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Risk, Cost of Capital, and Expected Return

“The single most reliable indicator of fraud is the promise of high return with low risk.” — William Bernstein in The Investor’s Manifesto.

It’s no secret that risk and return are related.  But how should we measure risk? For decades, the finance community has been equating risk with volatility (often calculated and presented in the form of standard deviation).

Others, however, have argued that volatility isn’t necessarily the best measure of risk. They argue that cost of capital is a better measure of risk–a primary reason being cost of capital’s direct link to expected return.

Cost of Capital: Bond Returns

To illustrate the link between cost of capital and expected returns, consider the bond market. The interest rate a company offers on its bonds is both the company’s cost of capital and the bond buyers’ expected return. Simple, right?

And the worse a company’s credit rating, the higher the interest rate it will have to offer on a series of bonds in order to get investors to buy them. End result:

higher risk = higher cost of capital = higher expected returns.

Cost of Capital: Stocks vs. Bonds

The same relationship exists when comparing stock returns to bond returns. Capital raised by issuing bonds comes at a lower cost to the company than capital raised by issuing stock. Why? Because investors demand greater expected returns from stocks than they do from bonds in order to compensate for the uncertainty of payoff.

higher risk = higher cost of capital = higher expected returns.

Cost of Capital: Small-Cap and Value Stocks

The link between risk, cost of capital, and expected returns also explains why small-cap stocks and value stocks have historically earned higher returns than their large-cap and growth counterparts.

Start-up companies involve more risk than large, well-established companies. So it makes sense that a small-cap company has to offer investors a proportionally greater share in the company’s profits in order to raise a given amount of capital.

higher risk = higher cost of capital = higher expected returns.

The same thing occurs with value companies as compared to growth companies. If the expected returns were the same, why would you ever invest in a poorly-run company in a declining industry? You wouldn’t. And neither would anybody else. To attract capital, value companies have to offer more attractive expected returns than growth companies.

higher risk = higher cost of capital = higher expected returns.

Remember, we’re talking about expected return.

All of this is not to say that small-cap stocks will earn more than large-cap stocks, or that stocks will earn more than bonds. Over any given period, something other than the “expected” may certainly occur.

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Comments

  1. Great explanation. I like to think of the notion of high return with low risk as the Santa Claus of investing. You want to believe because its such a nice story and feels good to believe, but it just isn’t rational to believe.

  2. @Dylan

    I love the analogy- but the jolly old man with high returns with low risks is a lot more likely to be Bernie Madoff than St Nick.

    -Rick

  3. Hmm, isn’t there something circular about this definition of risk?

    e.g. Small cap value stocks are riskier. Why? Because they tell us they are by being cheaper, as defined by P/E or dividend ratio.

    Okay, how does that risk manifest itself? By blowing up or by volatility (either way), not by the sticker price alone.

    I don’t think I’m being clear here, but something doesn’t smell quite right. 🙂

  4. Monevator, the market makes smaller cap and value companies cheaper because they are riskier (it’s the lower price that keeps those shares competitive).

    Think of the risk like this. Investors buy stock in companies because they think that the stock will be worth more at future points in time. The chances that it won’t be is the risk. If the company has less capital (small cap) or is distressed or seen as broken/damaged (value) there is greater chance it wont be worth more at times. So, sellers of small cap and value stocks accept a lower price so others will actually buy it and take that risk. If the risk pays off, their discounted purchase price leads to greater a gains potential (i.e. they get a risk premium).

    Does this smell any better? 🙂

  5. Pretty theory, but here’s mine. Many fewer analysts cover the small and value names for a variety of reasons. Less coverage leads to inefficient pricing of the shares (sorry Burton M.), which leads to greater opportunity for outperformance…who knows, maybe the CEOs of these companies can actually do their jobs better when they don’t have to dance for Wall Street…cheers!

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