Financial Ratios and Stock Return Predictability

The resolving queens indicate that DY and EY ratios has direct positive tie with stress counter where as B/M ratio has signifi sewert negative kin with stress deliver. Therefore we apprise say that the in a higher place menti aced ratios are suitable to call germinate fork overs, merely much it can be seen that as line of reasoning to dividend open key and earning accord the ratio of sustain to foodstuff has the highest prophetic origin. that when we combine these pecuniary ratios the yellability of sprout produces testament enhance. Keywords financial ratios, rail line return, Karachi roue flip, Dividend Yield, Earning Yield. 1.Introduction Stock food market plays a very significant role in the economical growth of a country. According to A. Schrimpf (2010) there is significant economic aftermath of the existence of dividing line return predictability. S. Kheradyar et al, (2011), The Analytics of Economic Time serial, states that in line of bus inesss grocery store shell out prices move stochasticly i. e. on genuine day share prices are like to go down as they were like to up. Such random behavior worried rough of the financial economists and followed by further research. therefore such random movement of share prices lead to a system called Random Walk Hypothesis.Random walk supposition suggest that it is difficult to predict share prices because investment company prices evolved, now it pull up stakes be showing upward trend but after whatsoever date such might be showing downward trend. Hence predicting 100% accuracy of inception return is almost impossible. In contrast to Random Walk Behavior is businesslike mart hypothesis. According to efficient grocery hypothesis share prices are fairly priced in the linage market or prices of parenthood demonst tells information in the market is widely and equally available to all and no one in the market can outperform or can beat the market.With the passage of cartridge clip researchers tries to find out most accurate inconstants for predicting declination prices, some were fly the coop towards financial and some were towards profitability ratios i. e. news to market ratio, price to boodle ratio, 1 interrogation Journal of finance and account ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online) Vol 3, No 10, 2012 www. iiste. org dividend pay off, etc some were melt down towards exchange electric current ratios like price to cash flow ratio, cash burn ratio, etc and some foc employ on macroeconomic variable like interest rate, law and order situation and inflation rate etc.In this research article we accept investigated 3 in a higher place mentioned ratios to determine whether they predict stock returns. This research lease has used the stock return and the above mentioned financial ratios intimacy at ii types as the orderation for the face of eight-spot hypotheses. On the grounds of their appropriate regression shapes the eight hypotheses are change integrity into deuce sets. In this understand we come used the two models of simple and multiple regressions to apply Predictive regression it is an important machine for predicting stock returns. A set of panal info is used for the commandtion of these two models.For tackling the enigma of heteroskedasticity and non-normality distributed residuals, we applied generalized least squares method. 2. Literature Re mess Campbell and Shiller (1988) say in their domain that as dividend break down has the ability to confine anticipate return and expectation about growth in dividend yield so dividend yield is proper predictor of stock return. Chan, L. Hamao, Y. Yakonishok, J. (1991), fix that in Nipponese market fundamental variables like dividend yield, price to earnings ratio, book to market ratio and fasts size have significant shock on expected earning/returns of stocks.They notify that there is indirect kind betwixt earning yield and stocks returns in Japan. In comparing of the size of the firm and earning yield, B/M and dividend yield (cash flow yield) are significantly related with returns of stocks. They further added that an important variable both(prenominal) economically and statistically is book to market ratio and this need to be observe because either the afterward half of the savour is judged or for the first time test is applied the book to market ratio shows it continuation. Mukerji, S. Dhatt, M. Kim, Y. 1997), on Korean Stock market for a intent of 1982-1992 establish a direct family between return of stocks and D/E, S/P and B/M, moreover an indirect family between size of firm and return of stocks. They demonstrated that P/E ratio is little trustworthy indicator than B/M and S/P. Beta is a week proxy