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PORTFOLIO OF STOCKS

Peter Easton

Ohio State University

and

University of Melbourne

Gary Taylor

University of Alabama

Pervin Shroff

University of Minnesota

Theodore Sougiannis

University of Illinois

July 2000

**We thank Jeff Abarbanell, Doug Hanna, John O’Hanlon, Richard Leftwich, Steven Monahan, Jim
**

Ohlson, Ken Peasnell, Stephen Penman, Peter Pope, Stefan Reichelstein, Greg Sommers, Paul Taylor,

Martin Walker, Dave Williams, two anonymous referees, and workshop participants at the University

of California, Berkeley, the University of Chicago, Lancaster University, Manchester University, the

University of Minnesota, New York University, the Ohio State University, the University of Oregon,

and the University of Utah for helpful comments on earlier drafts.

ABSTRACT

We invert the residual income valuation model (using current stock prices, current book value

of equity and short-term forecasts of accounting earnings) to obtain an estimate of the expected rate of

return for a portfolio of stocks. Our approach is analogous to the estimation of the internal rate of

return on a bond using market values and coupon payments.

Estimation of the cost of equity capital by inverting the residual income valuation model requires

an estimate of growth in residual income beyond the forecast horizon. The contribution of our method

is that we use the stock price and accounting data to simultaneously estimate the unique implied growth

rate and the internal rate of return. This growth rate provides an adjustment for the fact that our

estimate of the internal rate of return is based on current book value of equity and short-term earnings

forecasts.

Our analysis of DJIA firms yields estimates of expected growth that are considerably higher

than those assumed by earlier studies. Our estimated market premium over the risk-free rate is closer

to the historical premium than that obtained by other studies using earnings forecast data.

After completing the pro-forma forecasting of earnings (as described in, Penman [2000], for

example) and/or after obtaining analysts’ forecasts of earnings for a number of firms with comparable

operating activities, our method may be used to estimate the market’s expectation of the cost of capital

and growth for these firms. These estimates for comparable firms may be used to determine the

intrinsic value of an unlisted firm, a division of a firm, or a firm that is believed to be relatively

over/under-valued.

1.

**INTRODUCTION AND SUMMARY
**

We invert the residual income valuation model (using current stock prices, current book value

**of equity and short-term forecasts of accounting earnings) to obtain an estimate of the expected rate of
**

return for a portfolio of stocks. Our approach is analogous to the estimation of the internal rate of

return on a bond using market values and coupon payments.

Estimation of the cost of equity capital by inverting the residual income valuation model requires

an estimate of growth in residual income beyond the forecast horizon. The contribution of our method

is that we use the stock price and accounting data to simultaneously estimate the unique implied growth

rate and the internal rate of return. This growth rate provides an adjustment for the fact that our

estimate of the internal rate of return is based on current book value of equity and short-term earnings

forecasts.

Recent papers (notably Fama and French [1997]) have demonstrated shortcomings in

estimates of the cost of equity capital based on historical data. Use of the historical market premium to

estimate the expected premium and basing estimates of risk loadings ($s) on a long time-series of data

introduce a high degree of estimation error. Recognizing the problems associated with the use of

historical data, recent studies have relied on analysts’ earnings forecasts and the residual income

valuation model to form estimates of cost of equity.1 However, as a practical matter, forecasts are

available only for a finite horizon, necessitating assumptions about earnings beyond the forecast horizon.

Most prior studies assume an expected rate of growth in residual earnings in order to calculate

1

For example, Claus and Thomas [1998], and Gebhardt, Lee, and Swaminathan [1999].

1

**a terminal value. While Claus and Thomas [1998] provide an economic argument for estimating the
**

rate of growth in residual income beyond the forecast horizon as three percent less than the risk free

rate, they provide no empirical analyses as to whether this estimate is reasonable. Frankel and Lee

[1999], Lee, Myers, and Swaminathan [1999], and Gebhardt, Lee, and Swaminathan [1999] assume

the rate of growth beyond the I/B/E/S forecast horizon that is implied by fading the firm’s return-onequity to the industry median return-on-equity over varying forecast horizons. Their only justification

for this assumption is that this fade “captures the long-term erosion in return-on-equity over time”.

They do not examine the empirical validity of this assumption.

Estimates of the cost of equity (r) may be very sensitive to assumptions about the rate of

growth in residual income (g) and the literature provides little guidance as to the appropriateness of any

particular assumed rate. Unlike these papers, which use ad hoc arguments to support an assumed

rate of growth, we estimate the rate of growth that is implied by market prices, book values, and the

finite period forecasts of accounting earnings.2

Our estimate of the expected cost of equity capital (r) is also based on analysts’ forecasts of

accounting earnings. However, unlike extant studies, we simultaneously estimate the cost of equity as

well as the expected rate of growth in residual income (g) from these data. Our estimate of g is the

unique perpetual growth rate such that market price is equal to the book value plus the discounted

2

**The following argument, suggested by a referee, provides useful intuition here. “Surely what we
**

assign to g is taken away from r (the market has simply given us r-g). If g is artificial then the

corresponding r is also suspect. Noise in the parsing process translates into noise in the discount rate

estimate.” The extant literature uses economic arguments as a basis for assigning g’s that are not implied

by the market prices, book value and earnings forecasts and the consequent error is parsed to the

estimate of r. In contrast, our method breaks r-g into the unique r and the unique g that are implied by

market prices, book values and analysts’ earnings forecasts.

2

We define g as the perpetual rate of growth in residual income such that market price is equal to book value plus the present value of this four-year residual income growing in perpetuity. The advantage of this approach is that the estimate of the cost of equity is not dependent on assumptions regarding the expected rate of growth. The method could be readily applied to longer time periods if forecast data became available. Our forecast data permit the calculation of aggregate earnings for the subsequent four-year period and hence residual income for the entire four-year period. Dividing both sides of this linear expression by book value leads to a simple linear relation between the current price-to-book ratio and the ratio of the sum of the earnings forecasts for the subsequent four years to current book value.present value of residual income.g and the expected rate of return r. book values. This specification leads to a linear (regression) 3 We use four years of forecasts because that is the longest time period for which data are readily available. and forecasts of earnings. simultaneously calculating r and g provides an estimate of r that recognizes and adjusts for the fact that our estimate is based on book value and short horizon forecasts of earnings. our estimate of the expected rate of growth is the rate implied by market prices. We invert the residual income valuation model and we use forecasts of earnings obtained from I/B/E/S. we express current price as a linear function of current book value and expected aggregate four-year earnings. Rather.3 The multiples on book value and aggregate earnings are both functions of r and g. Thus. 3 . In other words. there are two unknown variables -. recorded book values. and observed market prices to solve for estimates of the cost of equity and expected growth in residual income. Using the residual income valuation model as the foundation. The residual income valuation model equates price with the sum of book value and the present value of expected residual income.

