Company Fundamentals and Equity Returns in India

Abstract

This paper examines the relationship between four company fundamental variables (viz. market capitalization, book equity to market equity ratio, price earnings ratio and debt equity ratio) and equity returns in Indian stock market using monthly price data of a sample of 455 companies forming part of S&P CNX 500 Index over the period June 1997 to June 2007. We also investigate whether the inclusion of any one or more of these fundamental variables can better explain cross sectional variations in equity returns in India than the single factor CAPM. We find that market capitalization and price earnings ratio have statistically significant negative relationship with equity returns while book equity to market equity ratio and debt equity ratio have statistically significant positive relationship with equity returns in India. The investment strategies based on these variables produced extra risk adjusted returns over the study period. Using Davis Fama and French(2000) methodology we find that Fama-French three factor model ( based on market risk premium, size premium and value premium) explains cross sectional variations in equity returns in India in a much better way than the single factor CAPM. These results have important implications for market efficiency, asset pricing and market microstructure issues in Indian stock market.