Cost Of Equity Estimates Research Articles

Revisiting the estimation of the cost of equity of euro area banks

The aim of this article is to estimate the cost of equity for a large sample of euro area banks. To this end, the authors consider several estimation methodologies falling under two main approaches: (i) multi-factor time-series models of stock market returns; and (ii) dividend discount models. It is found that, at country level, the estimates of the various models display a similar time variation, but differences in levels can be substantial. The relationship between the different cost of equity estimates and bank observables is relatively weak. Estimates from dividend discount models show a somewhat more robust relationship with bank fundamentals, while those from factor models do so more clearly only for larger banks. A combined measure built as a simple average across models also shows a moderate association with fundamentals. Overall, the results highlight the uncertainties inherent in cost of equity estimation and the importance of considering different alternative models.

The Predictive Performance of Asset Pricing Models: Evidence from the Australian Securities Exchange

This paper considers the accuracy (or otherwise) of cost of equity estimates provided by a range of Australian asset pricing models on industry returns. The results suggest that a simple, constant-benchmark approach (fixed excess return of five percent per annum) provides the best forecast for the cost of equity capital for the various industry segments of the Australian Securities Exchange examined across the observation window. Our results from Australia corroborate U.S. findings regarding the disconnect between asset pricing models that provide the best ex-post explanation of asset returns and models that produce superior ex-ante predictions of the cost of capital.

Industry cost of equity capital: European evidence for multifactor models

We estimate the costs of equity capital for 117 industries from 16 European countries employing the CAPM and 8 multifactor asset pricing models as well as a variety of different econometric techniques. In doing so, we extend previous research on cost of equity estimation in mainly two ways. First, our study involves European instead of US or UK industries, which are investigated in previous research, and we find that cost of equity estimates obtained from the CAPM or multifactor asset pricing models are as imprecise for European industries as for US and UK industries. Second, in addition to the CAPM, the Fama and French [1993. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics 33: 3–56] three-factor model, and the Carhart [1997. “On Persistence in Mutual Fund Performance.” The Journal of Finance 52 (1): 57–82] four-factor model, which are usually employed, our study includes six multifactor models that have not yet been examined on their ability to provide precise estimates of the costs of equity: the five-factor model of Fama and French [1993. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics 33: 3–56] as well as the multifactor models of Pástor and Stambaugh [2003. “Liquidity Risk and Expected Stock Returns.” Journal of Political Economy 111 (3): 642–685]; Campbell and Vuolteenaho [2004. “Bad Beta, Good Beta.” American Economic Review 94 (5): 1249–1275]; Hahn and Lee [2006. “Yield Spreads as Alternative Risk Factors for Size and Book-To-Market.” Journal of Financial & Quantitative Analysis 41 (2): 245–269]; Petkova [2006. “Do the Fama–French Factors Proxy for Innovations in Predictive Variables?” The Journal of Finance 61 (2): 581–612]; and Koijen, Lustig, and van Nieuwerburgh [2010. “The Cross-Section and Time-Series of Stock and Bond Returns.” Working Paper, University of Chicago, University of California at Los Angeles, New York University]. Our results suggest that these models provide even more imprecise cost of equity estimates. One main reason for these inaccurate estimates is the large temporal variation of the risk loadings on the non-traded factors in these models.

The Cross Section of Long-Term Expected Returns

Effective capital budgeting decisions require reliable estimates of long-term expected returns. I extract a predictor for long-term returns from the book-to-market ratio by controlling for its variation associated with long-term expected profitability. The resulting predictor reliably describes the cross section of returns out-of-sample for at least five years, even when focusing exclusively on large-cap stocks and controlling for expected-return estimates generated by implied cost of capital models, factor models, and characteristic-based models. My results have important implications for improving our cost of equity estimates.

Estimating and testing beta pricing models on industries

This paper uses the betas of book-to-market portfolios as proxies for systematic risks of industries instead of the individual betas computed from individual time-series regressions. Our empirical specification improves both the precision of the beta estimates and the cost of equity estimates. Estimating and testing beta pricing models via the proposed method highlights that consumption growth, liquidity risk, market excess returns, and the value factor explain the cross-sectional differences in expected industry returns, while there are no significant risk factors using the traditional approach. The fact that consumption risk is priced with monthly data is an interesting result, as the financial literature has struggled to prove that the consumption capital asset pricing model explains monthly returns.