our estimates of r range from 11 percent to 16 percent. Lee.S. For the years 1981 to 1998. (See “Security Price Index Record Statistical Service”. Myers.relation in which both the intercept and the slope coefficient are functions of r and g permitting the estimation of these variables. stock market.DJIA).6 Based on this 4 The historical premium is the average obtained from Ibbotson Associates [1998]. and Swaminathan [1999] use an estimated r and the assumption that g is the rate of growth in residual income that is implied by “fading” the firm’s return-on-equity toward its industry median over a long horizon.8 percent premium in contrast to the 3 . 5 The actual realized growth in earnings for the S&P index over our sample period was 7. For the overall sample. To the extent that our sample of I/B/E/S stocks represents the U.92 percent. The relatively low estimate of the premium in these studies may be due to their somewhat arbitrary assumptions about the rate of growth in residual earnings beyond the forecast horizon. the average estimated growth in earnings is 10. 6 They note the following reason for the potential lack of validity of this assumption: a firm’s return-on-equity would not be expected to fade to the historic industry median return-on-equity -.4 Our estimates of growth in residual earnings g imply rates of growth in earnings that range from 7 percent in 1992 to 11 percent in 1981. [1998]: 298-303). Our estimated premium over the risk-free rate (proxied by the 5-year Government T-Bond rate) is between 6 percent and 8 percent in recent years. These estimates are similar to the historical 6 . application of our model to this entire sample provides an estimate of the expected return on the market.rather it will fade to the expected industry median.4 percent obtained by other studies that use forward-looking data to estimate r. Examples of studies that have estimated the ex ante premium are Claus and Thomas [1998] and Gebhardt.5 The simultaneous estimation of r and g is potentially critical to the evaluation of a stock or an index (such as the Dow Jones Industrial Average -.6 percent. Since the industry return-on-equity will change from being high to low as the stage of the life-cycle of the firms in the industry changes from the growth phase 4 . Standard and Poors. and Swaminathan [1999]. Lee.

for example) and/or after obtaining analysts’ forecasts of earnings for a number of firms with comparable operating activities.assumption.7 through the stable phase and then the decline. However. After completing the pro-forma forecasting of earnings (as described in. Penman [2000]. However. 7 We estimate firm-specific expected rates of return in the latter part of the paper using samples of firms matched on industry and market capitalization. this implies that the return-on-equity will decline asymptotically toward the expected cost of equity capital. or a firm that is believed to be relatively over/under-valued. our method may be used to estimate the market’s expectation of r and g for these firms. Arguments that the DJIA was rationally priced at the end of 1998 would need to justify these high expectations.8 percent in 1982 and the highest is 13. These matches are a crude attempt at finding comparable firms. 5 . the method may also be useful in firm valuation. Of course. The most obvious application of our method is the estimation of the internal rate of return from an investment in a portfolio of stocks (as we demonstrate in this paper). The expected rate of return r associated with the expected g of 13. We use market prices for the DJIA stocks to determine the market’s expectation of r and g for the DJIA for each of the years for which we have data. a division of a firm. after the return-on-equity has faded to the industry median the residual income continues at a constant level in perpetuity (that is the rate of growth is zero). Zhang [1999] shows that this will not occur when accounting is conservative. they conclude that the DJIA is over-valued in recent years. The lowest expected g is 5. These estimates for comparable firms may be used to determine the intrinsic value of an unlisted firm. say.6 percent in 1998 is 15. Since book value will generally continue to grow. the assumption that the historic industry median return-onequity will be equal to the expected return-on-equity may not generally hold as a practical matter. an initial public offering which they are attempting to value.7 percent per year in perpetuity.6 percent in 1998. Further. investment bankers could reasonably be expected to compile a set of traded firms that are comparable with. Myers. Lee. their conclusion depends crucially on the validity of their assumption regarding g. and Swaminathan [1999] assume that.

book value. each of the next four years may be summed to obtain aggregate earnings for the entire four-year period and hence residual income for this period. permitting the estimation of these variables. and the forecasts of earnings. the forecasts of earnings for. using the residual income valuation model as the foundation. we use the fact that accounting earnings may be summed over time. in effect. and stock prices. is derived in this section.1. They show that this aggregation of earnings over varying time intervals leads to increasing explanatory power of earnings for returns as the returns interval increases. is at the core of the empirical analyses in Easton. which may be simply illustrated by the fact that annual earnings are equal to the sum of four quarterly earnings. 6 . This specification leads to a linear (regression) relation in which both the intercept and the slope coefficient are functions of the cost of equity capital and growth in residual income. obtained by inverting the residual income model using the estimate of growth that is implied by market prices. In other words. and Ohlson [1992]. The estimate of the cost of equity capital is the internal rate of return that is. THE ESTIMATION PROCEDURE Our procedure for determining the cost of equity capital using forecasts of earnings. we express current price as a linear function of current book value and expected aggregate four-year earnings. recorded book values. The multiples on book value and aggregate forecasted earnings are both functions of r and g.2. The procedure has two essential elements.8 Second. Dividing both sides of this expression by book value leads to a simple linear relation between the current price-to-book ratio and the ratio of aggregate forecasted earnings-to-current book value. say. 2. Harris. First. The Residual Income Valuation Model The no arbitrage assumption and clean surplus accounting are sufficient to derive the residual 8 This attribute.

B0 is the book value per share at time 0. In contrast. book values and forecasts of earnings. Prior studies estimating r from the residual income valuation model assume a forecast horizon and calculate a terminal value that captures residual earnings beyond the horizon. Since the growth rate is assumed. 7 . r is the only unknown variable. and [Xt . Xt is the (comprehensive) earnings per share for fiscal period t-1 to t. r is the expected rate of return.r Bt-1] is the residual earnings per share for period t-1 to t. The terminal value is generally calculated by treating the horizon residual earnings as a perpetuity growing at an assumed rate. which is then inferred from the model. Clean-surplus accounting requires that reported book value of common equity at time t is equal to reported book value of common equity at time t-1 plus net income available to common shareholders for period t-1 to t minus net capital contributions to/from shareholders at time t. E0 is the expectation operator with expectations conditional on the information available at time 0. Equation (1) may be re-written to isolate the finite period for which we have forecasts of 9 The no arbitrage assumption has been shown by Rubinstein [1976] to be sufficient to derive the dividend discount model.income valuation formula:9 (1) where P0 is the market price per share at time 0. our approach involves the simultaneous estimation of r and the rate of growth that are implied by the market prices.

X1.earnings: (2) Recognizing that. in period t reduces next period earnings by rdt. d3. In order to operationalize model (2) we treat the four-year residual earnings [from equation (4)] as a perpetuity and we define g as the (unknown) annual growth rate such that: 10 The steps in deriving equation (4) involve expression of B3. under clean surplus accounting. d2. 8 . consistent with the assumption of no arbitrage and the Miller and Modigliani [1961] propositions. This term captures the present value of expected abnormal profitability over the next four-year period recognizing the notion (underscored in Ohlson [1995]) that. dt. the first summation of equation (2) may be rewritten as follows:10 (4) where R = (1+r)4 is one plus the four-year expected return on equity and XcT is aggregate four year cum-dividend earnings. d1 and B0 and collecting terms. (3) where dt is the dividend payment per share at time t. payment of dividends. and B1 as functions of X3. X2. B2.

