Framework Of Estimating Implied Cost Of Equity Capital

Only when investors forecast that the rate of return on investment is more thanrequired rate of return, i.e. cost of equity capital, can investors choose the investmentobjective.This means if they can not estimate the cost of equity capital accurately,investors might make a false option.Implied cost of capital refers to the discount rate which makes the assets valueequal the present value of the expected earning in the future. The accuracy of theevaluation depends on the accuracy of the estimated model, the reliability of theearnings forecast and the rationality of the stock intrinsic value. However, if there issystematic bias for analyst's earning forecast or stock value is replaced by stockprice, the result's correctness of the implied estimate of cost of capital will beinfluenced. Meanwhile, there is a big difference on the calculation result of differentestimate models of implied cost of equity capital. It's hard to for investors to make adecision.Stock price includes investors'expectation to enterprise's prospect and theexpectation to the fluctuation of the stock market. Since cost of equity capital is thebasis of long-term investment, stock's short-term fluctuation which occurs whenstock price fluctuates along with the market should be removed. The study builds aframework of estimating the cost of equity capital based on the outcome of literaturereview: firstly, de-biased analyst forecast, i.e., remove the systematic deviation ofanalyst earning forecast in advance to get the market earning forecast; secondly,stock bubble filter, i.e., filter the bubbles in stock price and get the expected value ofstock intrinsic value; thirdly, the estimation of implied cost of equity capital, i.e., optimizing a method to calculate the implied cost of equity capital based onde-biased earning forecast in advance and the stock price filting bubbles.The original data had been retained from CSMAR database, Chinese Economicdatabase, ifeng.com website and put into SQL Server database to be processed there.The general statistical analysis including regression analysis has been completed bySPSS16.0. As for the processing of time series data ,EViews 6 is applied to completeit.This research measured and calculated Shanghai Composite Index (SCI) during1998 to 2010. During the period of from May to December, 2005 and from August toOctober, 2008 and so on, SCI was lower than the basic market value and was in anegative bubble range. SCI was far higher than the basic market value in October,2007. This research calculated 1134 listed companies for A stock in Shanghai andShenzhen between 2003 and 2010 and compared the result with the original date ofanalyst's earning forecast. The skewness decreased by 9.33%, 8.79% and 14.47%respectively for phase 0, phase1, phase 2 when the the deviation of the earningforecast was removed in advance; The mean of the implied cost of equity capital is12.97%,16.42%,14.59%, 6.42%, 6.47% and 10.77% respectively calculated by the sixestimation models: DIV1, DIV2, OJ, PFE, RIV1 and RIV2 based on de-biasedearning forecast and the stock price after the bubbles have been removed. Connectingthe implied cost of equity capital with the future realized returns, cost of equitycapital and the accumulative reward realized in next quarter, next two quarters and tillnext three years conformably have a significant positive correlation(P<0.001)estimated by PFE model. The findings show that PFE model with both debiasedearning forcast and filtered stock price has the strongest forecast capacity. In contrast,PFE model and the future realized returns don't have a long-term consistent positivecorrelation when neither of the earging forcast nor stock price having been treated,which has verified the validity of the framework. In practice, this study provides a reasonable framework of estimating the cost ofequity capital. It is very important to remove the bias of analyst earnings forecastsand the bubbles of stock price, and the PFE model should be the preferred one.Also, this study extends the arbitrage pricing model (ATP), which investigateseffects of macroeconomic factors and firm-specific risk factors on the stock returns toat the same level. this study establish a hierarchical model to analyze the effect ofmacroeconomic factors on the stock market and the one of the market on each stock.There are two innovations in this study. The first one is the measure of theintrinsic value of a stock. Cointegration tests and error correction model are used toexplore the long-run equilibrium relationship between the macroeconomic variablesand SSCI, and then the stock market bubble was calculated based on the deviationfrom the equilibrium.Stock bubble is derived from stock price to get its intrinsic value.The secone one is the creation of a complete three-step framework of the implied costof equity capital estimation including the earnings forecast bias removing, the stockbubbles filtering, and the selecion of the optimized estimation model.