Evaluating Firm-Level Expected-Return Proxies

Evaluating Firm-Level Expected-Return Proxies

By Charles M. C. Lee, Eric C. So, Charles C. Y. Wang
June 3,2017Working Paper No. 3188

We argue, from an extensive literature review, that in the vast majority of research settings, biases in alternative expected-return proxies (ERPs) are irrelevant. Therefore, in most settings, the choice between alternative ERPs should be based on an evaluation of their relative measurement-error variances. We develop a parsimonious evaluation framework that empirically estimates a given ERP’s cross-sectional and time-series measurement-error variances. We then apply this framework to five classes of firm-level ERPs nominated by recent studies, including factor-based ERPs from finance and implied costs of capital (ICC) estimates from accounting. Our analyses show ICCs are particularly useful in tracking time-series variations in expected returns. We also find broad support for a “fitted” or “characteristic-based” approach to ERP estimation.

Keywords
implied cost of capital, expected rates of return, performance evaluation