Market-Expected Return on Investment. Principle 5 in Evidence-Based Investing

The Capital Asset Pricing Model (CAPM) is a financial tool used by investors and analysts for calculating the expected return on an investment, particularly in the stock market. The fundamental concept behind CAPM revolves around assessing the risk associated with a security and determining its expected reward based on that risk. According to CAPM, the only significant risk to consider for this calculation is systematic risk, which is the risk inherent to the entire market rather than risk unique to a specific stock.

To compute the expected return using CAPM, you start with the risk-free rate, which is typically the yield of a government bond, representing a safe investment. To this, you add a premium for taking on additional risk. This risk premium is derived by multiplying the security’s beta, which measures its volatility relative to the market, by the market risk premium—the difference between the expected market return and the risk-free rate. The outcome of this formula provides the investor with an estimate of the expected return, balancing the security’s risk against the potential profit.

CAPM, therefore, helps investors by guiding them on the expected return they could achieve for the level of market risk they are willing to accept. This model is widely used for portfolio optimization, pricing assets, and in financial decision-making processes related to investments in the stock market.

There is a wealth of academic research into what really drives higher expected returns. Simply put, expected returns = current market prices + expected future cash flows. Investors can use this basic equation to optimize their portfolios accordingly.

How MEROI Sets the Bar for Corporate Performance

Market-Expected Return on Investment (MEROI) offers executives and investors a valuable benchmark for gauging how much future profitability a company’s investments need to deliver to justify their current price. By comparing the present value of future company profits with the investments made, MEROI establishes a clear hurdle for performance. In essence, it answers: What is the minimum return the company must generate to meet market expectations?

This perspective ensures that decision-makers are not just considering past results or industry averages—they’re sizing up the company’s ability to deliver returns that align with what the market has already priced in. As a result, MEROI becomes a practical tool for assessing whether a company’s performance expectations are attainable, given the investments it has undertaken, and helping both corporate leaders and investors manage risk and set informed strategies.

The Evidence on Higher Expected Returns

In our last post, we described how to build lifetime wealth by patiently benefiting from the market factors that contribute the most to higher expected returns. So, what are those factors, and how did we identify them to begin with?

Since at least the 1950s, a “Who’s Who” body of scholars has been studying portfolio management to answer key questions, like:

1. What factors drive expected market returns? Which factors have persisted over time, around the world, and through various markets? Once we’ve identified a potential factor, are there reasons it’s likely to persist moving forward?
2. What drives portfolio performance (alpha vs. beta)? When comparing portfolios, what best explains their different performances? Does the biggest difference come from different exposures to overall return factors? In financial parlance, that’s a portfolio’s beta. Or is it the portfolio manager’s stock-picking or market-timing skills? That’s value-added alpha.

A Brief History of Factor Investing

In 1992, professors Eugene Fama and Kenneth French published their landmark paper, “The Cross-Section of Expected Stock Returns,” in The Journal of Finance. The paper led to the Fama-French three-factor model, which laid the groundwork for factor-based investing. (It also earned Fama a Nobel Prize in Economics in 2013.)

The three-factor model built on an earlier, single-factor Capital Asset Pricing Model (CAPM). While CAPM found market beta alone could explain around 70% of the differences, the three-factor model, with three sources of beta, offered over 90% explanatory power.

In 2014, Fama-French published “A five-factor asset pricing model” in the Journal of Financial Economics. They then stress-tested these same five factors in international markets and published the results in a 2017 paper in the same publication.

In short, over time, the academic community has continued to study new and existing factors. How do they interact with one another? How do they contribute to beta-generating returns? The more we understand about factor investing, the harder it is to believe investors can add consistent value by chasing extra, alpha-generated returns. At least not beyond what already is available through a low-cost, well-structured, evidence-based portfolio.

Or, as Fama has explained more simply:

“Pick your risk exposure, and then diversify the hell out of it.”

The Challenge of Measuring Returns in the Age of Intangibles

As companies increasingly pour resources into intangible assets like software, patents, research, and brand recognition, the task of accurately measuring their returns gets a bit trickier. Unlike factories or machinery—which show up clearly on balance sheets and have well-established methods for accounting—these intangible investments tend to blur the lines between routine expenses and long-term assets.

