Costs of Equity Capital and Model Mispricing

Abstract

Costs of equity for individual firms are estimated in a Bayesian framework using several factor‐based pricing models. Substantial prior uncertainty about mispricing often produces an estimated cost of equity close to that obtained with mispricing precluded, even for a stock whose average return departs significantly from the pricing model's prediction. Uncertainty about which pricing model to use is less important, on average, than within‐model parameter uncertainty. In the absence of mispricing uncertainty, uncertainty about factor premiums is generally the largest source of overall uncertainty about a firm's cost of equity, although uncertainty about betas is nearly as important.