The role of market efficiency on implied cost of capital estimates: an international perspective
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The role of market efficiency on implied cost of capital estimates: an international perspective David Schröder1 Received: 10 May 2019 / Accepted: 30 September 2020 © Springer-Verlag GmbH Germany, part of Springer Nature 2020
Abstract This study examines the role of market efficiency on international differences in the usefulness of the implied cost of capital (ICC) to measure expected stock returns. The analysis exploits cross-country differences in market efficiency around the world using a variety of empirical measures of market efficiency. A key methodological contribution of this paper is to assess the quality of the ICC as estimate of expected returns by evaluating its forecast error for subsequent stock returns. The results show that the accuracy of the ICC as measure of expected stock returns is positively associated with the countries’ level of market efficiency. Keywords Implied cost of capital · Expected stock returns · Market efficiency · Analyst forecasts · Mispricing · Cross-country study JEL Classification G12 · G14 · G15 · G18 · K00 · M41
1 Introduction The implied cost of capital (ICC) is the internal rate of the return that equates a firm’s market price to discounted earnings forecasts. Since the first articles appeared, the ICC has been used as estimate of expected returns in many different areas in accounting
I am grateful to Walter Beckert, Florian Esterer, Charles Lee, Anne Villamil (the editor) and two anonymous reviewers for their helpful comments and discussions. I would like to thank Patrick J. Kelly, Ladislav Kristoufek and Swisscanto for providing me with the data. Any remaining errors are mine.
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David Schröder [email protected] Birkbeck College, University of London, Malet Street, Bloomsbury, London WC1E 7HX, United Kingdom
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and finance.1 As the computation of the ICC explicitly relies on equity market prices, any price distortions caused by market inefficiencies are expected to reduce the quality of ICC estimates. However, there is little empirical evidence about the link between market efficiency and the ICC so far, especially in an international context. This paper thus examines international differences in the usefulness of the implied cost of capital (ICC) to measure expected stock returns across 30 countries. In particular, this study investigates whether the ability of the ICC to predict the cross-section of stock returns is systematically related to the countries’ degree of market efficiency. The analysis exploits cross-country differences in market efficiency around the world using a variety of empirical measures of a country’s level of market efficiency, including autocorrelation patterns of stock market returns, transaction costs and analyst coverage. Prior research by Griffin et al. (2010) and Kristoufek and Vosvrda (2013) documents large cross-country differences in market efficiency. Using various concepts of market efficiency, these studies show that equity markets in developed economies tend to be more efficient relative to emerging economi
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