Rational asset pricing: book-to-market equity as a proxy for risk in utility stocks

Abstract

Previous research has shown that the asset pricing model of Sharpe, Litner and Black fails to capture the relationship between market β and average return. This previous work showed that the relationship between β and average return was flat. Subsequently it was shown that a strong relationship between book-to-market equity and stock price returns existed. It has also been shown that book to market equity has strong roots in economic fundamentals.

Utilities have historically used betas to justify rate increases I developing rate structures that meet the rate of return demands for investors given the risk profiles that the company betas suggest. Realizing that low betas argue against large rate increases l utilities have turned to other avenues to justify higher returns. The suggested relationship of book-to-market equity and average stock returns would provide utilities with a new argument. This thesis will show that the search for a risk proxy in the rate of return relationship for the electric utility is not resolved. The relationship reported between book-to-market equity and stock price returns does not appear to be statistically significant in the electric utility sector and extreme caution is advised in using this empirical model to predict or explain stock price returns.