An Empirical Analysis of Firm-Specific Factors and Equity Premium: Evidence from Manufacturing Sector of Pakistan

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.