Controlling Accounting Conservatism and Earnings Growth to Estimate the Implied Cost of Equity Capital

Abstract

Combining the models of Ohlson (2005) and Dechow & Dichev (2002), this study estimates the implied cost of equity capital by simultaneously controlling the measures of accounting conservatism and earnings growth. When the Capital Asset Pricing Model (CAPM), Arbitrage Pricing Theory (APT), and Fama & French (1993) Three-factor Model got problems in estimating the cost of equity capital, the method based on accounting valuation models may play an important role in this field. The findings show that the model controlling for accounting conservatism and earnings growth exhibits greater explanatory power to the variation of stock prices than the one without controlling. Furthermore, when comparing the relative explanatory power to the future stock returns, there exists no evidence that the accounting-based estimation of the cost of equity capital is superior to that estimated by the CAPM. However, the negative relation between the cost of equity capital estimated by the CAPM and future stock returns is inconsistent with the CAPM's prediction. Further tests of the incremental magnitude between the coefficients of the accounting-based estimation of the cost of equity capital and those estimated by the CAPM, in explaining the variation of future stock returns, show that the former dominates the latter, largely because of the negatively significant coefficients of the cost of equity capital estimated by the CAPM.