Academic journal article Journal of Emerging Trends in Economics and Management Sciences

Relationship between Stock Returns and Firm Size, and Book-to-Market Equity: Empirical Evidence from Selected Companies Listed on Milanka Price Index in Colombo Stock Exchange

Academic journal article Journal of Emerging Trends in Economics and Management Sciences

Relationship between Stock Returns and Firm Size, and Book-to-Market Equity: Empirical Evidence from Selected Companies Listed on Milanka Price Index in Colombo Stock Exchange

Article excerpt

Abstract

This paper aims to reinvestigate the behavior of expected stock returns with respect to two popularly known firm level characteristics: firm size and book-to-market equity in Sri Lankan context. The sample of the study consist of 12 companies out of total 25 companies listed on Milanka Price Index in base year of 2005 in Colombo Stock Exchange, financial year ended in December and have positive book values are only taken into consideration. The formal tests is applied the Fama-MacBeth (1973) procedure for the period from 2005 to 2010. Empirical findings reveal that Book-to-market equity has a significant negative role in expected stock returns while firm size does not have any significant behavior in expected stock returns. In reality, even though there are plenty of sources affected on expected stock returns, this study only reflect two popularly known firm level characteristics to examine the behavior of expected stock returns and covers only six years' annual data of 12 companies listed on Milanka Price Index due to the CSE will review & revise the companies to be included in the MPI on a yearly basis commencing from 2005. This study has practical implications for different interested parties such as investors, governments, policy makers, stock market analysts, stock market regulators and multinational corporations to make decisions on their different field based on Sri Lankan context. For an example, Investors can invest in small or large firms which have small book-to-market equity because of findings of this study reveal that no relation in the economy between firm size and return, and negative relation between book-to-market equity and return.The paper builds on previous work, but highlights two new findings. Namely, book to market equity only has significant negative role in behavior of stock returns of financial companies as well as non-financial companies while firm size does not have significant relation with stock returns of financial and non-financial companies and selected two firm specific factors highly explain the behavior of stock returns of financial companies than non-financial companies.

Keywords: Firm Size, Book-to-Market Equity, Expected Stock Returns, Milanka Price Index, Colombo Stock Exchange.

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

There is an accepted norm in finance that firm specific variables & macroeconomic variables explain the behavior of expected stock returns. Even though previous studies {e.g.: Gordon (1959); Friend & Puckett (1964); Bower and Bower (1969);malkiel & cragg (1970) and Zahir (1992)} found that expected stock returns is highly sensitive to macroeconomic factors, there are number of firm specific factors such as earnings, dividends, risk, leverage, size, book-to-market ratio, right issue and bonus issues explain the behavior of expected stock returns.

There are different models developed to explain the relationship between risk and returns. Capital Asset Pricing Model (CAPM) of Sharpe (1964), Lintner and Mossin (1966) (SLM) or Sharpe (1964), Lintner (1965) and Black (1972) (SLB) is the first model to explain the relationship between risk and return. The developers of this model found that market beta is positively related to expected stock returns. Even though this finding is supported to earlier researchers such as Lintner (1965), Black, Jensen, and Scholes (1972) and Fama and MacBeth (1973), the limitation of this model is that it is employed market beta only as risk factor and not employ the macro and firm specific factors to explain the behavior of expected stock returns and also the most of recent researchers Stattman (1980), Reinganum (1981), Rosenberg et al. (1985), Lakonishok and Shapiro (1986), Chan et al. (1991), Fama and French (1992,1998) , Daniel et al. (1997), Patel (1998),Chui and Wei (1998), Rouwenhorst (1998) and Claessens et al. (1998) report that market beta has little or no ability in explaining the behavior of expected stock returns and firm size and book-to-market equity play significant role in explaining the behavior of expected stock returns. …

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