Abstract--A Canonical Analysis of Market Return-Risk and Financial Characteristics of Industrial Firms

Abstract

A CANONICAL ANALYSIS OF MARKET RETURN-RISK AND FINANCIAL CHARACTERISTICS OF INDUSTRIAL FIRMS Rodney L. Roenfeldt and Philip L. Cooley* Market return and risk should be jointly considered in any investment decision. In an effort to examine some of the underlying components of market excess return and risk, the relationship between these two measures and firm financial characteristics is analyzed. Since both market return and risk are considered simultaneously in an investment decision, they are also simultaneously related to firm financial characteristics using canonical correlation analysis. Using firms* market excess return and risk as the criterion variable set and six financial variables (current ratio, fixed charge coverage, financial leverage, retained earnings to total assets, total asset size, and market activity?shares traded divided by shares outstanding) as the predictor variable set, a canonical model is estimated for each of the three periods 1964-67, 1968-71, and 1964-71. Support is provided by the ca? nonical model for the hypothesis that firms' market excess return and risk are functionally related to firms' financial characteristics. The first canonical correlation for all three periods studied is .62 or greater. Also, the first canonical variate for all three periods shows a sizable overlap in information of the return-risk variable set given the financial variable set as indicated by redundancy measures ranging from 20.9 to 27.8 percent. Examining both canonical variates for all three time periods reveals some common features of the models. Higher retained earnings to total assets is associated with a higher market return in all three periods while simultaneously being associated with a lower market risk except for the period 1964-71 when market risk is unaffected by this variable. In addition, a high market activity is associated with both a higher market return and risk except for 1964-71 where market activity is inversely related to market return. The influence of total asset size on market return and risk is somewhat inconsistent. Larger firms are associated with lower returns in 1964-67 and 1968-71 and with lower risk in 1964-67 and 1964-71. Both, University of South Carolina.