Evaluating Firm-Level Expected-Return Proxies

We develop and implement a rigorous analytical framework for empirically evaluating the relative performance of firm-level expected-return proxies (ERPs), based on the premise that superior proxies should closely track true expected returns both cross-sectionally and over time (that is, the proxies should exhibit lower measurementerror variances). We then compare five classes of ERPs nominated in recent studies to demonstrate how researchers can easily implement our two-dimensional evaluative framework. Overall, our findings support the trend towards characteristic-based ERPs. We also document a tradeoff between time-series and cross-sectional ERP performance, indicating the optimal choice of proxy may vary across research settings. Our results illustrate how researchers can use our framework to critically evaluate and compare a growing body of ERPs. JEL Classifications: G10, G11, G12, G14, M41 ∗We thank Bhaskaran Swaminathan of LSV Asset Management, as well as seminar participants at Stanford University, Northwestern University, University of Chicago, University of California-Irvine, Louisiana State University, National University of Singapore, University of Pennsylvania (Wharton), University of Toronto, University of Michigan (Ross), Harvard Univeristy, Yale University, Columbia University, Indiana University, University of Washington (Seattle), and UCLA (Anderson), for helpful comments and suggestions on an earlier draft. We thank Kyle Thomas for excellent research assistance. An earlier version of this paper was titled “Evaluating Implied Cost of Capital Estimates.” Evaluating Firm-Level Expected Return Proxies 1