Noise and Deficiency of the Implied Cost of Capital as an Expected Return Proxy

Because stock price generally deviates from the intrinsic value, stock price is a noisy indicator of the intrinsic value. As an expected return proxy, the implied cost of capital (ICC)—the internal rate of return that equates the noisy stock price to discounted expected future dividends—thus includes a mispricing-driven component. The mispricing-driven component is positive and increases with the degree of undervaluation for undervalued firms and is negative and decreases with the degree of overvaluation for overvalued firms. Our findings suggest that the mispricing-driven component plays a dominant role. Due to the dominant role of the mispricing-driven component, ICC is a deficient expected return proxy for examining the effect of a factor on expected return. Moreover, existing methods do not seem able to address this deficiency