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The impact of analyst-investor disagreement on the cross-section of implied cost of capital

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  • Michalis Makrominas

    (Department of Maritime Studies, Frederick University, Cyprus)

Abstract

Implied cost of capital estimates are typically calculated using analysts’ forecasts as proxies for the market’s earnings expectations. We examine the case where deviations between investors’ expectations and analysts’ beliefs, as manifested by analysts’ recommendations, cause predictable variation in implied cost of capital. We find that stocks recommended by analysts as Buy or Strong Buy have, ceteris paribus, higher implied cost of capital than stocks recommended as Underperform or Sell, and that the effect is more clearly pronounced in stocks that have been downgraded. We attribute the effect to differential expectations between analysts and investors regarding future profitability, rather than differential expectations regarding systematic risk. We demonstrate that adjusting analysts’ earnings forecasts in line with the market’s earnings expectations largely eliminates the observed variation, indicating that such corrective mechanisms could and should be incorporated in the estimation of implied cost of capital.

Suggested Citation

  • Michalis Makrominas, 2015. "The impact of analyst-investor disagreement on the cross-section of implied cost of capital," Australian Journal of Management, Australian School of Business, vol. 40(2), pages 224-244, May.
    • Handle: RePEc:sae:ausman:v:40:y:2015:i:2:p:224-244
    DOI: 10.1177/0312896214528185
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    References listed on IDEAS

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    More about this item

    Keywords

    Analysts’ forecasts; analysts’ recommendations; bias; implied cost of capital;
    All these keywords.

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • G3 - Financial Economics - - Corporate Finance and Governance
    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting

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