(5) where G = (1+g) 4 is one plus the expected rate of growth in four-year residual income. In other words. For example. Our estimate of r (together with current price. simultaneously calculating r and g provides an estimate of r that recognizes and adjusts for the fact that our estimate is 11 We define g as the expected average annual rate of growth in residual income from the date on which the forecasts of earnings are made. are taken into account when calculating r. would permit the estimation of the internal rate of return implied by the current price. for example. This definition differs from the definition more frequently encountered when using the residual income model in equity valuation (see. Previous applications of the residual income model generally define g as the growth in residual income from the last year for which a forecast of earnings is available. and the four years of earnings forecasts. The core issue is estimation of g (or g4) so that the residual income model can be inverted to obtain an estimate of r. In other words. the residual income model is often based on the following formulation: where g4 is the growth in residual income from the fourth year onwards. g is the unique growth rate.11 The fouryear growth rate of (1+g)4-1 is the rate such that the present value of the growing perpetuity (beginning with the four-year expected abnormal earnings calculated via equation (4)) explains the difference between price and current book value. when four years of forecasts are available. Penman [2000] and Claus and Thomas [1998]). which. 9 . book value. if known. The advantage of simultaneously calculating this rate and the cost of equity capital is that the effects of GAAP accounting which lead to (1) a difference between book value and price and (2) short term forecasts of earnings being not necessarily indicative of long run earnings. book value and forecasts of earnings) may be used to determine the rate of growth g4 by inverting this formulation of the model.

Dividing equation (5) by book value B0.that is. different GAAP may lead to a different estimate of g and a different estimate of r. For example.g provides this adjustment. residual income beyond the forecast horizon will be high relative to residual income within the forecast horizon -.based on book value and short horizon forecasts of earnings -. Myers. From equation (2) it is evident that. g will be large. and re-arranging yields: (6) where (6a) (6b) The linear relation between P0/B0 and XcT/B0 in (6) suggests that the average four-year cost of equity capital (R-1) and the average four-year growth in residual income (G-1) may be estimated from the intercept and the slope coefficients from a linear regression. This caveat applies to all of the studies cited in this paper that use forecasts of earnings to estimate r or implicit prices. a change in GAAP that leads to different earnings within the forecast horizon would lead to different implicit prices in Lee. if the forecast of residual income over the finite forecast-horizon (four years in our example) is small relative to the difference between price and book value. providing a corresponding unique estimate of r. Although g adjusts for the fact that our estimate of r is based on book value and short horizon forecasts of earnings. and Swaminathan [1999]. For any firm j we can observe price 12 It is evident from the residual income valuation formula (equation (1)) that the difference between price and book value indicates the sign of future residual income and a high price-to-book ratio implies high (positive) future residual income. 10 .12 The remainder of the analyses in this section is the development of a procedure for simultaneously estimating g and r.

Thus. and AjcT is the forecasted aggregate cum-dividend 13 That is: (6d) 11 . We rely on the idea that we can define an unobservable variable XjcT such that:13 (6c) That is. As a practical empirical matter we estimate the following regression relation: (7) where " 0t is the regression intercept parameter to be used as an estimate of (0. We design (below) an estimation procedure that overcomes the effects of this error. The procedure is as follows..2. XjcT is the aggregate cum-dividend earnings that would obtain if all J observations had the same R and G.4 and assuming E0[dt]= d0.. t=1. there are three sources of error in this proxy: (1) R and G may vary across the sample of observations. and (3) expected dividends may not equal dividends paid at date 0.2. Our method of estimation of R and G takes this into account. t=1..Pj0 and the corresponding book value Bj0 but we must obtain a proxy for aggregate expected future earnings XjcT...4. Our empirical proxy for XjcT is obtained by using I/B/E/S analysts’ forecasts as the measure of E0[Xt]. " 1t is the regression slope parameter to be used as an estimate of (1.. (2) the market’s expectations of future earnings may differ from I/B/E/S forecasts.

calculated as follows: (7a) where E0(I/B/E/S) is the I/B/E/S forecast of earnings (Xjt) for firm j at date 0 and dj0 is the actual dividend payment for firm j for the period ending at date 0. they would have earned roughly the historical market return. the estimate of r for the entire cross-section of observations in 1985 when we calculate cum-dividend earnings using a 12 percent rate is 0. After calculating r and g based on this assumption. The error introduced by using the empirical proxy AjcT reduces the R2 and biases the estimate of the regression slope coefficient downward.14 If we could observe XjcT. Of course. and if we were to use these observations in regression (7) instead of AjcT . an unbiased estimate of the coefficient may be obtained by dividing its estimated value by the estimate of the R2:15 14 We begin by assuming that the displacement of future earnings due to the payment of dividends is 12 percent of the dividend payment based on the assumption that.earnings for the four year period t =1 to t =4. Since the downward bias in the estimate of the slope coefficient is directly proportional to the decrease in the R2 from one. For example.12702 and the estimate after one iteration is 0. the R2 would be one.12871. Estimates of g are virtually unchanged for this sample. the change in our estimates of r due to this refinement is very small even in the first iteration.in our case 12 percent. we then re-calculate expected cum-dividend earnings by compounding the expected dividends (according to equation (7a)) at our estimated r. The essence of the argument is as follows.12839. We repeat this procedure until the revision in the estimate of cum-dividend earnings leads to no change in our estimates of r and g. it is probable that for a portfolio of firms with very high dividend payout ratios. if these dividends had been retained in the firm. Their paper provides a detailed analysis of the point that the downward bias in the estimate of the slope coefficient in regression (7) will be proportional to the decrease in the R2 from one. We then repeat the regression analysis with this revised estimate of cum-dividend earnings to obtain revised estimates of r and g. Then we use the following iterative procedure for dealing with the fact that calculation of aggregate cum-dividend earnings should be based on r rather than an assumed rate -. 15 Ryan and Zarowin [1991] make a similar point in the context of overcoming the effects of measurement error on estimates of the earnings response coefficient. Let :j 0 = 12 . the estimates of the cost of equity capital may vary considerably across the iterations. After two iterations it is 0. For each of our samples.

Assuming that :j 0 is independent of Pj 0/Bj 0 and XjcT /Bj 0.that is.that is. R. the negative roots also exist but these are economically meaningless. DATA AND SAMPLE SELECTION We illustrate our method of estimating r and g using the following data. the variances of XjcT /Bj 0. 13 . and F2P are.16 3. the estimate of the slope coefficient is FxP /(F2x+F2:) and the estimate of the regression R2 is (FxP )2/[(F2x+F2:)F2P ] where FxP is the covariance of XjcT /Bj 0 and Pj 0/Bj 0. Note that both the estimate of the slope coefficient and the regression R2 are biased downward from their true values because of the addition of F2: in the denominator. 16 We take the positive fourth roots of our estimates of (1+g)4 -. respectively.and (1+r)4 -. and F2x. Of course. :j 0. F2:. " 0c and " 1c are consistent and unbiased estimates of (0 and (1.AjcT /Bj 0 be the error in the regression independent variable. The same data have been used in the numerous other studies based on the residual income valuation model cited elsewhere XjcT /Bj 0 . G -. and Pj 0/Bj 0. and These estimates of (0 and (1 and equations (6a) and (6b) are used to obtain estimates of r and g.(8) and (9) where " ^1 is the estimate of the slope coefficient from regression (7) and R2 is the coefficient of determination from this regression.

