Beta Estimation with Stock Return Outliers: The Case of U.S. Pharmaceutical Companies

34 Pages Posted: 29 May 2009 Last revised: 8 Jun 2009

See all articles by Alexandra K. Theodossiou

Alexandra K. Theodossiou

Texas A&M University-Corpus Christi-College of Business

Panayiotis Theodossiou

Ball State University

Uzi Yaari

Rutgers University; School of Business-Camden

Date Written: May 20, 2009

Abstract

Efficient estimation of the equity cost of public corporations is an essential component of computing the required rate of return of real investment projects, and therefore the basis for a rational investment policy. The accepted methodology relies on the CAPM model to define the return risk premium, and the OLS method to estimate the beta risk coefficient required for calculating the premium. This study challenges the use of the OLS method for this task by demonstrating its vulnerability to the impact of stock return outliers caused by large, unpredictable, company-specific events. That impact is verified on a sample of U.S. pharmaceutical companies by comparing the OLS estimation performance with that of our proposed method based on Huber’s Robust M (HRM) estimator, a related statistical method that follows a mixed return model identifying regular and outlier return components. Using the HRM-estimated beta as a benchmark, we demonstrate that (1) outliers can substantially bias the OLS beta, (2) the bias is negatively correlated with company size, and (3) the size of the bias is often moderated but not eliminated by extending the estimation period. The latter finding suggests that a robust method like HRM is preferable where estimators ought to represent the behavior of the majority of historical data despite the presence of outliers. The risk of trusting the OLS beta is especially high when estimation must rely on a small sample.

Keywords: stock beta estimation, OLS vs. Robust M beta estimation, equity cost of capital, pharmaceutical industry

JEL Classification: G12, G31

Suggested Citation

Theodossiou, Alexandra K. and Theodossiou, Panayiotis and Yaari, Uzi, Beta Estimation with Stock Return Outliers: The Case of U.S. Pharmaceutical Companies (May 20, 2009). Available at SSRN: https://ssrn.com/abstract=1410371 or http://dx.doi.org/10.2139/ssrn.1410371

Alexandra K. Theodossiou

Texas A&M University-Corpus Christi-College of Business ( email )

6300 Ocean Drive
Corpus Christi, TX 78412
United States

Panayiotis Theodossiou (Contact Author)

Ball State University ( email )

2000 W. University Ave
Muncie, IN Delaware 47306
United States

Uzi Yaari

Rutgers University ( email )

School of Business
Camden, NJ 08102
United States
610-664-2086 (Phone)

HOME PAGE: http://camden-sbc.rutgers.edu/FacultyStaff/Directory/yaari.htm

School of Business-Camden ( email )

Rutgers University
227 Penn Street
Camden, NJ 08102
United States
610-664-2086 (Phone)
610-664-2198 (Fax)

HOME PAGE: http://camden-sbc.rutgers.edu/FacultyStaff/Directory/yaari.htm

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