Types of Investor Uncertainty and Cost of Equity

Abstract

This study examines the explanatory power of different sources of investor uncertainty for expected stock returns and implied costs of equity. We develop novel estimates of two sources of investor uncertainty, one related to future performance and unrelated to accrual errors (cash flow uncertainty) and one related to investor uncertainty of future performance because of accrual errors (information quality uncertainty). Distinct from prior studies, our estimates of investor uncertainty are forward-looking, represent conditional volatilities surrounding expectations of future cash flows and accruals, and are based on a matched-firm process that minimizes the mechanical correlation between the two uncertainty variables. Our tests reveal that different types of investor uncertainty have different, and countervailing, effects on cost of equity in a manner directionally consistent with theory. We find a strong negative relation between cash flow uncertainty and multiple estimates of cost of equity with economic magnitudes similar to those on book-to-market and accruals. In addition, incremental to cash flow uncertainty, we find a strong positive association between information quality uncertainty and future stock returns. Collectively, our study offers the first direct empirical evidence that different sources of investor uncertainty can have countervailing effects on costs of equity.