For example, when a company develops a new app or invests in its brand, traditional accounting often treats much of this spending as a current expense, not a strategic investment that could boost future earnings. The result? Profits and returns may look artificially lower in the short term, even though these investments might drive considerable value down the road.

To get a clearer picture of true corporate performance, investors and analysts increasingly need to look past the standard numbers. It means separating genuine investment in the future from everyday operational costs—no small feat, but essential in an economy where ideas, creativity, and innovation matter as much as—or more than—bricks and mortar.

Factors That Figure into Higher Expected Returns

Grounding your investment strategy in rational methodology strengthens your ability to stay on course toward your financial goals, as we:

1. Assess existing factors’ ability to offer higher expected returns and diversification benefits
2. Understand why such factors exist, so we can most effectively apply them
3. Explore additional factors that may complement our structured approach

Assessing the evidence (so far)

Studies dating back to the 1950s have identified three stock market factors that have formed the backbone for evidence-based portfolio construction. Over the long-run, investors can pursue higher expected returns by tilting their portfolio toward:

1. The equity premium: Stocks (equities) have returned more than bonds (fixed income).

2. The small-cap premium: Small-company stocks have returned more than large-company stocks. (Although recent analysis suggests this factor may require additional dissection to isolate its essential premium.)

3. The value premium: Value companies have returned more than growth companies (Value companies exhibit lower ratios between their stock price and various business metrics such as company earnings, sales, and/or cash flow. Growth companies exhibit higher such ratios.) Based on these metrics, value stocks appear to be either undervalued or more fairly valued by the market, compared with their growth stock counterparts.

This is the trio of stock market factors described in Fama-French’s three-factor model. Similarly, studies have identified two primary factors driving long-term higher expected returns for fixed income (bond) investments:

1. Term premium: Bonds with distant maturities or due dates have returned more than bonds that come due quickly.

2. Credit premium: Bonds with lower credit ratings (such as “junk” bonds) have returned more than bonds with higher credit ratings (such as U.S. treasury bonds).

Additional evidence from the “Factor Factory”

With the factors above identified, does this mean we know everything about how to build “perfect” portfolios? Hardly! Continued inquiry has found additional market factors at play, with additional potential premiums. For example, the five-factor model Fama/French examined includes equity, small-cap, and value, plus potential premiums from profitability and momentum:

• Profitability: Highly profitable companies have delivered premium returns over low-profitability companies.
• Momentum: Stocks that have done well or poorly recently tend to continue to do the same for longer than random chance seems to explain.

While these “new” factors may have existed for some time, our ability to isolate them is more recent. As a result, opinions vary on when, how, or if profitability, momentum, and hundreds of other potential factors contribute to higher expected returns.

If there are hundreds of factors to consider as potential sources of higher expected returns, how do we know which ones to heed, and which may be best ignored? Whenever we assess the validity of new and existing market insights, we ask pointed questions that can take years to resolve:

• Have we replicated the studies across factors, over time and around the world?
• Is there robust analysis, not only from industry insiders but also from objective academics?
• Has a proposed new factor survived extensive peer review, if not unscathed, at least free of mortal wounds?

If we can say “yes” to these three queries, we figure we’re heading in the right direction. As Fama explains, “There’s one robust new idea in finance that has investment implications maybe every 10 or 15 years, but there’s a marketing idea every week.”

The power of combining valuation and intangibles

One current frontier in return measurement is the ability to connect valuation methods—like Marginal Efficiency of Return on Investment (MEROI)—with more accurate accounting for intangible investments. Why does this matter? Traditionally, most analyses focus on physical assets, while intangible assets like intellectual property, brand value, or R&D often get short shrift in standard accounting.

By properly incorporating these intangibles, we gain a clearer, more nuanced view of what drives company profits and, ultimately, shareholder returns. When you combine comprehensive accounting for intangible investments with forward-looking valuation measures, you can better assess which companies are genuinely undervalued or poised for long-term growth. This alignment helps investors avoid underestimating entire sectors of the market (think: technology or healthcare) where intangible assets take center stage.

Taking a Closer Look: Limitations of Traditional Return Measures

Before we leave the world of factors, it’s worth shining a light on the tools often used to gauge a company’s financial return—measures like return on equity (ROE), return on invested capital (ROIC), return on incremental invested capital (ROIIC), and internal rate of return (IRR). As familiar as these metrics may be to investors and analysts, each comes with caveats that can impact their usefulness in navigating markets.

