Implied Cost of Capital in the Cross-Section of Stocks

Recent research shows that the implied cost of capital (ICC), measured from analyst forecasts and current stock prices, predicts market returns. This paper studies the cross-section of stocks and finds that ICC negatively predicts returns. An investment strategy that goes long low-ICC stocks and short high-ICC stocks provides an alpha of 6% per year. Evidence suggests that the negative relation is due to the fact that stocks with a high level of ICC are systematically related with overly optimistic earnings forecasts. High-ICC stocks are also associated with a low probability of survival. Investors fail to incorporate this bias, leading to more negative earnings surprises. The findings highlight the need to exercise caution when using ICC as a measure of cost of capital for individual firms.