The Weighted Average Cost of Capital (WACC) is most often estimated using market values and market-implied discount rates. This approach is well aligned with valuation and with the idea that markets are forward-looking.
In empirical asset pricing, however, the objective is different. Rather than estimating intrinsic value, the goal is to explain why firms with certain characteristics earn systematically different average stock returns. In this setting, historical and book-based measures of capital costs – interpreted as realized financing costs rather than required returns – can be informative.
This post discusses the role of book-based WACC in cross-sectional return analysis, highlights important limitations, and summarizes evidence from my Master’s thesis showing that book-based costs of capital were more informative than market-based alternatives when explaining the cross-section of returns.
What is meant by book-based WACC
A book-based WACC is constructed using:
- Book values of equity and debt from the balance sheet
- Realized equity financing costs, measured as cash remuneration to equity holders (dividends and net share repurchases) relative to book equity
- Contractual or realized costs of debt, such as interest expense relative to book debt
Importantly, the equity component is not interpreted as a required or expected return, but as the firm’s ex-post cash cost of servicing equity capital.
By contrast, a market-based WACC relies on market capitalization, market values of debt, and discount rates inferred from current prices and expected returns.
Both approaches are internally coherent. Their relevance depends on the research question.
Why book-based WACC can be informative in asset pricing
Book-based WACC captures historical financing conditions and realized capital servicing costs that reflect past issuance and payout decisions. These characteristics tend to evolve slowly and are often persistent over time.
In cross-sectional return studies, persistence is frequently important. Many established return predictors are derived from accounting data rather than market prices, including measures of profitability, investment, and leverage. Book-based capital costs naturally belong to this broader class of slow-moving firm characteristics.
A further advantage is that book-based WACC is largely insulated from contemporaneous price movements. Because it is constructed from accounting quantities and realized cash flows, it avoids mechanical links between explanatory variables and returns that can complicate interpretation when market-based measures are used.
Evidence from the Master’s thesis
In my Master’s thesis, a book-based cost of capital proved more informative than a market-based cost of capital when explaining the cross-section of stock returns.
When incorporated into measures of economic value creation, the book-based cost of capital exhibited stronger and more robust associations with average returns across portfolios. Market-based cost of capital measures, while theoretically appealing from a valuation perspective, showed weaker explanatory power in this empirical setting.
The full thesis is available here: Value-Creation Pricing Factor (PDF).
Limitations of book-based WACC
At the same time, book-based WACC has important limitations.
Historical financing costs may no longer reflect firms’ current risk profiles. Business risk, leverage, and competitive conditions can change, making book-based measures potentially stale.
In addition, the explanatory power of book-based WACC may reflect delayed market adjustment rather than compensation for risk. Because book-based measures update slowly, they may proxy for information that markets incorporate only gradually.
Finally, book-based WACC aggregates several distinct elements, including historical financing conditions, managerial payout and issuance decisions, and accounting conventions. This complicates interpretation and makes it difficult to attribute explanatory power to a single underlying mechanism.
Brief context from the literature
Existing theory does not provide a clear framework for why historical, cash-based financing costs should dominate market-implied discount rates in explaining the cross-section of returns.
In corporate finance, market-value weights and market-implied discount rates are generally viewed as theoretically correct for WACC in valuation. The use of book-value weights is typically justified as a practical approximation rather than a normative benchmark (see, for example, Fernández (2011), and Damodaran’s valuation materials NYU Stern page).
At the same time, a well-established valuation and performance-measurement literature applies a cost of capital as a charge to book capital, most notably in residual income and EVA frameworks. In these models, book values define the capital base, while the required return itself remains market-based (see Ohlson, 1995).
Open questions
Against this backdrop, the finding that a book-based cost of capital is more informative than a market-based alternative in explaining the cross-section of returns should be interpreted as an empirical regularity that points to a missing mechanism in standard asset-pricing benchmarks.
A compelling explanation is that historical financing costs embed managerial timing skill in capital issuance and payout decisions. Firms differ systematically in their ability to issue equity or debt, and to distribute cash, when financing conditions are favorable. These decisions accumulate over time and are reflected in realized, book-based financing costs.
In contrast, market-implied costs of capital reflect prevailing market sentiment and discount rates at a point in time, but abstract from the conditions under which existing capital was raised and serviced. As a result, they do not capture cross-sectional differences in firms’ realized financing outcomes arising from heterogeneous issuance timing ability.
If financing timing is a persistent managerial attribute, then book-based capital costs may serve as a sufficient statistic for the long-run interaction between managerial decisions and capital market conditions. This provides a natural explanation for why book-based measures outperform contemporaneous market-based costs in explaining returns, even though the latter remain theoretically appropriate under frictionless markets.
Understanding how issuance timing skill is priced, how persistent it is across firms, and whether it reflects informational advantages or agency-driven behavior remains an open avenue for future research.
Conclusion
Book-based WACC is not a substitute for market-based discount rates in valuation. Its relevance instead lies in empirical asset pricing, where the objective is to explain cross-sectional differences in realized stock returns rather than to infer intrinsic value.
Evidence from the Master’s thesis indicates that historical, cash-based financing costs contain economically meaningful information in this setting. One plausible interpretation is that book-based measures reflect firm-specific histories of financing decisions, including managers’ ability to time equity and debt issuance and to service capital under favorable conditions. These realized financing outcomes accumulate in book values but are not captured by contemporaneous market-implied costs of capital.
While this interpretation offers a coherent economic rationale for the empirical results, a fully developed theoretical framework linking issuance timing, persistence in financing conditions, and expected returns is still lacking. Consequently, the findings should be interpreted with appropriate caution.
Clarifying the mechanisms through which historical financing costs become priced in the cross-section of returns remains an important direction for future research.
