Theory Of Size Effect Essay

Starting from the late 1970’s, empirical examinations of the traditional CAPM indicate the possible existence of anomalous excessive returns related to size, book-to-market, earnings yield and leverage variables among others. Ball (1978) suggest that the Earnings Price (E/P) ratio, an accounting variable obtained by dividing the earnings of a firm with its stock price, may be a direct proxy for expected returns. He states that the abnormal returns on stocks following earnings announcements are not explained by the CAPM. In light of the deficiencies associated with the CAPM, especially the use of a questionable market portfolio proxy as per Roll (1977), the E/P is an important factor in explaining expected returns (Ball, 1978). However Reinganum (1981) concludes that the size effect encompasses the E/P ratio effect hence the former explains the return-generating process better than the latter.

Banz (1981) finds that stocks of small New York Stock Exchange (NYSE) listed companies earn higher average risk-adjusted returns than those of large companies when the stocks are sorted on the basis of market capitalisation. According to him, the existence of such a size effect bears evidence that the CAPM is misspecified as the returns on small stocks are higher than what it predicts.

Adding to findings by Banz (1981) ,

(1991) examines the relationship between earnings yield, size, and book-to-market ratio, cash flow yield and returns. They find book to market ratio to be the economically and statistically most vital variable across all months in explaining returns. The study establishes a positive and significant relationship between the cash flow yields and expected stock returns. In addition, Chan et al. (1991) endorse the existence of a size effect, thus after adjusting for market risk, small firms are observed to outperform larger firms in line with (Reinganum,1981; Banz, 1981; Basu, 1983; Keim, 1983), though in some cases, the size effect is not