“Implied Cost of Capital and the Predictability of Market Returns” by David Ng
LSV Asset Management
In this paper, we examine the ability of the aggregate implied cost of capital (ICC) to forecast future stock market returns. A stock's implied cost of capital is defined as the expected return that equates its current price to the present value of its expected future free cash flows. We compute implied costs of capital for each firm in the S&P 500 index every month from 1981-2009 and use their value-weighted average as a measure of market-wide implied cost of capital. We find that the market's implied cost of capital strongly predicts subsequent stock market returns. In multivariate regressions, the aggregate implied cost of capital is a significant predictor of future returns in the presence of the book-to-market ratio, dividend-to-price ratio, earnings-to-price ratio, term spread, default spread, net equity issuance, inflation, stock market variance, long term government bond yield, long term government bond return, lagged stock returns, consumption-to-wealth ratio, investment to capital ratio, and the sentiment measures in Baker and Wurgler (2006), and it outperforms most of these variables. Under a mean-variance framework, forming portfolios based on ICC expected returns result in utility gains of more than 5% per year. The results remain robust under various bootstrap and simulation exercises. Out-of-sample evidence shows that implied cost of capital has strong forecasting power in recent years. This forecasting power is consistent with the interpretation of implied cost of capital as a measure of time-varying expected returns (see Pastor, Sinha, and Swaminathan (2008)).