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A forecast evaluation of expected equity return measures

Author

Listed:
  • Chin, Michael

    (Bank of England)

  • Polk, Christopher

    (London School of Economics)

Abstract
Recent studies find evidence in favour of return predictability, and argue that their positive findings result from their ability to capture expected returns. We assess the forecasting performance of two popular approaches to estimating expected equity returns, a dividend discount model (DDM) commonly used to estimate `implied cost of capital', and a vector autoregression (VAR) model commonly used to decompose equity returns. In line with recent evidence, in-sample tests show that both estimates generate substantially lower forecast errors compared to traditional predictor variables such as price-earnings ratios and dividend yields. Out-of-sample, the VAR and DDM estimates generate economically and statistically significant forecast improvements relative to a historical average benchmark. Our results tentatively suggest that the VAR approach better captures expected returns compared to the DDM.

Suggested Citation

  • Chin, Michael & Polk, Christopher, 2015. "A forecast evaluation of expected equity return measures," Bank of England working papers 520, Bank of England.
    • Handle: RePEc:boe:boeewp:0520
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    File URL: https://www.bankofengland.co.uk/-/media/boe/files/working-paper/2015/a-forecast-evaluation-of-expected-equity-return-measures.pdf?la=en&hash=93B838D820B7082C74138D805B8B8E6B16CCACBE
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    Citations

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    Cited by:

    1. Pinter, Gabor, 2018. "Macroeconomic shocks and risk premia," LSE Research Online Documents on Economics 90370, London School of Economics and Political Science, LSE Library.
    2. Sanna, Dario, 2020. "A Fast and Parsimonious Way to Estimate the Implied Rate of Return of Equity," MPRA Paper 102003, University Library of Munich, Germany.
    3. Saleheen, Jumana & Levina, Iren & Melolinna, Marko & Tatomir, Srdan, 2017. "The financial system and productive investment: new survey evidence," Bank of England Quarterly Bulletin, Bank of England, vol. 57(1), pages 4-17.

    More about this item

    Keywords

    Expected returns; implied cost of capital; dividend discount model; return predictability; forecasting;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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