Analystss Estimates of Cost of Equity Capital

Abstract

We explore a large sample of analysts’ estimates of cost of equity capital (CoE) revealed in analysts’ reports to evaluate their determinants and ability to capture expected stock returns. We first document that CoE estimates are more likely to be provided by less experienced and less busy analysts and for harder-to-value firms. We also find that CoE estimates are significantly related to beta, size, book-to-market ratio, leverage and idiosyncratic volatility but not to profitability, investments or other return predictors. The CoE estimates also incrementally predict future stock returns, which possibly reflects analysts’ ability to garner information about expected returns through their direct interactions with investors. We also find that analysts increase their CoE estimates following extreme earnings surprises, indicating that companies with volatile earnings as perceived as more risky. Finally, based on a pair-wise comparison of CoE estimates with alternative expected return proxies (estimated from CAPM, Fama-French factor models or implied cost of capital models), we find that CoE estimates tend to be least noisy. We conclude that analysts’ CoE estimates, where available, are a useful proxy for expected stock returns.