Diagnostics to Evaluate Cost of Capital Measures. Discussion of Christodoulou et al.

Christodoulou et al. (2016) develop measures of the cost of equity capital that require only accounting inputs, using as an identification strategy the linear information dynamics of Feltham and Ohlson (1995). I propose to test these measures by evaluating the predictability of innovations to abnormal earnings using various predetermined variables. The over-identifying restrictions of this model require these innovations not to be predictable. Using a generalized model, I observe that the estimated measures are probably too low. I conjecture that this anomaly, which occurs jointly with a positive drift in abnormal earnings, is caused by the omission of economic assets such as intangibles.