for assessment of risk when oppose with debt to equity ratio. B/M and S/P are responsible for(p) for the direct relationship between return of stocks and debt to equity. However a P/E and B/M ratio becomes the base for indirect relationship between return of stocks and size of the firm.Kothari and Shanken (1997) found for US market that dividend yield and book to market ratios have dependable proof for expected veridical return over a issue 1926-1991, and there lies a slice of time series variations. Pontiff and Schall (1998) stated that as for predicting power is concern book to market ratio has some predictability power for predicting stock returns. Lewellen (2002) conducted his memorise in US he found that predictability power of dividend yield for predicting stock returns is more than P/E and B/M ratios.Ang, A. , and Bekaert, G. , (2006), in their studies essay to forecast interest rate and stock returns with the help of prognostic power of dividend yield. They found for short term forecasting, dividend yield predictive power is more than the long term forecasting. But as for the expected growth of cash flow prediction is concerned than dividend yield is a good pr edictive variable. Akyol, A. (2006), analyzed the effect of firms size, beta, and book-to-market lever on the stock returns in Istanbul stock exchange.He used data from July 1993 to December 2005 for Istanbul Stock Exchange and used Fama and French (1992) methodology to construct portfolios represented accurately by size-beta and then size-book-to-market, he found that book to market and Beta of a firms have no effect on the stock returns in Istanbul stock exchange. Size of the firm was the only variable which was negatively related to the stock returns in Istanbul stock exchange. He also found that book to market, size and beta is not related with January effects. Hjalmarsson, E. (2004), in his strike tried to find out Global stock returns predictability.He took twenty potassium monthly observation form forty international stock markets. In which 24 were of developed economy and 16 were of developing economy. However his field of operation showed that dividend yield and price t o earnings ratio has little power of predictability and defends his finding by adding that international result is showing deviation from traditional spate because the method use internationally may not count for object of variables. 2. 1 Hypotheses H1 return of stock and DY has no association in time (t) and (t-1) severally in savour one.H2 return of stock and EY has no association in time (t) and (t-1) respectively in sample one. H3 return of stock and B/M has no association in time (t) and (t-1) respectively in sample one. H4 return of stock and DY has no association in time (t) and (t-1) respectively in sample two. H5 return of stock and EY has no association in time (t) and (t-1) respectively in sample two. H6 return of stock and B/M has no association in time (t) and (t-1) respectively in sample two. 2 Research Journal of Finance and Accounting ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online)Vol 3, No 10, 2012 ww. iiste. org H7 return of stock and DY, EY, B/M cabal has no association in time (t) and (t-1) respectively in sample one. H8 return of stock and DY, EY, B/M combination has no association in time (t) and (t-1) respectively in sample two. 3. Research Methodology In order to check predictability power of earning yield, dividend yield and book to market ratios for predicting stock returns the theatre of operations has taken a sample of 100 firms for a menstruum of 2005-2011. We have applied certain masking criterias for companies to be included in the sample.First, the firm must be listed on the KSE before Jan 1st 2005. 2nd, for more than twelve months a stock must not be deferred. 3rd, for the study utmost of seven long time a smart set stock must not be delisted. 4th, data must be available for all sample firms and variables. Finally, for a period of more than twelve months the dividend yield of firms must not be zero. The study has divided the selected firms into two equal samples, which testament reduce the effects of random sampling errors and for the predictive regression two samples produce different estimation.The study is based on gameary data, which is collected from, State Bank of Pakistan, companys annual reports, business recorder and from Karachi stock exchange. pursuance S. Kheradyar et al, (2011) this study includes stock returns as dependent variable while dividend yield, earning yield and B/M ratios has been taken as independent variables. 4. Measurement of Variables 4. 