The Term Structure of Implicit Discount Rates in Security Valuation

A reformulation of the residual income model is used to generate estimates of discount rates implicit in UK security prices. The terminal value of the infinite valuation model is incorporated into the coefficient on current earnings. By varying the length of the forecast horizon, different combinations of implicit discount rates are revealed that allow the estimation of time-variant costs of equity. Results indicate no specific pattern of discount rates, thus revealing neither myopia on short-term earnings nor excessive optimism on long(er)-term earnings. Surprisingly, there is weak evidence that if any myopia exists, it is concentrated in larger and lower price-earnings firms. Copyright Blackwell Publishers Ltd, 2005.