Earnings Smoothness, Average Returns, and Implied Cost of Equity Capital

ABSTRACT: 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. Although 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. Overall, the evidence is inconsistent with the notion that attempts to smooth earnings can lead to a lower cost of equity capital.