Implied Cost of Equity: CAPM Versus Fama-French

This study uses U.S. implied cost of equity estimates to compare the CAPM with a risk-return version of the Fama-French model. The risk-return Fama-French model assumes that the size and value factors proxy for the risk of nonmarketable assets, like human capital and entrepreneurial income. The implied cost of equity estimates are a closer fit with the risk-return Fama-French model than with the CAPM.

A Comparison of Cost of Equity Estimates of Local and Global CAPM: Experience from a Developing Country, Mexico

Given that Mexican companies holding foreign currency debt are extremely exposed to the volatility in currency exchange rates, we ask if the required returns determined by the Local CAPM model and those determined by the Global CAPM model are significantly different. In our study, which was conducted between 2006 and 2010, we found the two models projected significantly different estimated capital costs. We tracked 19 companies that trade on the Mexican Stock Market and found that the average of the Local CAPM is 13.83% while that of the Global CAPM is 20.38%. Our discovery that the estimated cost of capital for the Mexican firms in the global capital market is significantly higher than in the local — reaching 1000basis points in some cases — suggests the need for further studies to investigate the statistical and economic significance of this difference.

Estimating the Cost of Equity: Does Theory Help or Hurt?

We compare the accuracy of cost of equity estimates based on leading factor models to two simple alternatives: the asset mean and the market mean. The market mean proves to be a serious competitor to traditional implementations of factor models even if the underlying factor model is true. Pricing errors (alphas) that are negatively correlated with firm and industry market betas further improve the performance of the market mean relative to model-based approaches. We propose Bayesian estimators that address key weaknesses in standard plug-in approaches. These estimators outperform plug-in methods and the market mean in simulations and out-of-sample.

Using earnings forecasts to simultaneously estimate firm-specific cost of equity and long-term growth

A growing body of literature in accounting and finance relies on implied cost of equity (COE) measures. Such measures are sensitive to assumptions about terminal earnings growth rates. In this paper we develop a new COE measure that is more accurate than existing measures because it incorporates endogenously estimated long-term growth in earnings. Our method extends Easton et al. (J Account Res, 40, 657–676, 2002) method of simultaneously estimating sample average COE and growth. Our method delivers COE (growth) estimates that are significantly positively associated with future realized stock returns (future realized earnings growth). Moreover, the predictive ability of our COE measure subsumes that of other commonly used COE measures and is incremental to commonly used risk characteristics. Our implied growth measure fills the void in the earnings forecasting literature by robustly predicting earnings growth beyond the five-year horizon.

Should Managers Estimate Cost of Equity Using a Two-Factor International CAPM?

For a large sample of U.S. companies, we compare the cost of equity estimates of a two-factor international CAPM with those of the single-factor domestic CAPM and the single-factor global CAPM. Our purpose is to assess how much difference it makes for U.S. firms to use the two-factor ICAPM instead of a single-factor model. We find: 1) the cost of equity estimates of the two-factor ICAPM are reasonably close to those of either single-factor model for U.S. firms with low-to-moderate foreign exchange exposure; and 2) perhaps surprisingly, for U.S. firms with extreme foreign exchange exposure, the cost of equity estimates of the two-factor ICAPM tend to be very close to those of the domestic CAPM, and even closer than to those of the single-factor global CAPM.

