Resolving the Reliance on Fixed Estimation Dates in the Implied Cost of Equity Capital Approach

Abstract

Abstract Our study’s objective is to develop and analyze a dynamic approach for estimating firms’ expected cost of equity capital. We contribute to the literature by enabling the usage of any required estimation date, resolving the major shortcoming of the existing models—their reliance on one fixed estimation date. This paper presents our model and discusses it from the perspective of the extant body of literature. We show that the current state of the art approach in dynamic estimation does not satisfy theoretical and practical demands, and offers scope for significant improvements. We conduct our analysis by specially considering capital market efficiency, the consistent appreciation of cash flows with respect to timing, and straightforward practical implementation for researchers and practitioners. Building on semi-strong capital market efficiency, the analysis reveals further insights into residual income valuation as we demonstrate that any realization of residual income in the course of the year is irrelevant to valuation in the absence of dividend realization. Consequently, assumptions regarding the shape of earnings in the course of the year are also irrelevant to valuation. Additionally, our theoretically founded model conveniently facilitates the undistorted incorporation of different fiscal year-ends in large samples and avoids stale measures of expected cost of equity capital.