Estimating the Cost-of-Equity Capital Using Empirical Asset Pricing Models

Abstract

Empirical asset pricing models seek to capture characteristic-based patterns in the cross-section of average stock returns. I propose a new approach for constructing these models, and investigate its performance with respect to estimating the cost-of-equity capital. Using a model that accounts for the cross-sectional relation between five characteristics and average stock returns, I obtain cost-of-equity estimates that outperform those produced by the Fama-French five-factor model in out-of-sample tests. Because the proposed approach builds directly on standard cross-sectional regression techniques, it provides complete flexibility in choosing the firm characteristics used to formulate the cost-of-equity estimates.