Liquidity and Stock Size Premia in Japanese Regional Financial Markets: An Industry Level Analysis

Equity markets are increasingly being seen as having a important role within the financial architecture focussed towards the financing of Small and Medium Enterprises (SME) firms that dominate regional economies. The high costs involved with lending small amounts to smaller firms in the presence of asymmetric information and the lack of economies to scale substantially reduce the competitiveness of the banking system in issuing cost effective relationship-based finance. Consequently well designed development and alternative investment boards with effective regulation and enforcement of disclosure rules can substantially reduce the high costs normally associated with stock exchange financing options. The Japanese regional exchanges have been able to reap significant economies of scale in achieving horizontal integration of their operations with a common clearing, settlements and payment systems largely through having a shared stable macroeconomic environment. While this enables their ability to compete with the lethargic regional banking sector it also facilitates the study of the informational premiums arising from the asymmetric information of focussing on SME financing. This paper estimates the costs of equity across major industry sectors in the three Japanese regional stock exchanges of Nagoya, Fukuoka and Sapporo as well as the very different internationally-focussed markets of Tokyo and Osaka. The Fama and French (1993) three-factor model Capital Asset Pricing Model is augmented to take account of company size and illiquidity factors that are prominent in regional markets. Results show that premia associated with size are dominant in valuation and cost of equity estimates for the international exchanges of Tokyo and Osaka while liquidity is the dominant factor in the three regional markets. Costs of equity are very low in Tokyo and much higher in Osaka, reflecting the limited role of the equity market in the latter in contrast to its specialization in other financial products. Costs of equity are substantially higher in all three regional exchanges reflecting a high informational or liquidity premium.

Foreign Exchange Exposure and Cost of Equity for U.S. Companies: Local Versus Global CAPM

For U.S. firms with extreme foreign exchange (FX) exposure levels, we ask whether the single-factor global CAPM yields significantly different cost of equity estimates from the local CAPM. For a sample of U.S. firms from 2000-2007, we find a clear and statistically significant relation between the differences of the two models’ cost of equity estimates and the firms’ FX exposure estimates. However, the economic significance is questionable, even for firms with extreme FX exposure levels.

Market liquidity and stock size premia in emerging financial markets: The implications for foreign investment

Equity markets are increasingly seen as important sources of investment funds in many emerging economies. Furthermore, many countries see the development of such markets as a means to facilitate both foreign equity portfolio investment and foreign direct investment (FDI). This may occur through acquisition of shareholdings in domestic companies, which supplements the low levels of funding from domestic savings. But many emerging stock markets exhibit substantial risk premia that increases the cost of equity for listed domestic firms and deters potential foreign investors. This paper estimates the cost of equity in four major African markets: South Africa, Kenya, Egypt and Morocco. These represent the largest and most developed equity markets in Africa and also act as regional hub markets. London is also included as a link between the emerging and developed financial markets. The Fama and French [Fama, E., & French, K. (1993). Common risk factors in the returns on stocks and bonds. Journal of Financial Economics, 33, 3–56] three-factor model capital asset pricing model is augmented to take account of company size and illiquidity factors that feature in African financial markets. The results show that the premia associated with size are more prevalent than with liquidity although both are highly significant in both valuation and cost of equity estimates. The evidence suggests that the lowest cost of equity is achieved in the two major international markets of London and Johannesburg, while the less-advanced North African markets of Morocco and Egypt have higher costs of equity. The developing Kenyan market has the highest cost of equity, although the costs associated with the main market are less than one-third of that in the Alternative Investment Market.

Market Liquidity and Stock Size Premia in African Emerging Financial Markets: The Implications for Foreign Investment

Equity markets are increasingly seen as important sources of investment funds in many emerging economies, both in Africa and elsewhere. Furthermore, many countries perceive the development of such markets as a means to facilitate both foreign equity portfolio investment and foreign direct investment (FDI) through the acquisition of shareholdings in domestic companies, and thus supplement the low levels of funding from domestic savings. But many emerging stock markets exhibit substantial risk premia, which both push up the cost of equity for listed domestic firms and deter potential foreign investors. This paper estimates the cost of equity in four major African markets: South Africa, Kenya, Egypt and Morocco. These collectively represent the largest and most developed equity markets in Africa and also act as hub markets in their respective regions. London is also included as a link between the emerging and developed financial market. The Fama and French (1993) three-factor model Capital Asset Pricing Model is augmented to take account of company size and illiquidity factors that feature in African financial markets. Results show that the premia associated with size are more prevalent than with liquidity although both are highly significant in both valuation and cost of equity estimates. The evidence suggests that the lowest cost of equity is achieved between the large international market of London and the smaller but well regulated Moroccan market, while Egypt has a higher cost of equity. The small developing market of Kenya has the second highest cost of equity, although the costs associated with the main market are less than ten percent of that faced by companies in the fledgling Alternative Investment Market. South Africa has the highest cost of equity although this reflects a proliferation of smaller firms in this market.

