Do You Really Know Your Cost of Capital?

Abstract

We argue that the cost of equity capital varies much less across firms than previously thought. We find that expected return differences across stocks are short term in nature and become empirically indistinguishable from zero in five years. When we aggregate expected returns over longer periods of time, our results translate into 99% of the firms having their cost of equity within 1% of the market‐wide average. The amount of variation in the cost of capital implied by these results is of the order of one‐fifth or perhaps only of one‐tenth of the variation in firms' discount rates indicated by surveys. Our results suggest that high‐risk firms apply much higher, and low‐risk firms much lower, discount rates than they should.Why do differences in firms' cost of equity capital converge in just a few years? This is because the differences in firm characteristics translating into cost of equity differences vanish over time. For example, competition in the product market makes it hard for profitable firms to maintain their edge, allowing less profitable firms to catch up. As a result, firms representing different levels of risk can, over time, be expected to become more like one another. Some differences in firm characteristics, such as in the ratio of the book and market value of equity, can also stem from the mispricing of stocks. Financial markets are arguably more efficient than product markets, so potential differences in mispricing can be expected to converge even faster than differences in firm characteristics.