Title:

Properties of implied cost of capital under alternative valuation models and analyst behaviour: evidence from the U.K.

Investors have strong incentives to assess the expected return of common equity as an important
variable in portfolio management, capital budgeting, investment appraisal and resource allocation
decision. A relatively novel methodology of estimating the expected return links market prices with
analystissued expected cash flows to deduce the implied cost of equity capital. The purpose of this
thesis is to evaluate five earningsbased implied cost of capital estimates and to assess the sensitivity
of earningsbased implied cost of capital against a number of parameters introduced by alternative
equity valuation models and analyst behaviour.
The dissertation utilizes a relatively large dataset ofU.K. firms for the period 19942003. The
individual and joint assessment of implied cost of capital estimates bears upon the investigation of
several empirical questions. In particular, an examination of the average magnitude of implied cost of
capital estimates measures the degree of meanpoint accuracy of these estimates, in relation to
expected return. Comparative statistics and a set of (non)parametric tests of independence are used to
assess the proximity/departure of the distributions of alternative implied cost of capital estimates.
Cases of extreme divergence among the estimates are marked by relative values of exante
characteristics and a breakpoint level of implied cost of capital.
The ability of implied cost of capital to characterize crosssectional variation in expected equity return
is evaluated through tests of linear association between implied cost of capital estimates and a number
of firm/industry specific risk factors, includingthe special cases of Research and Development and
Advertising expenditure. Incrementally, the usefulness of implied cost of capital estimates as
parsimonious predictors of realized return is assessed, with return predictability tests carried out
against various forecasting horizons, at firm and industry levels, across particular clusters of stocks,
and under the assumption that a firm's risk premium is a positive function of the market excess return.
Finally, the impact of analyst behaviour on the quality of earnings forecasts and, pervasively, on the
quality of earnings based implied cost of capital estimates is examined. Several attributes of analyst
behaviour are initially identified as sources of analyst bias. These attributes are then quantified with
the use of easily measurable proxy variables facilitating the development of an econometric model that
predicts analyst forecasting errors, and the consolidation of fitted values of expected errors in the
estimation process of' adjusted' implied cost of capital estimates. The variation of implied cost of
capital estimates across analyst investment recommendation is hypothesized and tested, and the cases
of analyst forecast sluggishness and/or thin trading leading to information mismatch between analyst
expectations and market prices are considered.
The results of this thesis are of interest to researchers dedicated to the implied cost of capital, the
crosssection of expected returns, earnings based equity valuation, model equivalence, analyst
earnings forecasts, analyst behaviour, and, to a minor extent, the U.K. aggregated equity risk premium.
The tests performed are sufficient in clearly designating the preferred implied cost of capital estimate.
A number of implications for academics and practitioners are discussed.
