The implied cost of capital: A new approach

Abstract

We use earnings forecasts from a cross-sectional model to proxy for cash flow expectations and estimate the implied cost of capital (ICC) for a large sample of firms over 1968–2008. The earnings forecasts generated by the cross-sectional model are superior to analysts' forecasts in terms of coverage, forecast bias, and earnings response coefficient. Moreover, the model-based ICC is a more reliable proxy for expected returns than the ICC based on analysts' forecasts. We present evidence on the cross-sectional relation between firm-level characteristics and ex ante expected returns using the model-based ICC.