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RESEARCH PRODUCT

The Risk-Relevance of Accounting Data: Evidence from the Spanish Stock Market

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This paper analyses the relevance of accounting fundamentals to inform about equity risk as measured by the cost of equity capital. Assuming the latter is a summary measure of how investors make decisions regarding the allocation of resources, the strength of the association between the cost of capital and the accounting-based measures of risk indicates how important these measures are for market participants when making economic decisions. To infer the cost of equity capital, we use the O'Hanlon and Steele's method, which is based on the residual income valuation model. Moreover, we use the insights from this model to provide a theoretical underpinning for the choice of the accounting variables related to risk. The sample refers to the non-financial firms listed in the Madrid Stock Exchange along the period 1987–2002. Our results support our initial expectations regarding the association between the cost of equity capital and the accounting-based risk variables, thereby supporting the usefulness of fundamental analysis to determine the risk inherent in share's future payoffs. In particular, we highlight the role of investing risk, which has been ignored in previous research. Our results are also robust to measures of risk other than the cost of capital such as the variability in total returns and the firm's systematic risk (β).