Risk and Ex Ante Cost of Equity Estimates of Emerging Market Firms

We examine the empirical relationship between estimates of ex ante cost of equity and risk for a sample of individual emerging market equities for the period 1990-2000. The ex ante cost of equity estimates are obtained using the residual income valuation model. As in studies that use mean realized returns on emerging market indexes, a measure of total risk (return volatility) is the most significant risk factor in explaining ex ante expected return estimates. For emerging market equities with substantial investability to global investors, global beta adds some explanatory power.

Cost of Equity Uncertainty and Rate of Return Regulation: Implications of New Developments in Financial Economics

Estimation of a corporation's cost of equity is crucial for various financial analyses. One area in which it is necessary is in rate of return regulation. In order for the regulator to set an appropriate rate of return, the corporation's cost of equity must be estimated accurately. This article examines the two most common methods used to estimate the cost of equity: the discounted dividend model and the capital asset pricing model. Recent developments in financial economics make traditional applications of these methods suspect. These developments are the use of share repurchases, and a prospective equity risk premium much lower than historic values suggest. The uncertainty described here, in combination with previously known sources of uncertainty, suggest that increased scrutiny of cost of equity estimates is warranted. Also, the ongoing search for improved models of the cost of equity should continue.

Unbiased estimation of expected return using CAPM

Estimation of expected return is required for many financial decisions. For example, an estimate for cost of capital is required for capital budgeting and cost of equity estimates are needed for performance evaluation based on measures such as EVA. Estimates for expected return are often based on the Capital Asset Pricing Model (CAPM), which states that expected excess return (expected return minus the risk-free rate) is equal to the asset's sensitivity to the world market portfolio ( β) times the risk premium on the “world market portfolio” (the market risk premium). Since the world market portfolio, by definition, contains all assets in the world, it is not observable. As a result, an estimate for expected return is commonly obtained by taking an estimate for β based on some index (as a proxy for the world market portfolio) and an estimate for the market risk premium based on a potentially different index and multiplying them together. In this paper, it is shown that this results in a biased estimate for expected return. This is undesirable since biased estimates lead to misallocation of funds and biased performance measures. It is also shown in this paper that the straightforward procedure suggested by Fama and MacBeth [J. Financ. Econ. 1 (1974) 43] results in an unbiased estimate for expected return. Further from the analysis done, it follows that, for an unbiased estimate, it does not matter what proxy is used, as long as it is used correctly an unbiased estimate for expected return results.

Handle with care: cost of equity estimation with the discounted dividend model when corporations repurchase

It is standard to use the discounted dividend model to estimate the cost of equity. The model is flawed, however, for corporations that repurchase shares. As many corporations have begun to repurchase significant amounts of their shares, the way this affects cost of equity estimates warrants study. This article illustrates that the discounted dividend model, as customarily applied, will lead to cost of equity estimates that are too low.

A Comparison of Cost of Equity Estimates of Local and Global CAPMS

Cost of equity estimates are compared for three pricing models: the traditional local CAPM, the single (market) factor global CAPM, and the two-factor global CAPM, with both market and currency index factors. For 2989 US stocks, the average difference in the cost of equity estimates is about 48 basis points between the local CAPM and the single-factor global CAPM, and is about 61 basis points between the two global models. For 70 developed-market ADRs, the corresponding average differences are 76 and 47 basis points, respectively. For 48 emerging-market ADRs, the corresponding average differences are 57 and 70 basis points.

ESTIMATING THE COST OF EQUITY FOR CORPORATIONS THAT REPURCHASE: THEORY AND APPLICATION

ABSTRACT The standard discounted dividend model provides flawed estimates of the cost of equity when corporations repurchase shares, which many now do. A simulation model shows that the discounted dividend model, as customarily applied, will lead to cost of equity estimates that are too low. A corrected model is developed, and illustrated with actual data.