Skip to Main Content
HBS Home
  • About
  • Academic Programs
  • Alumni
  • Faculty & Research
  • Baker Library
  • Giving
  • Harvard Business Review
  • Initiatives
  • News
  • Recruit
  • Map / Directions
Working Knowledge
Business Research for Business Leaders
  • Browse All Articles
  • Popular Articles
  • Cold Call Podcast
  • Managing the Future of Work Podcast
  • About Us
  • Book
  • Leadership
  • Marketing
  • Finance
  • Management
  • Entrepreneurship
  • All Topics...
  • Topics
    • COVID-19
    • Entrepreneurship
    • Finance
    • Gender
    • Globalization
    • Leadership
    • Management
    • Negotiation
    • Social Enterprise
    • Strategy
  • Sections
    • Book
    • Podcasts
    • HBS Case
    • In Practice
    • Lessons from the Classroom
    • Op-Ed
    • Research & Ideas
    • Research Event
    • Sharpening Your Skills
    • What Do You Think?
    • Working Paper Summaries
  • Browse All
    Cost of Capital Dynamics Implied by Firm Fundamentals
    23 Jan 2013Working Paper Summaries

    Cost of Capital Dynamics Implied by Firm Fundamentals

    by Matthew Lyle and Charles C.Y. Wang
    Despite ample evidence that expected returns are time varying, there has been relatively little empirical research on estimating the dynamics of firm-level expected returns. Capturing the dynamics of firm-level expected returns is important, because it allows for a better understanding of firm risk over time and can inform investors in tailoring their portfolios to match their desired investment horizons. Findings show that cost of capital is time varying and highly persistent. The authors also demonstrate that the model produces empirical proxies of expected returns that can predict future stock returns up to three years into the future and sorts portfolio returns with near monotonicity. Aside from its practical contributions, this paper adds to a budding finance and accounting literature that studies the properties of expected return dynamics. Key concepts include:
    • The model can forecast stock returns up to three years into the future and tracks economic conditions.
    • From a practical standpoint, the approach has several advantages relative to the current methodologies for estimating expected returns. The model is easy to implement, requiring only realized returns, realized BM ratio, and realized ROE.
    • The model also allows for discount rates to be dynamic and produce a full projection of future—time varying—cost of capital estimates.
    • On average, the term structure of cost of capital, like the yield curve for bonds, is upward sloping. However, during times of high economic uncertainty, as in recessions and crisis periods, the term structure flattens and can be downward sloping.
    LinkedIn
    Email

    Author Abstract

    We provide a tractable stock valuation model to study the dynamics of discount rates using only two firm fundamentals: the book-to-market ratio and expected ROE. We find that the model is easily applied to a large cross section of firms and that firm-level discount rates vary over time and are highly persistent. The model can forecast stock returns up to three years into the future and tracks economic conditions. During normal or expansion periods in the economy, the dynamics of cost of capital generate an upward sloping term structure; however, in times of high economic uncertainty, the term structure flattens and can be downward sloping.

    Paper Information

    • Full Working Paper Text
    • Working Paper Publication Date: November 2012
    • HBS Working Paper Number: 13-050
    • Faculty Unit(s): Finance
      Trending
        • 16 Mar 2023
        • Research & Ideas

        Why Business Travel Still Matters in a Zoom World

        • 01 Mar 2023
        • What Do You Think?

        How Much Does 'Deep Purpose' Matter to the Bottom Line?

        • 14 Mar 2023
        • In Practice

        What Does the Failure of Silicon Valley Bank Say About the State of Finance?

        • 13 Mar 2023
        • Op-Ed

        How Leaders Should Leave

        • 25 Jan 2022
        • Research & Ideas

        More Proof That Money Can Buy Happiness (or a Life with Less Stress)

    Charles C.Y. Wang
    Charles C.Y. Wang
    Glenn and Mary Jane Creamer Associate Professor of Business Administration
    Contact
    Send an email
    → More Articles
    Find Related Articles
    • Accounting
    • Finance

    Sign up for our weekly newsletter

    Interested in improving your business? Learn about fresh research and ideas from Harvard Business School faculty.
    This site is protected by reCAPTCHA and the Google Privacy Policy and Terms of Service apply.
    ǁ
    Campus Map
    Harvard Business School Working Knowledge
    Baker Library | Bloomberg Center
    Soldiers Field
    Boston, MA 02163
    Email: Editor-in-Chief
    →Map & Directions
    →More Contact Information
    • Make a Gift
    • Site Map
    • Jobs
    • Harvard University
    • Trademarks
    • Policies
    • Accessibility
    • Digital Accessibility
    Copyright © President & Fellows of Harvard College