1995) and either forecasts for each of the fiscal years ending December 31. our method may be used by analysts who have created their own forecasts). adding forecasted earnings (for the year ending approximately 10 days after the forecast) and subtracting net capital contributions. These data included forecasts for a fiscal year ending just 10 days later (that is. That is. We determine median forecasts from the available analysts’ forecasts on the I/B/E/S file released on the third Thursday of December. 1998 and 1999 or the forecast for the fiscal year ending December 31. 1997.17 Earnings forecasts are derived from the summary 1999 I/B/E/S tape. Note. the December 1995 forecasts became available on 21st December. We include only firms with December fiscal year.in this paper. however. 18 We deleted firms with non-December year-end so that the market implied discount rate and growth rate are estimated at the same point in time for each firm-year observation. Accordingly.18 For observations in 1995. tertiary and full coverage research files. Book value of equity (data item 60). in effect we have forecasts for the subsequent four years. we use the forecast for 1996 17 Observations with negative book value are deleted. we use the actual forecasts for each subsequent year (in this example. 1996. We use actual yearend book values (from Compustat) since most of the earnings and dividend activity are known by the third Thursday of December. secondary. and number of shares outstanding (data item 25) are obtained from the 1999 Compustat annual primary. 1996 through 1999) and when these forecasts are not available. 1996 and a forecast of growth in earnings for the subsequent three years (1997 through 1999).end. results must be interpreted with caution. for example. When available. The results are robust to using forecasts of year-end book value obtained via the clean surplus relation. price at fiscal year-end (data item 199). forecasts of book value are determined by taking opening book value. that our purpose is to illustrate how the method could be used if reliable forecasts were available (for example. Like these studies we do not attempt to adjust for possible biases in the forecast data. That is. December 31. 14 .

14 for the 1981-1985 time period to 0. 15 . The estimate " 1tc of the slope coefficient ranges from a low of 3. 19 In this example.546 observations.17 in 1984 to a high of 6. 4. the estimate of the intercept is negative in every year ranging from a low of -3. we caution the reader that conclusions about changes across years may reflect changes in sample composition rather than changes in the underlying (stock-market wide) variables.26 in 1998 to a high of -1. The annual average r and g are 0. Since the sample composition changes over time.13 and 0. Accordingly.and calculate forecasts for 1997 through 1999 using the I/B/E/S forecasts of growth in earnings. Although there is an obvious timetrend in r from an average of 0.10.13 for the 1995-1998 time period.242 firms in 1998. Equation (6a) suggests that the estimate " 0tc of the intercept coefficient will be negative -.30 in 1984.76 in 1998. EMPIRICAL ANALYSES Descriptive statistics for the sample firms are provided in Table 1. and the predicted sign of the denominator is positive since an expected rate of return which is less than the expected rate of growth in residual income would imply an infinite value. firm-year observations with a negative forecast of earnings for 1996 are deleted because growth from this negative base is not meaningful in our context. The pooled adjusted R2 is 42. The annual sample size increases each year from a low of 756 firms in 1981 to 2.the predicted sign of the numerator is negative since G is expected to be greater than one on average.19 Our sample covers the years 1981 to 1998 and includes a total of 26. respectively. we do not draw conclusions from this because of the change in sample composition over time.2 percent.

22 We considered repeating the analyses for the sub-sample of firms that survived the entire period for which we have data.22 The estimated premium in recent years is between 6 percent and 8 percent. However. the Treasury-bond rates for each year are included as the last column of Table 1. the difference between r and the T-bond rate) is positive.4 percent obtained by prior studies that use analysts’ forecasts to estimate r (for example. and Swaminathan [1999]).The annual estimated g remains relatively constant over the sample period. The relatively low premium obtained in these studies may be partly attributed to the fact that they assume g rather than estimating it 20 Source: Ibbotson Associates [1998] 21 The validity of comparisons with the T-bond rate is limited by the fact that we are calculating an r for the infinite horizon future while the T-bond rate is for a finite five-year horizon.20 Second. Again this may reflect change in sample composition (we will return to this point). In view of recent arguments in the popular press that market expectations may be overly optimistic. we provide some additional statistics to help address the question. are the market’s expectations regarding rates of return reasonable? First.8 percent premium based on historical data (Ibottson Associates) in contrast to the 3 .21 As expected our estimate of the premium (that is. Panel B. The very low estimated premium in the early years of the data is partially explained by the fact that I/B/E/S concentrated on large firms during this period. Lee. This is similar to the 6 . the average return on the Standard and Poors 500 Index over the years 1926 to 1998 was 13 percent which equals the expected rate of return for 1998. The difference between the estimate of r and the estimate of g decreases significantly from 1981 to 1998. time-trends in the estimates of r and g for these data may represent no more than the changing economic characteristics of this particular group of firms over this portion of their life-cycle. Claus and Thomas [1998] and Gebhardt. 16 .

However. S. Steel (Coke) were eliminated as outlying observations.9 percent in 1992 to a high of 12. Proctor & Gamble. The average estimate of Gearn for the entire time period 1981 to 1998 is 11. These firms had either a price-tobook ratio or an aggregate forecasted earnings-to-book value ratio in the top/bottom 1% of the entire sample.089 (0.155 and 0. 5. American Tobacco Brand. book 17 .8 percent which is greater than the actual growth in earnings for the S&P 500 index of 7.094 (0.156 and 0. In several years a DJIA firm was excluded as an outlier. In 1981 I/B/E/S began reporting the long term earnings growth rate. This introduces error due to the mis-alignment of prices. in 1981 long term growth rates are missing for: Allied Signal. in the early years of the sample this is a missing data item for several firms. General Foods. Steel (Coke) in 1981 (1998) changes the estimates of the cost of equity capital and growth in residual earnings from 0.170 and 0. Including Bethlehem Steel and U. These estimates range from a low of 9.simultaneously with r. JohnsManville.. Sears Roebuck & Co.92 percent.157 and 0. International Harvester. In the early (later) years of the sample Bethlehem Steel and U. Note. The implied growth in earnings (Gearn) is also reported in Table 1. ANALYSES OF SUB-SAMPLES We consider several sub-samples of the data in order to demonstrate the application of our method of estimation. S. These estimates are greater than our estimates of Gearn in every year for which we have data. The number of observations is between 27 and 29 in the 1990s but declines to only 23 observations in 1982 and 18 observations in 1981. There are many reasons for the lack of data.6 percent in 1998.606 and significant at least at the 0. The annual estimates of r and g for the Dow Jones Industrial firms are detailed in Table 2. The Spearman correlation between the I/B/E/S forecasts of long term growth in earnings and our estimates of Gearn is 0.23 23 Our estimates are for the firms in the DJIA for which we have complete data.150). Standard Oil of California.01 level. respectively. We also provide I/B/E/S forecasts of long term growth (ltg). We also include DJIA firms with fiscal years ending in months other than December.136) to 0. however. For example. Some of these are as follows. that our growth estimate is for an infinite horizon while the I/B/E/S forecast is for a much shorter horizon (about five years). Owens-Illinois. and Woolworth.