Let’s break down why these popular measures aren’t always as straightforward as they seem:

• Return on Equity (ROE): While ROE can give insight into how efficiently a company uses shareholder capital, it can also be distorted by factors like high leverage (lots of debt) or share buybacks, masking underlying business performance.
• Return on Invested Capital (ROIC): ROIC helps assess how well a company turns invested capital into profits. However, differences in accounting practices or one-time charges can skew this figure, making apples-to-apples comparisons across industries or timeframes tricky.
• Return on Incremental Invested Capital (ROIIC): This metric focuses on the returns generated by new investments. While appealing in theory, ROIIC can be muddied by noisy data, often requiring precise tracking of capital flows that isn’t always possible in practice.
• Internal Rate of Return (IRR): IRR, commonly used in project evaluation, can be quite sensitive to the assumptions behind projected cash flows. Small tweaks to those inputs can lead to big swings in the result, making IRR less robust than it might appear.

The bottom line? While these return measures are widely used and can provide valuable snapshots, none offer a perfect lens for analyzing company performance or expected investment returns. Always consider their limitations and pair them with broader context when evaluating potential opportunities.

Parsing Expenses vs. Investments: A Clearer Lens on Returns

To further sharpen our understanding of corporate returns—especially in a world where intellectual property, software, and brand equity are core assets—it’s crucial to distinguish between what a company truly “spends” and what it “invests.” Traditional accounting often bundles them together, but this can muddy the waters when evaluating how well a business is really performing.

Here’s why this matters:

• Tangible vs. Intangible Assets: In decades past, investments tended to be physical—think machinery, buildings, or trucks. Today, investments are more likely to be in patents, R&D, digital platforms, or employee training. These intangible assets don’t show up on the balance sheet in the same way, making it trickier to paint an accurate picture of a company’s growth and profitability.
• Misleading Expense Lines: When expenditures like research and development or brand building are booked as regular expenses, we may understate a company’s true earning power—and misjudge its future prospects.
• Sharper Expectation-Setting: Breaking apart expenses that keep the lights on from investments in future growth lets us more accurately gauge what’s fueling returns. This, in turn, helps set realistic expectations when projecting performance, valuing companies, or assessing where higher expected returns might actually originate.

Ultimately, by carefully teasing apart these components, investors and researchers gain a more nuanced—and trustworthy—view of where value is being created.

Where Do Higher Expected Returns Come From?

Before we wrap, let’s touch on one more important point: Scholars and practitioners alike strive to determine not only that various return factors exist, but why they exist. This helps us assess whether a factor is likely to persist and continue contributing to higher expected returns, or whether it’s more likely to disappear upon discovery.

Explanations for why factors persist (or not) usually fall into two broad categories: risk-related and/or behavioral.

A tale of risks and expected rewards

Persistent premium returns are often explained by accepting market-related risks in exchange for expected reward. As we described in “How Markets Work for You,” these are the types of “worst than expected” risks that are almost instantly incorporated into pricing in largely efficient markets. Academics have identified some factors persistently experience more of these types of risks than others, so investors expect a premium return for investing in them.

For example, it’s presumed that value stocks are riskier than growth stocks. In “Value Premium Lives!” financial author Larry Swedroe explains:

“Among the risk-based explanations for the premium are that value stocks contain a distress (default) factor, have more irreversible capital, have higher volatility of earnings and dividends, are much riskier than growth stocks in bad economic times, have higher uncertainty of cash flow, and … are more sensitive to bad economic news.”

A tale of behavioral instincts

There may also be behavioral foibles at play. That is, our basic-survival instincts often play against otherwise well-reasoned financial decisions. As such, the market may favor those who are better at overcoming their gut reactions to breaking news.

Your Take-Home

The pursuit of higher expected returns may require taking on added risk, avoiding the self-inflicted wounds of behavioral temptations, or both. Regardless, existing and unfolding inquiry on market return factors continues to hone our strategies for most effectively capturing expected returns according to your personal goals.

By considering each new potential factor according to strict guidelines, our aim is to extract the diamonds of promising new evidence-based insights from the considerably larger piles of misleading misinformation. We feel you are best served by heeding those who take a similar approach with their advice.

To see all 10 principles of Evidence-Based Investing at a glance, please visit our Evidence-Based Principles Guide. These principles inform our investing process.