| Despite a belief among corporate executives that smooth earnings paths lead to a lower cost of equity capital, I find no relation between earnings smoothness and average stock returns over the last 30 years. In other words, owners of firms with volatile earnings are not compensated with higher returns, as one would expect if volatile earnings lead to greater risk exposure. Though prior empirical work links smoother earnings to a lower implied cost of capital, I offer evidence that this link is driven primarily by optimism in analysts' long-term earnings forecasts. This optimism yields target prices and implied cost of capital estimates that are systematically too high for firms with volatile earnings. The findings are important to executives because they cast doubt on the notion that attempts to smooth earnings can lead to a lower cost of equity capital. This study also highlights the importance of controlling for bias in the input variables used to generate implied cost of capital estimates, which has implications for studies that link accounting attributes to cost of capital. |
