Gist
- Investment bankers’ disclosed cost of equity (COE) estimates from takeover filings are significantly related to beta and firm size, but show weak or contradictory relations with many other firm-level risk factors—differing from common academic asset-pricing models. [1] [7]
- Banks assign higher COEs in management buyouts, lowering implied valuation of targets, which appears tied to incentive structures seeking target shareholder approval. [1]
- COE levels implied by bankers are notably higher (by ~2.1-5.5 percentage points) than those derived from models like CAPM or Fama-French, with low correlation between those model-implied COEs and bankers’ estimates. [7]
- These patterns suggest real strategic implications for acquisition pricing, valuation negotiation, and potential overconservatism in investment banking valuations, especially under incentive misalignment. [1] [7]
Analysis
The 2025 study “The Cost of Equity: Evidence from Investment Banking Valuations” by Eaton, Guo, Liu, and Tu offers empirical insights from manually compiled COE estimates disclosed in takeover regulatory filings for a large sample of deals between 1993 and 2017. [1] These estimates allow observation of how investment bankers actually set discount rates, in contrast with how academic models like CAPM or Fama-French predict them. Critical findings and their implications are outlined below:
Key Determinants of Bankers’ COE Estimates: The paper shows COEs relate strongly to beta (systematic risk) and size (smaller firms get higher COE). [1] These align with academic predictions under CAPM or multi-factor models. However, other observed firm characteristics—leverage, financial distress, volatility, profitability, investment levels—are largely uncorrelated or correlate in ways contradicting model predictions. [1] For example, rather than seeing COE significantly rising with leverage in many cases, the relation is weak or inconsistent. [1]
Incentives and Deal Type Effects: Management buyouts (MBOs) see significantly higher COEs. Because higher COE implies lower present value of expected cash flows, target valuations drop, effectively making bids more attractive. [1] This suggests bankers adjust COE not just for risk but for strategic negotiation incentives—to win buy-in from target shareholders or boards.
Comparisons to Model-Implied COEs: Related research (“Analysts’ Estimates of the Cost of Equity Capital”) finds that CoE estimates from analysts (distinct from bankers) are positively related to future realized returns, and strongly tied to beta, size, book-to-market, etc., but not to momentum, profitability, or liquidity. [2] Related work also documents that bankers’ COEs tend to exceed those implied by standard asset pricing models by approximately 2.1 to 5.5 percentage points. [7] Correlations between bankers’ COEs and model-implied ones are low (≈0.12-0.28). [7]
Strategic Implications:
- Buyers in takeover negotiations may be consciously using inflated COEs in certain deal types (MBOs) to reduce target value; this has implications for fairness opinions, deal premium negotiations, and due diligence.
- Valuations may embed systematic conservatism—e.g., over-penalizing risk or underrecognizing consistent revenue streams—in certain industries or under certain deal structures.
- Cross-deal comparability is weakened: because bankers’ COEs are heterogeneous and deviate from model predictions, comparing valuations across industries, deal types, or time may require correction or normalization for COE biases.
- Investors, regulators or boards interpreting fairness opinions or valuation reports should scrutinize the assumptions underlying COE, especially beta estimation, size adjustments, and incentives that may drive upward bias.
Open Questions and Cautions:
- Extent of risk factor mispricing vs. strategic bias: Are odd COE relationships (e.g., weak leverage effect) due to limited information, measurement error, or deliberate adjustment?
- Weight of industry vs firm risk: Industry volatility plays a role, per anecdotes of industries like biotech having higher rates, but less systematic evidence.
- Temporal dynamics: Do bankers adjust COE over time in response to market risk premia or interest rates, or are COE practices sticky? Related research into discount rates suggests short-to-medium term stickiness. [4] [11]
- Applicability to private equity and non-takeover valuations: Do similar COE behaviors hold outside takeover settings?
Supporting Evidence
- The study uses manually compiled COE estimates disclosed in takeover filings between 1993-2017. [1]
- Bankers’ COEs are significantly positively related to firm beta and size. [1]
- Despite academic models anticipating relations with leverage, profitability, investment etc., these characteristics show weak or contradictory relations to bankers’ COEs. [1]
- Management buyouts carry significantly higher COE estimates, leading to lower valuations. [1]
- Analysts’ CoE estimates are positively related to beta, size, book-to-market ratio, leverage, idiosyncratic volatility; but not to profitability, investment, momentum, liquidity. [2]
- Bankers’ COEs exceed those implied by CAPM or Fama-French models by approximately 2.1-5.5 p.p., with low correlations (0.12-0.28) between estimates. [7]
Sources
- [1] www.cambridge.org (Cambridge Core) — 07 April 2025
- [2] www.sciencedirect.com (ScienceDirect) — 2021
- [7] sites.duke.edu (Duke University) — 14 December 2022
- [4] www.nber.org (NBER) — 07 October 2025
- [11] bfi.uchicago.edu (University of Chicago) — recent