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Discussion of “on the relation between expected returns and implied cost of capital”

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Abstract

This paper discusses the paper “On the relationship between expected returns and implied cost of capital” by Hughes, Liu, and Liu. The discussion focuses on developing the intuition behind the mathematical results and on extensions of the analysis that future research could address.

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Notes

  1. An exception is the “target price” valuation method approach, where the current price is compared with discounted future dividends over, say, a 4-year horizon and a target price 4 years into the future. This approach generally assumes the discount rate is constant over the next 4 years, but makes no assumptions beyond that. That is, the target price is free to reflect whatever assumption regarding future discount rates is deemed appropriate. This approach still requires some constancy of the discount rate (e.g. 4 years), but this is less extreme than assuming constancy in perpetuity. See Ogneva et al. (2007) for a summary of alternative methods of estimating implied cost of capital.

  2. See Gebhardt et al. (2001) and Easton et al. (2002) for example.

  3. While discount rate volatility information isn’t relevant for this period’s one period discount rate (which is known), it is relevant for future discount rates. As a result it is relevant for the rate at which you could exchange dollars today for dollars more than one period away. In addition, this volatility is important in “futures” rates; e.g. what rate you would pay now to be able to invest a dollar starting one period from now.

References

  • Easton, P., Taylor, G., Shroff, P., & Sougiannis, T. (2002). Using forecasts of earnings to simultaneously estimate growth and the rate of return on equity investment. Journal of Accounting Research, 40, 657–676.

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  • Gebhardt, W., Lee, C., & Swaminathan, B. (2001). Toward an implied cost of capital. Journal of Accounting Research, 39, 135–176.

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  • Hughes, J., Liu, J., & Liu, J. (2009). On the relation between expected returns and implied cost of capital. Review of Accounting Studies. doi:10.1007/s11142-009-9093-8.

  • Ogneva, M., Subramanyan, K., & Raghunandan, K. (2007). Internal control weaknesses and cost of equity: Evidence from SOX 404 disclosures. The Accounting Review, 82(5), 1255–1297.

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  1. The Wharton School, University of Pennsylvania, Philadelphia, PA, USA

    Richard A. Lambert

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  1. Richard A. Lambert
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Correspondence to Richard A. Lambert.

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Lambert, R.A. Discussion of “on the relation between expected returns and implied cost of capital”. Rev Account Stud 14, 260–268 (2009). https://doi.org/10.1007/s11142-009-9097-4

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  • DOI: https://doi.org/10.1007/s11142-009-9097-4

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