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Estimating the Cost of Capital Using Stock Prices and Near‐Term Earnings Forecasts

Earnings-based valuation models, although long used by finance practitioners, have become increasingly popular among finance academics as well. Among the most important reasons for academics' increased acceptance of earnings-based valuation is the well-documented claim that earnings over a short (three- to four-year) forecast horizon tend to capture a large fraction—as much as 80%—of today's value, much more than is captured by near-term forecasts of free cash flow, the measure long advocated by finance theorists as the basis for DCF valuation. But most important for the purposes of this article, the recognition that such a large percentage of the current values of many public companies is captured within a short forecast horizon has led to a large academic literature that uses earnings-based valuation models together with current stock prices to “back out” estimates of the companies' implied expected rates of return and costs of equity capital. The effectiveness and precision of such reverse engineering depend on the reliability of the forecasts both within a finite forecast horizon and beyond. And although the models tested in academic work, which are based on large samples of forecasts and hard-to-verify assumptions about earnings beyond the forecast horizon, often do not appear to provide useful estimates, the author argues that such reverse engineering of the valuation models should become straightforward and workable once reliable forecasts of earnings are obtained—say, from the corporate (or investment) analysts who are familiar with the operations of the companies they work for (or cover).