Abstract
Equity premium is a vital number in finance to be considered for making fund allocation and investment decisions. This study explores the relationship between (controllable) determinants of firm-level equity premium in the context of Pakistan stock market. We use a sample of 306 firms’ annual data, from 01/2001 to 6/2017, using a two-stage least-squares method to estimate our model. During the selected sample period, the average market premium of the Pakistan stock exchange (KSE100 Index) was twenty percent. The average equity premium of individual firms was only eight percent. Company fundamentals are considered determinants of firm-level equity premiums. Panel data econometrics techniques were used to estimate the modified version of the multifactor model for the Pakistan Stock Exchange. It is found that the market premium, return on equity, dividend payout ratio, accounts receivable, and firm size significantly and positively affect the firm-level equity premium. However, increase in the debt-to-equity ratio and quick ratio negatively affects that premium. The company fundamental variables are controllable for the firms and can be improved by company management to encourage investors and maximize shareholder wealth.
Highlights
One of the most pressing, contemporary topics in advanced corporate finance and financial economics is the equity premium and the magnitude of that equity premium in total returns. e equity premium is the additional return that investors require from investing in riskier stocks rather than in risk-free securities. e risk premium drives the total expected stock returns and is a key determinant of the cost of equity
Conclusion and Recommendation is paper quantifies the impact of company fundamentals on the firm-level equity premium in an emerging market, Pakistan, using a panel data technique for 306 nonfinancial firms listed on the Pakistan Stock Exchange for the period January 2001 to December 2015. e company fundamental factors included profitability, liquidity, dividends, solvency, efficiency, and size
We selected proxies for measuring company fundamentals of return on equity, quick ratio, dividend payout ratio, debt-to-equity ratio, account receivable turnover ratio, and size, as company fundamental variables as determinants of the equity premium. e company fundamentals are the controllable factors for companies and can be revisited by companies if they affect company returns
Summary
One of the most pressing, contemporary topics in advanced corporate finance and financial economics is the equity premium and the magnitude of that equity premium in total returns. e equity premium is the additional return that investors require from investing in riskier stocks rather than in risk-free securities. e risk premium drives the total expected stock returns and is a key determinant of the cost of equity. E equity premium is the additional return that investors require from investing in riskier stocks rather than in risk-free securities. Fama and French [1] define the equity risk premium as the difference between expected market portfolio return and the risk-free rate of return. According to Mehra and Prescott [2], the difference between the market portfolio of stock and the risk-free interest rate is excess return, and this is called the equity premium. The equity premium is the reward for taking that higher risk. It is a major factor for investors in estimating the total expected return of venture capital investment demand. Many studies have validated the Capital Asset Pricing Model (CAPM), which is the origin of the equity premium in various capital markets [5,6,7]. e preliminary empirical test of CAPM predicts a positive statistically significant intercept term and concludes that the CAPM corresponds to the expected return of the market. e
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