Testing Nonlinear Relationships between Excess Rate of Return on Equity and Financial Ratios
12 Pages Posted: 26 Apr 2001
Date Written: April 9, 2001
Models that use financial ratios proved to be helpful in decision making of an equity investor. Commonly these models assume linear relationships between a ratio and the rate of return. In this paper the authors test the hypotheses of specific industry independent nonlinear relationships between financial ratios and excess rate of return on equity as defined in Mramor, Mramor Kosta (1996). Mramor, Mramor Kosta tested their hypotheses on financial data of Slovenia for the years 1992 and 1994 and their results were encouraging. However, their tests had three main data problems which may have altered the results: they used proxies for market rates of return on equity of Slovenian companies, they used proxies for risk adjustment of the rates of return and they used data for an economy in transition, where all the market structure and its functioning is not yet developed and stable.In this paper data is used for the stable market economies of the U.S.A. and Japan and direct market measures of the rate of return and risk (CAPM model) were obtained through extensive calculations and adjustments. With this data the second hypothesis of Mramor, Mramor Kosta is tested and the best functional relationships for each financial ratio (within each industry) are determined. The results of the simple regression tests confirm the theoretically assumed relationships and assumed quite strong industry independence of the functional forms of these relationships.
Keywords: Financial ratios; Fundamental analysis; Nonlinear regression
JEL Classification: M49, C21, G12, G30
Suggested Citation: Suggested Citation