The relationship between return and market value of common stocks

Abstract

This study examines the empirical relattonship between the return and the total market value of NYSE common stocks. It is found that smaller firms have had htgher risk adjusted returns, on average, than larger lirms. This ‘size effect’ has been in existence for at least forty years and is evidence that the capital asset pricing model is misspecttied. The size elfect is not linear in the market value; the main effect occurs for very small tirms while there is little difference m return between average sized and large firms. It IS not known whether size per se is responsible for the effect or whether size IS just a proxy for one or more true unknown factors correlated with size. The single-period capital asset pricing model (henceforth CAPM) postulates a simple linear relationship between the expected return and the market risk of a security. While the results of direct tests have been inconclusive, recent evidence suggests the existence of additional factors which are relevant for asset pricing. Litzenberger and Ramaswamy (1979) show a significant positive relationship between dividend yield and return of common stocks for the 1936-1977 period. Basu (1977) finds that pricee earnings ratios and risk adjusted returns are related. He chooses to interpret his findings as evidence of market inefficiency but as Ball (1978) points out, market efftciency tests are often joint tests of the efficient market hypothesis and a particular equilibrium relationship. Thus, some of the anomalies that have been attributed to a lack of market efficiency might well be the result of a misspecification of the pricing model. This study contributes another piece to the emerging puzzle. It examines the relationship between the total market value of the common stock of a firm and its return. The results show that, in the 193661975 period, the common stock of small firms had, on average, higher risk-adjusted returns *This study ts based on part of my dtssertatton and was completed while 1 was at the Umverstty of Chtcago. 1 am grateful to my committee, Myron Scholes (chairman), John Gould. Roger Ibbotson. Jonathan Ingersoll, and especially Eugene Fama and and Merton Mtller, for their advtce and comments I wtsh to acknowledge the valuable comments of Btll Schwert on earher drafts of thts paper