simultaneously estimate firm-specific cost of equity and long-term growth

Review of Accounting Studies · 2011 · Volume 16 · Issue 3

Abstract

A growing body of literature in accounting and finance relies on implied cost of equity (COE) measures. Such measures are sensitive to assumptions about terminal earnings growth rates. In this paper we develop a new COE measure that is more accurate than existing measures because it incorporates endogenously estimated long-term growth in earnings. Our method extends Easton et al. (J Account Res, 40, 657–676,2002) method of simultaneously estimatingsample averageCOE and growth. Our method delivers COE (growth) estimates that are significantly positively associated with future realized stock returns (future realized earnings growth). Moreover, the predictive ability of our COE measure subsumes that of other commonly used COE measures and is incremental to commonly used risk characteristics. Our implied growth measure fills the void in the earnings forecasting literature by robustly predicting earnings growth beyond the five-year horizon.

Keywords

Cost of equity, Expected return, Expected earnings growth, Residual income model

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