Review of Accounting Studies, 8, 399–431, 2003
# 2003 Kluwer Academic Publishers. Manufactured in The Netherlands.
Inferring the Cost of Capital Using the
DAN GODE* email@example.com
Stern School of Business, New York University, 40 W 4th St, Suite 427, New York NY 10012
Columbia University, Graduate School of Business, 605-A Uris Hall, New York, NY 10027
Abstract. We compare risk premia (RP) inferred using the Ohlson-Juettner (RP
) and residual income
) models in three ways: (1) correlation with risk factors; (2) correlation with RP estimated
by multiplying current realizations of risk factors by coefﬁcients obtained from regressing prior-year RP
on prior-year risk factors; and (3) correlation with ex post returns. RP
has expected correlations with
risk factors, a modest correlation with RP estimated from prior-year regressions, and an economically
signiﬁcant association with ex post returns. RP
has generally higher correlations, but regression
coefﬁcients are sensitive to whether the industry median ROE is computed with or without loss ﬁrms.
Keywords: implied cost of capital, ex-ante cost of capital, risk premium, equity valuation, risk
JEL Classiﬁcation: M41, G12, G31, G32
Equity valuation models use a discount rate to estimate the present value of expected
dividends. Following Capital Asset Pricing Model (CAPM), the discount rate is
often expressed as the sum of the equity risk premium (RP) plus the risk-free rate.
Because the risk premium is not directly observable, it is inferred ex post from
realized returns or ex ante from the current price and expectations of future
dividends. Inferring the risk premium from realized returns has been problematic
because the correlation between expected returns and realized returns is weak (Elton,
1999). This has led to attempts to infer the risk premium ex ante (Harris and
Marston, 1992, 2001; Marston and Harris, 1993; Claus and Thomas, 2001; Gebhardt
et al., 2001).
In the ex ante approach, one infers the risk premium from the current price and
future expected dividends. Yet market expectations of future dividends are not
publicly observable. Instead, the closest publicly observable proxies for market
expectations are earnings estimates from sell-side analysts. Moreover, analysts do
not report their forecasts of the entire earnings stream. They report the forthcoming
or one-year-ahead earnings per share (eps
), two-year-ahead eps (eps
), and, in many
cases, the expected earnings growth over the next ﬁve years.