Consistent with the results from Table 1. These estimates of r and g reflect the apparent bull market this country has experienced over the last few years. may suggest that. However. the estimates of g and r are very similar whether or not these observations are included. We leave conclusions regarding mispricing to the reader. These rates. however.6 percent in 1998. coupled with an expected growth in residual income of 13. the current high level of the DJIA can be explained by the small difference between expected return on equity and expected growth in residual earnings. However. At the end of 1998.html.dowjones. The following question. there is a significant negative relation (correlation coefficient of -0. the average annual return on the DJIA over values and the date of the earnings forecast.7 percent. and Swaminathan [1999] to conclude that the Dow Jones group of stocks is over-valued. Assuming an expected growth of zero (or one that allows a firm’s return-on-equity to fade to its industry median) leads Lee. perhaps the market was overly optimistic. 18 . The average annual return over the entire history of the DJIA (1896 to 1998) is 7. In other words. We provide a detailed example of the implications of fading the firm’s returnon equity to its industry median in Appendix 2. the market’s expected rate of return on the DJIA was 15.86) between r-g and time. still remains: Is the market’s expected rate of return on the DJIA realistic? Since the focus of this paper is simply on estimating the market’s expectations of cost of equity capital (rather than using these estimates to comment on the rationality of the market) we only provide some statistics that may shed some light on this question. This rate is greater than the historic average return on the DJIA. 24 The source of data on the DJIA is the web-site http://averages. Myers.9 percent.24 Over the period during which there have been thirty stocks in the DJIA (1928 to 1998) the average annual return has been 7 percent.com/home.

operating risk will be higher if either the debt-to-equity ratio is higher or if the cost of debt is higher. the annual return has been greater than 15. Maydew and Weiss [1997] and Easton. r and g are much higher in the intangible intensive industries than the more stable regulated utilities industry. 26 Caution must be exercised when comparing our estimates of the cost of equity capital. and 357 (computer and office equipment).6 percent). and 87 (engineering.and the average annual return over the past four years has been much higher (24.our sample period (1981 to 1998) is 15. say. firms that have comparable accounting methods and firms of similar operating risk) in order to estimate the expected rate of return for a firm that. This application at the industry level provides a sense of what the method may yield if informed market analysts were to estimate the model for a group of similar firms (that is. 73 (business services). is not traded. 283 (drugs). slightly less than the expectation of 15. This classification of intangibles intensive firms is also used by Collins.7 percent in eleven of the eighteen years of our sample period. and three digit SIC codes 282 (plastics and synthetics). As expected. We have estimated the cost of equity capital which differs from the cost of capital for the operations of these industries. For the same level of equity risk. and management related services). Utility firms are defined as firms in the four-digit SIC codes 4900-4953 (electric.that is.25 We chose these industries because we have priors about expected r and g and a comparison of our estimates of r and g provide a basis for assessing the validity of these priors. in recent years. Table 3 presents the annual estimates of r and g for firms deemed to be in intangible intensive industries (Panel A) and in the utilities industry (Panel B). Shroff and Taylor [1999].4 percent -.7 percent -. R&D. accounting. r minus g is much lower for the intangible intensive industry 25 Intangible intensive firms are defined as firms in the two-digit SIC codes 48 (electronic components and accessories). 19 .26 Also. gas and sanitary services). This is consistent with the intangible intensive industries being more risky and tending to have higher expected future earnings as the effects of the earnings from the assets that are not recorded on the Balance Sheet start to accrue. Furthermore.

To gain an indication of the empirical relation between our estimates of the expected rate of return and variables that have been associated with expected returns in the extant literature (see.1 percent of the observations. OTHER VARIABLES ASSOCIATED WITH EXPECTED RETURNS. reflecting the high valuations placed on technology firms by the bull market in these years. We successfully match 31. for example. analysts using the model to calculate firm-specific estimates of cost of equity capital could achieve much better matches. stock market is particularly pertinent to our sample period.S.3 percent of the observations in this way. then on 2-digit code. realized returns are a very poor proxy for expected returns.8. Lee. If at least 20 matches are not available at the 4-digit level. Our matching is admittedly crude: arguably. He states: “In the recent past.compared to utilities. They find that the observation of a significant correlation between expected returns and realized returns is due to just one of the 48 industries in their sample (and this industry includes observations for just two firms on average). 35. 20 . 6. Fama and French [1992]). as Elton [1999] observes.27 We estimate firm-specific expected rates of return by matching each observation to 20 other firms. However. For each observation in each year we match firms via SIC codes. we match on 3-digit SIC code. Does anyone honestly believe that this was the riskiest period in history for the United States and the safest for Asia?” Furthermore.8 and 20. and finally on 1-digit code (we match 12. his observation should be underscored in our study where our estimates of expected returns are for the long-run future rather than for the short-run. and Swaminathan [1999] are consistent with Elton’s postulate. For each year of the sample we first seek at least 20 matches based on 4-digit SIC code. 27 It is tempting to compare our estimates of expected returns with return realizations. His observation regarding the U. The results of analyses of industry portfolios in Gebhardt. we analyze the correlation between our estimates of the expected return and these variables. the United States has had stock market returns of higher than 30 percent per year while the Asian markets have had negative returns.

when estimating r for a portfolio of stocks. say. This issue and many others associated with the practical implementation of the residual income valuation model are discussed in detail in Penman [2000]. However. $jt the estimate of the riskiness of returns for firm j implied by the capital asset pricing model. Differences in accounting methods across firms are averaged out via the regression.28 We then calculate the expected rate of return for these 20 observations using the procedure discussed in Section 2 and we assign that estimate to the subject firm. a non-traded firm by calculating the r and g for a similar set of firms. Descriptive statistics for each of these indicators of risk and for our estimate of the cost of 28 As a practical matter. the same observation applies. we may also wish to apply the estimate of g to the accounting data of the non-traded firm. and EPjt is ratio of earnings per share to price per share for firm j at the end of year t. Betas are estimated from the market model using a maximum of 60 and a minimum of 24 monthly returns up to the month prior to the earnings forecast release date t using the CRSP Value-Weighted Market Index and the Dimson [1979] correction for non-synchronous trading (monthly returns on individual stocks are obtained from the CRSP monthly returns file). g adjusts for the fact that the book value and forecasts of earnings are accounting numbers.respectively). We examine the correlation between our estimate of expected return rjt and each of the following variables: sizejt the natural logarithm of the market capitalization (that is. When using the method to calculate the cost of capital for. price per share multiplied by number of shares outstanding) of firm j at the end of year t. within the sets of firms matched on SIC codes. BPjt is ratio of book value to market value for firm j at the end of year t. Then. 21 . This may necessitate some adjustments to the accounting data of the non-traded firm to ensure that they are comparable with those of the comparable firms. we select the 20 observations that have a market capitalization that is closest to the market capitalization of the subject firm.

In light of Fama and French [1992] we are not surprised that we do not find a positive correlation between beta and expected return.312 and 5. only 0. The correlations between rjt.351).043.028).083 with a t-statistic of -2. Second.equity capital (rjt) are provided in Table 4. We simply note that this negative relation was also observed by 22 . however. The Spearman correlation between the expected cost of equity capital and beta is negative -0.40. The average of the annual correlations among each of the risk measures are reported in Table 5. We offer two explanations for this result. the empirical observation of a relation between firm-size and returns has been driven primarily by relatively very small firms while I/B/E/S tends to provide forecasts for larger firms.943 estimates of the cost of equity capital is 7. positive and significant (Spearman correlations of 0. the correlation with size is close to zero (0. book-to-price and earnings-to-price are. The estimates of the cost of equity capital range from -8. consistent with our expectations.1 percent of these estimates are negative: no estimates are significantly negative at the 0.6 percent to 33.05 level (the minimum t-statistic is -1. The negative correlation is. there is a more or less symmetric distribution of risk from lower than the market portfolio to higher than the market portfolio. The median t-statistic for our 21. First. Estimates of beta are centered around one and range from -2.164 with t-statistics of 3.341 million).59).499 to 4. The mean earnings-price ratio is 0. consistent with the higher prices of stocks observed in recent years. The average ratio of book-to-price is 0.128 and 0. However. difficult to explain. Even with our crude matching procedure.1 percent.627 reflecting the period from which we have drawn our sample and the fact that I/B/E/S tends to cover larger firms (median size of 4.194. the relation between firm size and returns that was documented for earlier periods has not been evident in the decade of the 1990s which is the period from which we draw most of our sample firms.925: that is.

