Discussion of “Evaluating cross-sectional forecasting models for implied cost of capital”

Abstract

An estimate of the implied cost of capital (ICC) is useful in valuation, investment, and capital budgeting. The computation of ICC requires earnings forecasts, for which prior studies generally use analyst forecasts to proxy. Hou et al. (2012) generate earnings forecasts using a cross-sectional model and thus estimate ICC for a large sample of firms, including those not covered by analysts. Li and Mohanram (2014) extend Hou et al. by considering two other cross-sectional earnings forecast models (RI and EP models). Li and Mohanram compare their models with the one in Hou et al. in two ways. First, they show that the earnings forecasts generated from their models outperform those from the Hou et al. model on forecast accuracy, forecast bias, and earnings response coefficients. Second, the ICC computed based on the earnings forecasts generated from the Hou et al. model exhibits lower correlations with future returns and more abnormal correlations with risk factors than the ICCs from the R