Testing International Asset Pricing

Models Using Implied Costs of Capital

Journal of Financial and Quantitative Analysis
Charles Lee
David Ng
Bhaskaran Swaminathan

Why implied costs of capital

Realized returns are extremely noisy proxies of

expected return;
Implied cost of capital are much more stable in
predicting expected return;

Objective
The main objective is to test whether the implied

cost of capital method leads to sharper inferences

about economic relations.
In international asset pricing:
Are risks priced locally or globally?

Are currency risks priced?

Method for computing ICC

The cost of equity capital for each firm is

computed as the IRR that equates the present

value of future free cash flows to equity (FCFE) to
current stock price, in U.S. dollars.

Pt = current stock price in U.S. dollars;

FE = earnings forecast;
b = plowback rate;
re = cost of equity capital.

Earnings forecasting
Forecast explicitly for years 1 and 2 (get them

from IBES);
Forecast year 3 as the growth rate between years
1 and 2;
Individual firms earnings growth rates are
assumed to revert exponentially to the long-run
nominal world GDP growth rate after year 3;
After year 10, the terminal value is computed
using the Gordon growth model.

Other forecasts
Plowback rate: 1 minus the firms dividend payout

ratio;
Exchange rate: Economist Intelligence Unit (EIU)
forecasts;

Measurement error

Since analysts are slower in updating their

forecasts than the market is in updating the stock

prices, some ICCs may be biased;
Uses correction recommended by Guay et al.
(2005)

Three alternate ICCs

Modified-PEG model of Easton (2004):

Ohlson and Juettner-Nauroth (2005):

Claus and Thomas (2001)

RRPs volatility is 10
times higher than
IRPs, irrespective of
the valuation model

Tries to show that IRP and expost RRP have a positive

relation

Key results in table 5 are

not sensitive to the use of
alternate measures of
implied costs of capital

Similar regression
coefficients, but with
lower statistical
significance

Size and BM are

positively related even
after controlling for
different characteristics

Conclusion
Findings support a broader use of the implied

cost of capital in the financial literature,

particularly in international asset pricing;
Findings are interesting to finantial practitioners
who wish to estimate the cost of equity capital for
their international investments;
Need to develop alternate asset pricing models
that accomodate the fact that firm characteristics
are priced;
ICC approach can provide important new insights
into the cross sectional determinants of firm level
expected retuns in the international context.