Analysts' dividend forecasts, portfolio selection, and market risk premia

The most relevant practical impediment to an application of the Markowitz portfolio selection approach is the problem of estimating return moments, in particular return expectations. We analyze the consequences of using return estimates implied by analysts' dividend forecasts under the explicit notion of taxes and non-flat term structures of interest rates and achieve quite good performance results. As a by-product, these results cast some doubt upon the adequacy of estimating market risk premia with implied returns, because estimation techniques with good performance results are hardly suited to describe market expectations. --analysts' forecasts,CAPM,implied returns,market risk premium,portfolio optimization,return estimation

Implied rates of return, the discount rate effect, and market risk premia

We show analytically under quite general conditions that implied rates of return based on analysts' earnings forecasts are only a downward biased estimator for future expected one-period returns and therefore not suited for computing market risk premia. The extent of this bias is substantial as verified by a bootstrap approach. We present an alternative estimation equation for future expected one-period returns based on current and past implied rates of return that is superior to simple estimators based on historical returns. The reason for this superiority is a lower variance of estimation results and not the circumvention of the discount rate effect typically stated as a major problem of estimators based on historical return realizations. The superiority of this new approach for portfolio selection purposes is verified numerically for our bootstrap environment and empirically for real capital market data. --analysts' earnings forecasts,discount rate effect,equity premium puzzle,implied rate of return

Estimating the expected cost of equity capital using consensus forecasts

In this study, we develop a technique for estimating a firm’s expected cost of equity capital derived from analyst consensus forecasts and stock prices. Building on the work of Gebhardt/Lee/-Swaminathan (2001) and Easton/Taylor/Shroff/Sougiannis (2002), our approach allows daily estimation, using only publicly available information at that date. We then estimate the expected cost of equity capital at the market, industry and individual firm level using historical German data from 1989-2002 and examine firm characteristics which are systematically related to these estimates. Finally, we demonstrate the applicability of the concept in a contemporary case study for DaimlerChrysler and the European automobile industry

The implied equity risk premium - an evaluation of empirical methods

A new approach of estimating a forward-looking equity risk premium (ERP) is to calculate an implied risk premium using present value (PV) formulas. This paper compares implied risk premia obtained from different PV models and evaluates them by analyzing their underlying firm-specific cost-of-capital estimates. It is shown that specific versions of dividend discount models (DDM) and residual income models (RIM) lead to similar ERP estimates. However, cross-sectional regression tests of individual firm risk suggest that there are qualitative differences between both approaches. Expected firm risk obtained from the DDM is more in line with standard asset pricing models and performs better in predicting future stock returns than estimates from the RIM

Implied rates of return, the discount rate effect, and market risk premia

"We show analytically under quite general conditions that implied rates of return based on analysts’ earnings forecasts are only a downward biased estimator for future expected one-period returns and therefore not suited for computing market risk premia. The extent of this bias is substantial as verified by a bootstrap approach. We present an alternative estimation equation for future expected one-period returns based on current and past implied rates of return that is superior to simple estimators based on historical returns. The reason for this superiority is a lower variance of estimation results and not the circumvention of the discount rate effect typically stated as a major problem of estimators based on historical return realizations. The superiority of this new approach for portfolio selection purposes is verified numerically for our bootstrap environment and empirically for real capital market data." [author's abstract

The Implied Equity Risk Premium - An Evaluation of Empirical Methods

A new approach of estimating a forward-looking equity risk premium (ERP) is to calculate the implied risk premium using present value (PV) formulas. This paper compares implied risk premia obtained from dierent PV models and evaluates them by analyzing their underlying firmspecific cost-of-capital estimates. It is shown that specific versions of dividend discount models (DDM) and residual income models (RIM) lead to similar ERP estimates. However, the results of cross-sectional regression tests of individual firm risk suggest that there are qualitative dierences between both approaches. Expected firm risk obtained from the DDM is more in line with standard asset pricing models and performs better in predicting future stock returns than estimates from the RIM.equity risk premium, cost of capital, expected stock returns

Estimating the Intertemporal Risk-Return Tradeoff Using the Implied Cost of Capital

We reexamine the time-series relation between the conditional mean and variance of stock market returns. To proxy for the conditional mean return, we use the implied cost of capital, computed using analyst forecasts. The usefulness of this proxy is shown in simulations. In empirical analysis, we construct the time series of the implied cost of capital for the G-7 countries. We find strong support for a positive intertemporal mean-variance relation at both the country level and the world market level. Some of our evidence is consistent with international integration of the G-7 financial markets.

Understanding the implied market risk premium in analysts´ forecasts

Analysts play a preponderant role in asset price formation. Although there is abundant literature on analysts' outputs, such as price targets, few robust analyses are performed on valuation inputs. This paper explores a large sample of analysts’ market risk premium estimates, evaluating whether specific characteristics/incentives influence the parameter used when performing valuation exercises. We use publicly available I/B/E/S price targets to derive the implied market risk premium, obtaining an average of 5.15% for2010-2019. We then employ a multivariate regression analysis and document that analysts providing optimistic earnings forecasts use heftier risk premium estimates, possibly to maintain predetermined price targets

The Value Premium and Beta Premium Sensitivity using a Direct Market Estimates Approach

I study the relative risk of value and growth stocks using beta premium sensitivities and find that, on average, value stocks are less risky than growth stocks based on this measure. I find that value stock betas tend to covary less with the expected market risk premium than growth stock betas. Value stocks are therefore less susceptible to time-varying risk during recessionary periods when the expected market risk premium is high. My finding does not offer support for a risk-based explanation of the value premium. The beta premium sensitivity is a measure of the covariation between a stock's time-varying beta and the expected market risk premium. I derive expected stock returns, the expected market risk premium and expected market volatility using a direct market estimates approach. This is the first study, to my knowledge, that investigates the relative risk of value and growth stocks in this manner. Under the direct market estimates approach I use professional stock analysts' forecasts and the CBOE VIX index to derive expected stock returns and the expected market volatility respectively. I also use an instrumental (conditioning) variables approach for comparison, as has been used in previous research, under which I derive expected returns using predictive regressions. My results using instrumental variables are in the opposite direction to those using direct market estimates, whereby I find that value stocks are riskier than growth stocks on average based on beta premium sensitivities. The divergent results do not appear to be caused by the tendency for professional stock analysts' forecasts to exhibit optimism, as both the direct market estimates and instrumental variables approaches exhibit more optimism for growth stock forecasts relative to value stock forecasts