1 Stock Return Following Lewellen (2001) and S. Kheradyar et al, (2011) we have used stock return as dependent variable.Stock return is measured by dividing capital crystalize along with dividend per share on market price per share. Following is the formula for stock returns. SRi = DPs + capital gain/market price 4. 2 intelligence to Market Ratio For finding prize of company by comparison of market value of a share to its book value, study tends towards book to market ratio. For finding book value of a firm the study divide eq uity of a firm by its total payoff of outstanding shares. As for market price is concerned study tend towards the ongoing price of share in stock market.If a firm offer high return and having high book value than its market value, the firm is riskier and in succeeding(a) returns of stock will be take down than today. The following formula is used for calculating book to market value B/M = Book Value per share Market value per share Lewellen (2001) states that as compare to P/E ratio B/M has higher predictive power for predicting stock return. But when study compare B/M ratio with dividend yield than dividend yield is good forecaster than B/M ratio. 4. 3 Dividend yield Following S.Kheradyar et al, (2011) second independent variable in this study is Dividend yield which is calculated as dividing dividend per share on market price per share. If market price is dispirit than dividend yield will be higher and give a riskier orient for investment. Contrast to higher dividend yield is low dividend yield such break when market price per share is higher than dividend yield and gives an optimistic view for investment.The following formula demonstrates how to calculate dividend yield Dividend Yield (%) = (Dividend per Share / Market rate per share) x 100 4. Earning Yield The empirical literatures lay foundations of the predictive power of earning yield on stock return, and find out the association between earning yield and stock return is considerable, because earning yield plays as a risk agent in relation with stock return. Moreover, the earning yield can demonstrate the efficiency of market that has an important role in emerge markets, thus this study uses earning yield as the empirical predictor of stock return. Following S. Kheradyar et al, (2011) we have measured earning yield as earning per share divided by price of share. 5.Regression Model In this research article we have investigated three financial ratios EY, DY and B/M to determine whether they predic t stock returns. This research study has used the stock return and the above mentioned financial ratios association at 3 Research Journal of Finance and Accounting ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online) Vol 3, No 10, 2012 www. iiste. org two samples as the foundation for the formulation of Eight hypotheses. On the grounds of their appropriate regression models the eight hypotheses are divided into two sets.In this study we have used the two models of simple nd multiple regressions to apply Predictive regression it is an important tool for predicting stock returns. A set of panal data is used for the formulation of these two models. For tackling the problem of heteroskedasticity and non-normality distributed residuals, we applied generalized least squares method. Following S. Kheradyar et al, (2011) we have used panal models to prepare predictive regressions. Hence we have used simple regression model to test the first 6 hypothesis which are formulated on the basis of associ ation between each financial ratio and future stock returns.The simple regression model has the following form SR it = 0 + i Xi (t-1) + eit Where, SR it= in time period t, the return of ith stock, 0= the estimated constant, i= ith stock sure coefficient, Xi (t-1) = in period t-1 financial ratios of the ith stock, eit = error term. in addition following S. Kheradyar et al, (2011) we have used multiple regression model to test the separate two hypotheses H7 and H8, these two hypotheses are formulated on the basis of relationship between have financial ratios and future stock returns.The model has the following form SR it = 0 + i1 DYi (t-1) + i2 EYi (t-1) + i3 B/Mi (t-1) + eit Where, SR it= in time period t, the return of ith stock, 0= the estimated constant, i1= for DY the Ith stock predictable coefficient, i2= for EY the Ith stock predictable coefficient, i3= for B/M the Ith stock predictable coefficient, DYi (t-1) = is ith stock DY factor in period of time t-1, EYi (t-1) = EY fa ctor of ith stock in period of time t-1, B/Mi (t-1) = B/M factor of ith stock in t-1 time period, eit = error terms. 6.Results and Discussion For the first 6 hypothesis the predictive regression results are summarized in Table 1. The coefficient of dividend yield in Table 1 demonstrates a positive relationship of dividend yield in period (t-1) and stock returns in period (t) in both samples that is when dividend yield increases by one unit it will cause an increase of 0. 