Nº 21-24: Dynamical Internal Cost of Capital Driven by Cash Flow Growth

Based on the insight that risk exposure as quantified in the consumption based asset pricing model
(CCAPM) is linearly proportional to the cash flow growth rate, we introduce a discounted cash flow model with a time-varying expected return structure matching the implicitly assumed risk exposure at each future point in time in the valuation model, i.e. the assumed cash flow growth rate process. This reduces the range of reasonable valuations outcomes to useful levels, given that the linearly proportional term structures of potential cash flow growth rates and equity risk premia are complementary, offsetting variables in a discounted cash flow pricing model. In the same manner we elaborate a time-varying internal cost of capital (ICC) model that reflects the implied risk exposure at each future point in time and thus has a clear interpretation as an expected return process. This time-varying ICC model is superior to the constant ICC model in a Fama-MacBeth regression setting to predict future realised returns. And using the expected return of the time varying ICC model as control in a Fama-MacBeth regression of the profitability, the investment and the value factor, both the profitability and the value factor become insignificant in explaining future realised returns. The superiority and economic significance of the time-varying ICC model is further confirmed in a trading strategy with yearly rebalancing.