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Keywords:

  • information attributes;
  • cost of equity capital;
  • composition;
  • precision;
  • dissemination;
  • realized returns

Abstract

A seminal model in finance links cost of equity capital to information precision, composition and dissemination. Using realized returns to proxy for cost of equity capital and the probability of an informed trade (PIN) to proxy for composition, prior research documents results consistent with the model's prediction regarding composition. Nonetheless, prior research that examines the construct validity cautions against the use of future realized returns to proxy for cost of equity capital and recommend rDIV_PREM or rPEG_PREM instead. The authors speculate but do not demonstrate how the results in existing research might be incorrect due to their use of realized returns. This paper provides such evidence. We find that the authors inference regarding PIN is dependent on their choice of realized returns to proxy for cost of equity capital. We also estimate a more complete specification of the model that includes precision and dissemination, and we decompose PIN into its component parts to isolate that portion of PIN that varies with dissemination. These refinements allow for new insights regarding the veracity of the model's predictions. We conclude that cost of equity capital is increasing in composition, and decreasing in dissemination, and find some, albeit not conclusive support, for the prediction that cost of equity capital is decreasing in precision.