Discussion Paper Series 2016-E-9

Simultaneous Estimation of Cost of Equity and Expected Earnings of Individual Firms with the Residual Income Model

Tetsuya Adachi, Takashi Asano, Tatsushi Okuda

On the basis of the residual income model, this paper proposes a statistical model for inferring implied cost of equity (COE) from cross-sectional data on stock prices and firms' attributes. The model is estimated using a quasi-maximum likelihood approach to simultaneously identify the COE, expected earnings growth rates, and expected excess earnings durations of individual Japanese firms listed on the First Section of the Tokyo Stock Exchange (excluding the financial industry sector). The estimation results show that the individual firms' attributes, such as industry sector, cash-flow/price, and dividend/price, are key determinants of the COE. Besides, the distribution of individual firms' COE has changed over time, which suggests that it is crucial to take account of market conditions and financial situations of the firms in the estimation. Moreover, our estimates of the firms' COE have a positive relation with expected returns on their stocks, and that relation is stronger than those obtained with existing models.

Keywords: Implied cost of equity; Residual income model; Quasi-maximum likelihood approach

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 2016 Bank of Japan All Rights Reserved.

Home Japanese Home