Foundations and Trends® in Accounting >
Vol 2 > Issue 4

By
**Peter Easton**, Center for Accounting Research and Education, The University of Notre Dame, peaston@nd.edu

Peter Easton (2009), "Estimating the Cost of Capital Implied by Market Prices and Accounting Data", Foundations and Trends® in Accounting: Vol. 2: No. 4, pp 241-364. http://dx.doi.org/10.1561/1400000009

© 2009 P. Easton

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**In this article:**

*Estimating the Cost of Capital Implied by Market Prices and Accounting Data* focuses on estimating the expected rate of return implied by market prices, summary accounting numbers, and forecasts of earnings and dividends. Estimates of the expected rate of return, often used as proxies for the cost of capital, are obtained by inverting accounting-based valuation models. The author describes accountingbased valuation models and discusses how these models have been used, and how they may be used, to obtain estimates of the cost of capital.

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1. Introduction

2. Valuing the firm

3. Changing the focus to valuation of equity and introducing reverse engineering

4. Reverse engineering the abnormal growth in earnings valuation model: PE ratios and PEG ratios

5. Reverse engineering the residual income valuation model to obtain firm-specific estimates of the implied expected rate of return

6. Reverse engineering the abnormal growth in earnings valuation model to obtain portfolio-level estimates of the implied expected rate of return

7. Reverse engineering the residual income valuation model to obtain portfolio-level estimates of the implied expected rate of return

8. Methods for assessing the quality/validity of firm-specific estimates

9. Extant firm-specific estimates are poor

10. Bias in estimates of the expected rate of return due to bias in earnings forecasts

11. Dealing with shortcomings in firm-specific estimates

12. Methods for determining the effect of a phenomenon of interest on the cost of capital

13. Data issues

14. Some thoughts on future directions

References

*Estimating the Cost of Capital Implied by Market Prices and Accounting Data* focuses on estimating the expected rate of return implied by market prices, summary accounting numbers, and forecasts of earnings and dividends. Estimates of the expected rate of return, often used as proxies for the cost of capital, are obtained by inverting accounting-based valuation models. The author describes accounting-based valuation models and discusses how these models have been used, and how they may be used, to obtain estimates of the cost of capital. The practical appeal of accounting-based valuation models is that they focus on the two variables that are commonly at the heart of valuations carried out by equity analysts – forecasts of earnings and forecasts of earnings growth.

The question at the core of this monograph is: How can these forecasts be used to obtain an estimate of the cost of capital? The author examines the empirical validity of the estimates based on these forecasts and explores ways to improve these estimates. In addition, this monograph details a method for isolating the effect of any factor of interest (such as cross-listing, fraud, disclosure quality, taxes, analyst following, accounting standards, etc.) on the cost of capital. If you are interested in understanding the academic literature on accounting-based estimates of expected rate of return this monograph is for you.

*Estimating the Cost of Capital Implied by Market Prices and Accounting Data* provides a foundation for a deeper comprehension of this literature and will give a jump start to those who have an interest in these topics. The key ideas are introduced via examples based on actual forecasts, accounting information, and market prices for listed firms, and the numerical examples are based on sound algebraic relations.