PREPRINT - The Relation Between Expected Returns, Realized Returns, and Firm Risk Characteristics

Existing literature employs two approaches to assess the validity of alternative proxies for firm-specific cost of equity capital (Et-1(rt)). One approach relies on the expected link between future realized returns and Et-1(rt), while the second approach relies on the expected relation between Et-1(rt) and firm-specific priced risk characteristics. The results of these two streams of literature are mixed with the first (second) approach providing no (strong) support for the construct validity of any (some) of the Et-1(rt) proxies examined. In this paper, we resolve the conflict between these two streams of research. In contrast to prior research, we document a strong positive association between the implied cost of capital estimates and future realized returns. We demonstrate that the negative or insignificant association between implied cost of capital estimates and future realized returns documented in prior research is due to empirical misspecification. Moreover, we show that although most of the estimates we examine are positively associated with future realized returns, only two, rDIV and rPEG, are also predictably related to firm-specific risk. Taken together our results suggest that rDIV and rPEG provide superior proxies for Et-1(rt).