An Adjusted ROA as a Proxy for Risk Premium Estimation – S&P’s 1 500 Case

Abstract

Risk premium is a category that is commonly used in various models assisting decision making process, such as widely described in literature Capital Asset Pricing Model. Furthermore, as scientists describe, the risk premium is a factor that has a significant meaning for the whole economy, since it gives a possibility to assess a fair pace of capital growth, and to set fair salaries, wages, prices of agriculture products, and prices of utilities. The appropriate size of risk premium can be additionally used to establish an effective discount rate, which is necessary for financial assets’ pricing. That makes risk premium one of the most important numbers in accounting and finance. However, so far scientists from the above mentioned disciplines have not reached an agreement on the appropriate – true – size of the equity risk premium. The paper presents an alternative method for historical risk premium estimation, which is based on accounting data from filed audited financial statements. The size of risk premium is assessed on the basis of statistical interval estimation of the sample mean. The sample is defined as individual annual adjusted rates of return for companies constituting (on 31st January 2008) Standard & Poor’s Composite Index 1 500. Data required to compute returns have been reported in financial statements during the period 1988-2007. In total, the sample consists of 22 390 observations. For the purpose of research, COMPUSTAT database (North America set) was used.