Hey Kid, Remember: The Cost of Capital is the Investor's Expected Return!

Note: Don’t forget to enter this month’s Money Movie Giveaway! All you have to do is leave a comment on the contest post by clicking here.

Such is one of the mantras of Dimensional Fund Advisors (DFA). The specific wording of this post’s title is that of Eugene F. Fama, Jr (son of Eugene Fama, Sr who is one of the academics behind efficient market theory and the Fama-French 3 Factor Model). Eugene Junior was recounting one of his childhood memories when Nobel Laureate Merton Miller would be at the house and would always tell him, “Hey Kid! Remember: The Cost of Capital is the Investor’s Expected Return!”. Eugene Junior said it wasn’t until many years later that he actually figured out what that meant. Quoting Eugene Jr.:

The 1990 Nobel Prize in Economics recognized Merton Miller of the University of Chicago for his research into the “cost of capital.” When markets work, the cost of capital to a company is equal to the expected return on its stock. This is a simple but profound notion. It means that companies use stock, like bonds, to fund operating capital. If a company sells off 10 percent of its stock, the buyer has a claim on 10 percent of the company’s future earnings. The return the investor receives is the return the company forgoes when it sells the stock. The expected return is therefore the “cost” the company pays to obtain capital. Investors provide capital in exchange for an expected return in exactly the way a lending bank provides capital in exchange for an expected interest rate.

If we had a healthy Walmart and an unhealthy K-Mart approaching a bank for a loan, the bank would demand a lower relative interest rate on funds lent to Walmart versus funds lent to K-Mart. Similarly, the equity market would expect a higher return on K-Mart stock versus Walmart stock to compensate for the extra risk. This is the only way a rational investor would buy K-Mart stock over Walmart stock. (If Walmart had a greater expected return then no-one would rationally buy K-Mart stock since it offered a lower return and greater risk.)

Fama Junior goes on to indicate that since the beginning of recorded data on stock prices, investors in unhealthy companies have been rewarded with greater returns on average than investors in healthier companies. This plays an important part of DFA’s strategies as I will expound upon in the near future.

Note: Don’t forget to enter this month’s Money Movie Giveaway! All you have to do is leave a comment on the contest post by clicking here.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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