Using Forecasts of Earnings to Simultaneously Estimate Growth and the Rate of Return on Equity Investment

Abstract

We develop a method for simultaneously estimating the cost of equity capital and the growth in residual earnings that are implied by current stock prices, current book value of equity, and short-term forecasts of accounting earnings. We demonstrate the use of our method by calculating the expected equity risk premium. Our estimate is higher than estimates in extant studies that are based on the same earnings forecast data. The main difference between our study and these papers is that while they provide arguments supporting anassumedrate of growth beyond the forecast horizon, weestimatethis rate.