or a firm that is believed to be relatively over/under-valued. for example) and/or after obtaining analysts’ forecasts of earnings for a number of firms with comparable operating activities. the book-to-price ratio and firm size a little differently.29 7. 29 Gebhardt. Lee. and Swaminathan [1999] observe a negative relation between beta and their estimate of the cost of equity capital in comparisons across quintiles of observations where the quintiles are based on estimated beta. Simultaneous estimation of these estimates provides a means of adjusting for the reliance of our method on book value of equity and forecasts of accounting earnings for a short horizon. These estimates for comparable firms may be used to determine the implicit value of an unlisted firm. Lee. Although we calculate beta. Lee. Since they do not report correlations between their firmspecific estimates of cost of equity capital and each of the risk factors. Penman [2000]. our calculations of the correlations among these variables (and the levels of significance of these correlations) are very similar to theirs. and Swaminathan [1999] for this sample of firms. we cannot draw comparisons. our method may be used to estimate the market’s expectation of r and g for these firms. the method may also be useful in firm valuation.Gebhardt. However. not surprisingly. a division of a firm. and Swaminathan [1999] report Spearman correlations among each of their risk measures. After completing the pro-forma forecasting of earnings (as described in. We repeat the point made in the introduction that the most obvious application of our method is the estimation of the internal rate of return from an investment in a portfolio of stocks. REITERATING THE PRACTICAL IMPLICATIONS We have developed a method for determining estimates of expected cost of equity capital and expected growth in residual earnings. Gebahardt. 23 .

Appendix 1 Derivation of an estimate of the growth in earnings Gearn from our estimate of growth in residual income g Although our estimate of growth in abnormal earnings is a fundamental ingredient in the implementation of the residual income model. Standard and Poors. is as follows. the more common estimate of growth in the academic literature and in the business press is growth in earnings. then this equation becomes:30 (a2) 30 An assumption about expected dividends is a necessary part of the derivation of a formula for growth in earnings. Gearn. analysts (such as I/B/E/S. This estimate (denoted Gearn) is a function of our estimates of r and g. For example. Note that the purpose of this Appendix is to show how growth in earnings is related to growth in residual income and to provide a formula for estimating a growth variable with which academics and investors are more familiar. we can write: (a1) Assume E0(dt) = d0 for all t. We provide estimates of Gearn in our empirical analyses in Section 4. 24 . The derivation of our estimate of growth in earnings. The derivation of our estimate of growth in earnings is provided in this Appendix. Value Line and Zacks) provide forecasts of earnings rather than abnormal earnings and management frequently give growth forecasts for their firm’s earnings. g. From the definition of growth in residual income.

then: (a6) Re-arranging yields our formula for four year growth in earnings: (a7) 25 .where: (a3) Since. under clean-surplus accounting: (a4) it follows that: (a5) If we define Gearn as the geometric average annual growth in earnings from the first four years to the second four years.

For example. The extant literature uses economic arguments as a basis for assigning g’s and the consequent error is parsed to the estimate of r. our method estimates the unique r and the unique g that are implied by market prices.65. an assumed growth rate of 0.417 and its forecasted return-on-equity at the end of 26 . This procedure is used by Frankel and Lee [1999]. The illustration is based on a detailed analysis of Merck as at December 31.Appendix 2 Implications of Fading the Return-on-Equity to the Industry Median Return-on-Equity A motivation for our paper is the observation that estimates of implicit price (as in Lee. Lee. Although an error of half of one percentage point in the estimate of the rate of growth may seem large. and Swaminathan [1999]) are very sensitive to the assumed rate of growth in residual income beyond the forecast horizon. and Lee. In contrast.50 with a corresponding expected g of 0. and Swaminathan [1999]) and estimates of the cost of equity capital (as in Gebhardt. Myers. 1998. A small change in the assumed g can cause a considerable change in the estimate of implicit value. Lee and Swaminathan [1999]. Ceteris paribus. and Swaminathan [1999]. close examination of the data suggests that the use of fade rates as a means of dealing with future growth. The aim of this appendix is to illustrate the issues associated with assuming the g that is implied by fading the firm’s return-on-equity to the historic median industry return-on-equity.058 would suggest an implicit price of $129. Merck’s return-on-equity in 1998 was 0. Gebhardt. if g is artificial then the corresponding implicit price or the corresponding r is suspect. at the end of 1998. book values and analysts’ earnings forecasts. In short.063. may introduce a great deal of error.60 an assumed growth rate of 0.068 would suggest an implicit price of $172. Myers. Merck’s price per share was $147.

18.50 and this (implicit) assumption of a very low g leads to a very low estimate of the cost of equity capital (0. -0. -0. The method used by Lee.004. For example. and 15 percent imply intrinsic values of $22.the I/B/E/S forecast horizon (2002) was 0. The problems.01. -0.27.94 in 2012 to 0. and Swaminathan [1999]) using the market price of $147. Lee.00 in 2013. which seems unlikely.03. We have chosen Merck because it provides a vivid illustration of the problems associated with imposing an assumed g rather than using the data to estimate g.91). In other words. and Swaminathan [1999] is to assume that this return-on-equity will fade over the years 2003 to 2010 from 0. -0. -0. -0.344 to the industry median return-on-equity which was 0. Lee.03.46. and Swaminathan [1999].94. 0. amounts to assuming the following rates of growth in residual income for the years (2003 to 2010) beyond the forecast horizon -. Lee. Lee. 0. and Swaminathan [1999] and Lee. -0.31 The rates of growth in earnings are very similar to the rates of growth in residual earnings (0.07. 0. -0. will be present whenever the assumption about the future return-on-equity differs from the market’s expectation. -0. -0.73. Myers and Swaminathan [1999] assume that g changes abruptly from -0.0.001).07.11. -0. Myers. More realistic estimates of r coupled with these low estimates of g lead to estimates of intrinsic value that are much lower than market prices.01. and $13.11.05. This very low return-on-equity.28.28.18. Myers.45. the assumed g is too low. 27 .05. -0.41. 10.344. and Swaminathan [1999] and Gebhardt. $16. Inverting the residual income valuation model (as in Gebhardt. use this assumed g and historical estimates of the cost of equity capital to estimate intrinsic value. respectively. -0. however. estimates of r of 5. In order to give an indication of the pervasiveness of problems associated with the use of 31 Gebhardt.

