Rate of Return and Business Risk

Abstract

This paper reports in succinct form the findings of a study undertaken a number of years ago that sought to measure the relation between risk and rate of return and, thus, to determine an empirical basis for implementing several Supreme Court decisions (Bluefield Waterworks Case, 1923, for one) that a public utility is entitled to earnings sufficient to permit its rate of return on invested capital to be similar to those in other undertakings which are attended by corresponding risks and uncertainties. Defining business risk as functionally related to the variability of earnings, a number of hypotheses concerning rate of return and risk are tested statistically, and a reasonable and significant association is discovered between them for both a sample of industries and individual companies. The statistical model, however, explains only about a quarter of the variability in rates of return among industries and firms, suggesting that it has not captured some important determinants of risk. The final section examines our results in the light of recent developments in the theory of financial risk.