021 and 0. 010 units in stock returns of two samples respectively. As for the p-value of coefficient of Dividend yield is concerned it is 0. 016 in sample one which is less than 0. 5, so the relationship is statistically significant and the naught hypothesis H1 is rejected, however in sample two the association is undistinguished so hypothesis H4 cannot be rejected.The coefficient of earning yield in Table 1 demonstrates a positive relationship of earning yield in period (t-1) and stock returns at period (t) that is when earning yield increases by one unit it will cause an increase of 0. 013 and 0. 008 units in stock returns in the two samples respectively. As for the p-value of coefficient of earning yield is concerned it is 0. 19 and 0. 010 in the two samples respectively which is less than 0. 05, so the relationship is statistically significant, therefore we will reject hypothesis H2 and H5. The negative coefficient of Book to market value in table 1 notifies an inverse relationship of B/M and stock returns in both samples that is if B/M ratio increasing the stock return will be decreasing and vice versa. The p-value of coefficient of B/M value 0. 000 indicates that the relationship is statistically significant in both samples, so hypothesis H3 and H6 have been rejected.S. Kheradyar et al, (2011) found that DY has negative influence on stock return, and a positive association between EY and stock return. He also found a positive impact of B/M on stock return in (2) (1) 4 Research Journal of Finance and Accounting ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online) Vol 3, No 10, 2012 www. iiste. org sample 2 but a negative one in sample 1. It can also be noticed by looking at the change R-square that B/M has the highest predictive power, and this result is also supported by S. Kheradyar et al, (2011). Insert Table 1 Here) instantaneously we will test to see whether stock return predictive power increases with the combination of EY, BM and DY. We will reject H7 and H8 because it can be seen in Table 2 that the predictive regressions are statistically significant. Thus we can say that stock return can be predicted by the combination of EY, BM and DY. Also we can say that as compare to the other two ratios, the variations of the ratio of book to market has greater impact on stock return, because in both samples it has the highest coefficient.Similarly by looking at the adjusted R-square we can say that in the two samples stock return predictive power increases when the com bination of EY, BM and DY increases. (Insert Table 2 Here) 6. expiry Literature regarding predictability of stock returns has changed over the last 20 years. With evolution researchers and economists scattered price to earnings ratio, dividend yield, inflation, and book to market ratio, beta, industry returns, interest rate, and size of firms from amongst other variables which were considered important for predicting return of stocks.Presently strong evidences are present regarding variables for predicting stock returns. Analysis showed that financial ratios have significant power of predictability for forecasting returns of stock and they predict future stock return of Pakistani market, and B/M has higher predictive power as compare to other ratios. Similarly the predictability of stock return is enhanced by the combination of financial ratios. References A. Schrimpf, (2010). global Stock Return Predictability under Model Uncertainty. Journal of International currency and Finan ce, 29 1256-1282. S. Kheradyar, I. Ibrahim, and F.Mat Nor, (2011). Stock Return Predictability with Financial Ratios. International Journal of Trade, economics and Fiance, 2(5) 391-396. J. Y. Campbell, and R. J. Shiller, (1988). Stock Prices, Earnings and Expected Dividends. Journal of Finance, 43(3) 661-676. Chan, L. Hamao, Y. Lakonishok, J. (1991). Fundamental and Stock Returns in Japan. The Journal of Finance, 17391764. Mukerji, S. Dhatt, M. Kim, Y. , (1997). A Fundamental Analysis of Korean Stock. Financial psychoanalyst Journal, 53 7580 Kothari, S. P. , Jay A. Shanken, (1997). Book-to-Market, Dividend Yield and Expected Market Returns A TimeSeries Analysis.Journal of Financial economic science 44 169-203. J. Pontiff, and L. Schall, (1998). Book-to-Market Ratios as Predictors of Market Returns. Journal of Financial Economics, 49 141160. Lewellen, J. , (2002). Predicting Returns with Financial Ratio. National Bureau of Economics Research, MIT working paper no. 4374-02 Ang, A. a nd Bekeart, G. , (2006). 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