and Swaminathan [1999] and 28 . This observation underscores the sensitivity of the estimate of r in Gebhardt. For each of the DJIA 30 stocks the estimate of the cost of equity capital is lower than the return-on equity. Considering the pessimistic forecast of future profitability. if the historic median industry return-on equity is low. The 2001 expected return-on-equity based on I/B/E/S forecasts is. The importance of estimating both r and g rather than assuming g is also emphasized by the estimates of implicit price in the last three columns of table A2. Although this is possible. and Swaminathan [1999] to their assumption about the rate of growth g. this seems to suggest rates of growth that are low particularly in view of the fact that these rates are assumed rates of growth in real -. the estimate of the cost of equity capital is low. The role of both r and g is evident from equation (5) -. Table A2 provides summary statistics for the analyses of the 30 stocks comprising the Dow Jones Industrial Average as of December 31.not nominal -. 1998. on average. r-g will be small (large) and the perpetual residual income will be divided by a very small (large) number. The implied cost of equity capital (based on this assumption) for an equally-weighted portfolio of DJIA firms is 7 percent which is only slightly above the five-year Treasury Bond rate of 5. the implied riskiness of these firms is remarkably low.earnings.fades in return-on-equity as a means of implicitly assuming g. suggests a considerable decline in the future profitability of these firms.if the assumed g is similar to (different from) the estimated cost of equity capital. Further. Lee. These prices are formed by taking the g that is assumed by Lee. In other words. In other words. we observe that the assumed rate of growth in earnings in 2010 is negative for eleven of the 30 DJIA firms. assuming that the firm’s return-on-equity fades to the industry median return-on-equity. 78 percent higher than the historic industry median return-on-equity.1 percent. Myers.

applying costs of equity capital r of 5. 10. These estimates are all less than the estimate of the rate of return on the DJIA of 15. 29 .7 percent which we estimate for 1998 and report in Table 3. and 15 percent. As in the Merck illustration these implicit prices vary considerably as we change the cost of equity capital.

75 106.38 31.50 236.924 -0.177 0.004 0.99 91.277 0.38 336.001 -0.169 -0.19 7.216 0.87 Disney 0.53 10.232 -0.047 184.152 0.036 -0.48 Johnson & Johnson 0.49 International Paper 0.00 141.64 43.72 108.16 24.083 -0.078 0.41 76.051 0.41 3M 0.038 72.153 0.64 27.48 39.878 83.108 0.259 0.091 53.268 0.63 68.042 44.211 0.14 26.074 -0.024 0.90 57.148 0.086 0.129 -0.035 25. 1998 Return-on-Equity Forecasted growth in: Implicit Price DJIA Company 2001 I/B/E/S forecast Industry Median Implied r Residual Income in 2010 Earnings in 2010 Market Price r=0.143 -0.49 54.14 General Motors 0.87 23.362 0.023 0.27 16.104 -.120 -0.136 0.937 -0.98 General Electric 0.22 24.338 0.061 75.47 34.31 9.34 Hewlett-Packard 0.67 35.155 0.378 0.04 Exxon 0.074 -0.052 -0.094 0.54 50.63 Alcoa 0.56 154.184 0.41 Boeing 0.136 0.004 0.010 71.19 30.58 22.21 53.029 102.223 -0.81 88.078 0.88 12.73 13.30 16.284 0.39 27.077 -0.74 American-Express 0.031 0.046 0.127 0.101 76.35 51.098 0.21 24.086 -0.002 -0.75 I BM 0.15 AT&T 0.090 0.41 54.025 0.06 14.10 Caterpillar 0.43 170.224 0.191 0.047 -0.154 0.077 0.261 0.31 99.313 0.151 0.56 128.06 50.13 73.084 102.094 25.060 32.42 15.80 48.11 48.906 147.83 5.075 0.61 Chevron 0.38 145.81 123.34 Morgan JP 0.047 71.191 0.302 0.60 31.96 18.70 23.135 0.128 0.26 Eastman Kodak 0.084 -0.085 0.117 71.38 20.105 50.79 46.058 105.13 43.305 0.56 233.212 0.050 0.10 r=0.131 -0.049 67.284 0.91 12.56 53.146 0.Table A2: Analyses of the firms in the Dow Jones Industrial Average as at 31 December.44 39.114 0.56 50.22 92.300 -0.54 Allied-Signal 0.151 0.00 102.137 0.171 0.163 0.78 30.013 74.38 McDonalds 0.06 214.113 0.034 0.00 68.035 -0.091 44.21 30 .10 21.066 -0.50 22.174 -0.017 71.130 71.48 19.154 0.56 139.161 0.194 -0.19 25.12 Citigroup 0.071 71.152 0.28 Dupont 0.10 Coca Cola 0.181 0.12 Merck 0.180 0.26 34.83 26.089 0.068 0.024 0.255 0.001 0.05 r=0.161 0.67 Goodyear 0.058 -0.

05.26 Average 0.053 -0.089 0. Industry Median is the historic median return-on-equity for the firm’s industry calculated using up to ten years of prior data and the Fama and French [1997] industry classifications (following the method in Gebhardt.069 86.070 -0.31 16. Lee and Swaninathan [1999].257 0.10. Lee and Swaninathan [1999]).07 54. 1998.50 46.024 42.116 42.Philip Morris 0.70 31.148 0.225 0.06 98.387 0.152 0. Forecasted growth in residual income in 2010 is the implied rate of growth is residual income from 2009 to 2010.137 0.132 0.054 0.251 0.15).18 17.137 0.117 -0.314 0. Forecasted growth in earnings in 2010 is the implied rate of growth is earnings from 2009 to 2010.07 36.10 21.017 0.075 -0.515 0.77 Union Carbide 0. Implicit price is the price implied by the forecasted patterns of return-on-equity and the imputed estimate of the cost of equity capital (r=0.50 131.138 0.182 0.044 0.17 35. Roebuck 0. and r=0.018 91.59 Wal-Mart 0.102 0.91 8.151 0. Market price is the price at the close of trade on December 30.034 0.12 UTD Tech 0.54 Sears.141 0.039 0.053 -0.075 -0.034 108. Spreadsheets used to calculate these implied costs of equity capital using the data for each of the DJIA firms are available from the authors. r=0.50 102.85 34.75 194.058 53.044 Notes to Table A2: I/B/E/S forecast is the forecast of return-on-equity based on I/B/E/S forecast of earnings as at 17 December 1998 and forecasts of dividends using the assumption of a constant dividend payout ratio as in Gebhardt.40 68.00 62. Implied r is the implied cost of equity capital obtained by inverting the residual income model after fading the 2001 forecasted return-on-equity to the industry median return-on-equity in 2010.77 19.22 10. 31 .81 Proctor & Gamble 0.

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130 1983 1098 -1.35 0.10 0.125 0.03 0.37 5.59 4.165 0.04 0.105 0.05 0.66 3.074 1992 1460 -1.067 1995 2042 -2.13 0.05 0.585 0.14 0.140 0.12 0.137 0.425 0.133 0.126 0.30 3.085 1990 1169 -1.108 1984 1158 -1.419 0.434 0.04 0.05 0.97 3.76 0.01 0.119 0.11 0.17 0.533 0.75 0.95 0.40 4.42 0.14 0.159 0.123 1985 1137 -1.04 0.133 0.68 5.72 0.132 0.064 1996 2402 -2.491 0.51 0.60 4.105 0.08 0.073 1987 1153 -2.10 0.190 0.122 0.08 0.133 0.135 1981 756 -1.13 0.15 0.62 0.26 6.84 0.444 0.107 0.125 0.099 0.04 0.32 0.143 1982 986 -1.10 0.543 0.101 1986 1151 -1.47 0.150 0.131 0.387 0.109 0.084 1991 1284 -2.58 5.05 0.09 0.09 0.480 0.422 0.187 0.489 0.062 1993 1717 -1.13 0.09 0.414 0.05 0.63 0.45 0.139 0.83 4.49 5.97 0.06 0.079 1988 1173 -1.20 4.03 0.051 1994 1907 -2.146 0.86 4.10 0.62 0.13 0.03 0.102 0.14 0.51 6.569 0.08 0.58 4.08 0.062 1997 2508 -2.124 0.466 0.07 0.112 0.489 0.118 0.03 0.14 0.81 4.150 0.112 0.106 0.03 0.09 0.435 0.121 0.152 0.12 0.13 0.09 0.09 0.10 0.16 0.12 0.10 0.04 0.11 0.097 0.20 0.03 0.13 0.12 4.09 0.062 1998 2242 -3.085 1989 1221 -1.14 0.04 0.Table 1 Annual Estimates of the Expected Rate of Return (r) and the Expected Long Term Growth in Residual Income (g) n "0c "1c R2 r g r-g Gearn ltg 26546 -2.12 0.12 0.04 0.187 0.135 0.115 0.38 3.363 0.21 0.544 0.051 Year 34 T-Bond .

