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Evaluating Firm-Level Expected-Return Proxies

Evaluating Firm-Level Expected-Return Proxies

By Charles M. C. Lee, Eric C. So, Charles C. Y. Wang
October 2015Working Paper No. 3188

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 measurement error 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.

Keywords
implied cost of capital, expected rates of return, performance evaluation