The Cost of Equity as a Yield: Embedded Bankruptcy Risk in Valuation

Abstract

This paper develops a valuation-based interpretation of the cost of equity by recovering an implied capitalization rate from observed equity prices and contemporaneous earnings under a maintained steady - state abstraction . In the empirical illustration, “earnings” (E) is taken as the earnings per share measure implicit in the reported price-earnings ratio (P/E) obtained from publicly available investment data sources (so that c is recovered mechanically as c = 1/(P/E)). The recovered rate is algebraically equivalent to the earnings yield and is interpreted as a valuation discount rate, analogous to a bond yield, rather than as an expected return implied by asset-pricing equilibrium restrictions. Exposure to financial distress and bankruptcy is embedded in reduced form through earnings capitalization, while price volatility is treated separately. An empirical illustration documents cross-sectional dispersion in implied capitalization rates across firms and market segments.