P/B is the price-to-book ratio at time t. R2 is the adjusted R2. is the aggregate expected cum-dividend earnings for the four-year period t =1 to t =4 that would obtain if all observations had the same R and G.Notes to Table 1: "0c and "1c (see equations (8) and (9)) are consistent estimates of (0 and (1 which are the coefficients in the linear relation between the ratio of price-to-book value and the ratio of aggregate earnings-to-book value: where: Pj 0 Bj 0 XjcT is the price of shares of firm j at time 0. T-Bond is the five-year T-bond interest rate. agb is the average ratio of four-year aggregate cum-dividend I/B/E/S analyst earnings forecasts (for periods t to t+4) to book value of equity at time t. Gearn is the estimated long-term growth in earnings. r is the estimated expected cost of equity capital. 35 .001 level. g is the estimated long-term growth in residual income. All estimates of r and g are significantly different from zero at the 0. is the per share book value of equity of firm j at time 0. ltg is the average of the I/B/E/S estimates of long term growth in earnings. agprc is the average ratio of four-year aggregate cum-dividend I/B/E/S analyst earnings forecasts (for periods t to t+4) to price at time t.

066 0. r is the estimated expected cost of equity capital. g is the estimated long term growth in residual income.082 0.57* -0.062 1982 23 0.036 1995 28 0.136 0.098 0.115 0.093 0.111 0.065 1986 25 0.16 0.001 level.066 1985 26 0.140 0.051 1997 29 0.156 0.130 0.136 0.032 1998 29 0.146 0.065 0.112 0.147 0.134 0.048 1991 29 0.065 1984 25 0.065 0. All estimates of r and g are significantly different from zero at the 0.130 0.110 0. 36 .144 0.053 1990 25 0.097 0.058 0.053 1987 26 0.150 0.050 1993 29 0.Table 2 Annual Estimates of the Expected Rate of Return (r)and the Expected Long Term Growth in Residual Income (g) for Firms in the Dow Jones Industrial Average Year n r g r-g 1981 18 0.072 1983 23 0.147 0.157 0. D is the Spearman correlation between the respective variable (in the column above) and time.059 0.121 0.056 1989 25 0.060 0.149 0.056 1994 29 0.081 0.124 0.058 1988 25 0.081 0.126 0.86** D Notes to Table2: Annual portfolios only consist of those firms that make up the Dow Jones Industrial Average for each year.021 0.094 0.162 0.039 1996 27 0.032 1992 29 0.119 0.

07 1985 144 0.09 1983 133 0.15 0. R&D.15 0.05 1986 151 0.09 0.03 124 0.03 117 0.04 109 0.11 0.02 116 0. 283 (drugs).13 0.07 0.11 0.04 122 0.07 0. gas and sanitary services).09 0.07 0.03 122 0.05 1998 460 0.02 133 0.11 0.06 0.11 0.09 0.12 0.04 117 0.09 1982 110 0.03 108 0.09 0.11 0.05 1994 279 0.06 0. and 87 (engineering.09 0.05 1995 326 0.09 0.05 1984 154 0.12 0.12 0. accounting.05 1988 159 0.05 0.10 0.13 0.04 112 0.14 0.08 0.05 0.02 118 0.12 0.02 125 0.03 1990 154 0.04 1996 439 0.11 0.13 0. and 357 (computer and office equipment).05 1989 162 0.12 0.13 0.14 0.06 0.04 127 0.11 0.Table 3 Annual Estimates of the Expected Rate of Return (r)and the Expected Long Term Growth in Residual Income (g) for Various Industries Panel A Intangible Intensive Industries Panel B Utilities Year n r g r-g n r g r-g 1981 78 0.04 1987 160 0.04 1997 482 0. 73 (business services).10 0. 37 .11 0.08 0.04 119 0. and management related services).09 0.04 0.04 133 0.15 0.06 0.05 Intangible intensive firms are defined as firms in the two-digit SIC codes 48 (electronic components and accessories). All estimates of r and g are significantly different from zero at the 0.13 0.04 117 0.14 0.13 0.12 0.001 level.02 1992 212 0. Utility firms are defined as firms in the four-digit SIC codes 4900-4953 (electric.08 0.13 0.12 0.15 0.11 0.10 0.09 0.14 0.15 0.05 100 0.08 0.11 0.13 0.10 0.16 0.13 0.07 0.03 139 0.13 0. and three digit SIC codes 282 (plastics and synthetics).04 1993 236 0.15 0.13 0.06 0.10 0.14 0.15 0.15 0.10 0.03 1991 181 0.

56 0.175 Notes to Table 4: is the estimated cost of equity capital for firm j at time t.003 0.331 333.256 Min -0. is the beta for firm j at time t derived from the capital asset pricing model.Table 4 Descriptive Statistics for 21.620 Mean 0.043 Median 0.371 0. is the market capitalization (price per share multiplied by shares outstanding) for firm j at time t (expressed in millions of dollars).122 2270.221 1.561 0.63 -2.123 4341.627 0.559 0.12 1.943* observations over the years 1981 to 1998 rjt MC jt $jt BPjt EPjt Max 0.74 1.064 -15.00 4.086 2. BP jt is the ratio of earnings per share to price per share for firm j at time t EPjt * this table includes observation for which we have sufficient data to calculate an estimate of beta.499 0.672.029 7775.061 SD 0.048 0. rjt MCjt 38 .925 2. $jt is the ratio of book value of equity to market value for firm j at time t.

01 level.165 (-8. 39 0.055**) -0.115**) EPjt 0.989) -0.107 (7.164 (5.351**) 0.779**) .180 (-7.060**) BPjt 0.083 (-2.028**) Notes to Table 5: See Notes to Table 4: * ** significant at the 0.903**) -0.209 (-7.023 (0.162 (-8.194*) -0.134 (-6.164 (6.053**) 0.102 (4.085 (-2.023**) -0.943 observations over the years 1981 to 1998 (t-statistics in parentheses).101 (4.362 (15.310**) 0.175 (-9.734**) 0.071) $jt -0.Table 5 Average of the annual correlations between the stated variables for 21.438**) -0.654**) 0. Pearson (Spearman) correlations are reported above (below) the diagonal.028 (1.430**) MC jt 0. rjt rjt MC jt $jt BPjt EPjt 0.927**) -0.075 (3.312**) -0.05 level significant at the 0.108 (-5.848**) -0.261 (-9.128 (3.

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