Implied Cost of Capital versus Fundamental Valuation Efficiency: A Clarification and Empirical Implications

Abstract

As the proxy for expected return, the implied cost of capital (ICC) is subject to a mispricing-driven measurement error because the price of a stock used to compute ICC can deviate from its intrinsic value. For undervalued stocks, the mispricing-driven measurement error is positive and increases with the degree of undervaluation while for overvalued stocks, the mispricing-driven measurement error is negative and decreases with the degree of overvaluation. Therefore, ceteris paribus, lower ICC is equivalent to higher (lower) fundamental valuation efficiency (FVE) for undervalued (overvalued) stocks. Furthermore, our evidence, based on 11 constructs, shows that the estimated relation of an FVE-associated construct with ICC is a potentially biased estimate of its relation with expected return because its estimated relation with ICC also captures its relation with the mispricing-driven measurement error, the sign of which switches between undervalued and overvalued stocks. Existing methods do not seem able to address the bias.