Mathijs van Dijk publishes in the Journal of Accounting and Economics

<link erim research centres erasmus_finance faculty _blank>Mathijs van Dijk’s paper “The Implied Cost of Capital: A New Approach” (co-authored with Kewei Hou and Yinglei Zhang) proposes a new proxy for a firm's expected returns (or cost of equity capital) based on a firm’s “Implied Cost of Capital” (ICC) – defined as the internal rate of return that equates the firm’s stock price to the present value of expected future cash flows. The ICC has been developed in the early 2000s and has gained considerable popularity in academic studies and in investment management applications. The common approach to estimate the ICC uses analysts’ earnings forecasts to proxy for cash flow expectations. However, recent empirical evidence suggests that the performance of the analyst-based ICC as a proxy for expected returns is not satisfactory. In addition, analyst forecasts are only available for a subset of firms.

Instead, the authors propose a “model-based ICC” that relies on earnings forecasts stemming from a parsimonious cross-sectional model. They show that 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, they find that the model-based ICC is a more reliable proxy for expected returns than the ICC based on analysts’ forecasts.

The authors apply their model-based ICC to re-evaluate a number of the well-known anomalies in the cross-section of U.S. stock returns and find that the conclusions are sensitive to the choice of expected return proxy (average ex post realized returns vs. ex ante model-based ICC).