Asset pricing tests often replace ex ante return expectation with ex post realization. The large deviation between the two drastically weakens the power of these tests. This paper proposes to use analysts consensus price target for a stock as the market expectation of the stock’s future price to directly construct the stock’s expected excess return. Analyzing the expected excess return behavior both over time and across different stocks shows that classic asset pricing theory works much better on ex ante return expectations than on ex post realizations. The analysis also provides new insights on the pricing of common equity risk factors.

Introduction

Asset pricing theories generate implications on the relation between the expected excess return of a financial security and its risk. Empirical asset pricing tests often replace the ex ante return expectation with ex post return realization. Realizations, however, can differ greatly and persistently from the expectation. The deviations can come from large surprises, expectation biases, or expectations of certain large, rare events that have not materialized yet in the test sample period (i.e., the peso problem). Regardless of the particular source, the large deviations can drastically weaken the power of the empirical tests (Lundblad (2007)). This lack of testing power contributes to the lack of empirical support for classic asset pricing theories. This paper proposes to test asset pricing implications using direct constructions of ex ante market expectation instead of using ex post return realization, thus mitigating the impact of ex post surprise on the estimated risk-return relation. Focusing on the U.S. equity market, the paper uses analysts consensus price target for a stock as the market expectation of the stock’s future price and constructs the stock’s ex ante expected excess return, or equity risk premium, as the log deviation between the price target and the stock price minus the one-year financing cost. Analyzing the equity risk premium behavior both over time and across different stocks shows that classic asset pricing theories work much better on ex ante return expectations than on ex post return realizations. Ex ante risk premium expectation can be constructed from several different channels, all of which can, in principle, be applied to replace ex post return realizations in asset pricing tests. For example, a large accounting literature derives the implied cost of capital (ICC) from current stock prices, various valuation model assumptions, and cash flow forecasts.1 Pastor, Sinha, and Swaminathan (2008) and Lee, Ng, and Swaminathan (2009) take the ICC approach to examine the intertemporal and international risk-return relations, respectively. Campello, Chen, and Zhang (2008) construct expected equity returns using corporate bond yields by recognizing that bonds and stocks are contingent claims written on the same asset. More re cently, several studies explore the idea of extracting risk premiums from option prices.2 The main issue that prevents these implied approaches from broader adoption in testing asset pricing models is that they often involve many assumptions that can significantly alter the results. For example, different combinations of valuation approaches and cashflow assumptions can generate many different sets of ICC estimates.3 Extracting risk premium from options or other contingent claims such as bonds also necessitates strong assumptions on price dynamics. Compared to these implied studies, this paper proposes a particularly simple approach for constructing the risk premium by directly relying on analysts price targets. In coming up with price targets, different analysts may have used different modeling approaches and cash flow forecasts. Directly using the price target consensus allows the paper to rely completely on average market expectation to construct the equity risk premium.