Cost of Capital: A Gut Check on High-Flying Stock Returns

Nearly every year, a handful of securities generate headlines for delivering eye-popping returns. A challenge for investors is determining what portion of that return is a one-off windfall and not something to expect going forward. Viewing expected returns through the lens of cost of capital may help benchmark what constitutes a reasonable expected return from the market.

Companies issue equity and debt, otherwise known as stocks and bonds, to raise capital for investing in and growing their business. The rate of return on capital invested in these securities depends on both the supply and demand. The return must be sufficiently high to entice investor demand but not so high as to discourage supply by the company, which could otherwise seek alternative sources of funding. The link between these forces means an investor’s expected return is the company’s expected cost of capital.

This framework may help stave off FOMO about an extraordinary return event. For example, the Magnificent 7 stocks grew by 76% in 2023. (1) Even if the concept of expected return is nebulous, does this seem like a reasonable cost of equity capital? How high would borrowing rates have to be for a business to issue stock at that expected return? If the Magnificent 7 companies can secure funding at a lower rate through other means, 76% is not their cost of capital, which means it is not an investor’s expected return.

We believe financial plans should focus on the expected return. You do not want to bank on the unexpected repeating. Long-term data is more informative than short-term returns in setting expectations for the future. Across a century of returns, the broad US market has gained about 10% annualized. (2) Academic research suggests that returns can be boosted even further by emphasizing stocks shown to have higher average returns than the market, such as those with smaller market caps, lower relative price, and higher profitability.

Rather than trying to guess which stocks might provide next year’s outsize returns or getting caught up in a cycle of fear and greed, we believe it is better to set reasonable long-term expectations to track progress toward your financial goals.