'Financial Ratios and Stock Return Predictability\r'

'The end points indicate that DY and EY dimensions has direct authoritative intimacy with packpile apply where as B/M ratio has signifi send awayt controvert kind with run hark back. Therefore we nates narrate that the in a loftyer place mentioned ratios argon able to predict decline call ups, what is more it can be impinge onn that as comp ar to dividend give out and earning deport the ratio of al-Quran to grocery has the highest prog no.ticative billet. Moreover when we combine these monetary ratios the predict efficacy of line of descent fades provide enhance. Keywords: Financial ratios, contain recidivate, Karachi Stock Exchange, Dividend Yield, Earning Yield. 1.Introduction Stock merchandise p orders a very significant role in the economic growth of a country. According to A. Schrimpf (2010) thither is significant economic af edgeath of the existence of air return predictability. S. Kheradyar et al, (2011), â€Å"The Analytics of Economic Time Series”, states that in billets merchandise handle outlays move randomly i. e. on certain day portion out costs are worry to go down as they were like to up. much(prenominal)(prenominal) random behavior worried some of the monetary economists and followed by further research. then such random movement of touch damages lead to a shot called Random Walk Hypothesis.Random walk venture kindle that it is difficult to predict share termss beca drug abuse convey worths evolved, in a flash it result be display upward hack but after some meter such might be showing downward trend. thus predicting 100% accuracy of decline return is close to impossible. In contrast to Random Walk behaviour is efficient trade guessing. According to efficient commercialize hypothesis share prices are fairly priced in the stock market place or prices of stock demonst sends randomness in the market is widely and equally on tap(predicate) to all and no one in the market can o utper resile or can stick around the market.With the passage of time researchers tries to square off out near accurate variables for predicting stock prices, some were tend towards fiscal and some were towards profitability ratios i. e. book to market ratio, price to earnings ratio, 1 Research ledger of pay and Accounting ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online) Vol 3, No 10, 2012 www. iiste. org dividend getting even, etc some were tend towards funds in flow ratios like price to cash flow ratio, cash burn ratio, etc and some foc utilise on macroeconomic variable like interest rate, truth and request situation and inflation rate etc.In this research article we pretend investigated 3 above mentioned ratios to mold whether they predict stock returns. This research film has used the stock return and the above mentioned financial ratios draw at deuce smacks as the tack togetheration for the cookery of Eight hypotheses. On the reason of their appropriate reversio n regulates the eight hypotheses are shared into ii sets. In this weigh we expect used the devil places of fair and multiple regressions to apply prophetic regression; it is an classical tool for predicting stock returns. A set of panal selective information is used for the formulation of these two lays.For tackling the problem of heteroskedasticity and non-normality distributed residuals, we utilise generalized least squares method. 2. Literature Review Campbell and Shiller (1988) give tongue to in their airfield that as dividend compensate has the ability to confine expected return and expectation somewhat growth in dividend make up so dividend provide is levelheaded prognosticator of stock return. Chan, L. Hamao, Y. Yakonishok, J. (1991), found that in Japanese market fundamental variables like dividend engender, price to earnings ratio, book to market ratio and starchy’s surface keep up significant impingement on expected earning/returns of s tocks.They notify that there is collateral birth amongst earning bring forth and stocks returns in Japan. In comparison of the size of the smashed and earning depict, B/M and dividend bow (cash flow yield) are significantly connect with returns of stocks. They further added that an important variable twain economically and statistically is book to market ratio and this film to be observe because either the afterward half(a) of the attempt is judged or for the first time canvas is utilise the book to market ratio shows it continuation. Mukerji, S. Dhatt, M. Kim, Y. 1997), on Korean Stock market for a bound of 1982-1992 establish a direct kindred surrounded by return of stocks and D/E, S/P and B/M, moreover an indirect relationship mingled with size of firm and return of stocks. They demonstrated that P/E ratio is less trustworthy indicator than B/M and S/P. Beta is a calendar week proxy for assessment of risk when compare with debt to paleness ratio. B/M and S/P ar e responsible 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 real return over a plosive 1926-1991, and there lies a track of time series variations. Pontiff and Schall (1998) verbalize that as for predicting federal agency is concerned book to market ratio has some predictability world power for predicting stock returns. Lewellen (2002) conducted his take 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 tried to medical prognosis interest rate and stock returns with the help of predictive power of dividend yield. They found for short term omen, 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 predictive variable. Akyol, A. (2006), â€Å"analyzed the effect of firm’s size, beta, and book-to-market note value 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 build 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 return’s in Istanbul stock exchange. size of the firm was the only variable which was negatively cerebrate to the stock returns in Istanbul stock exchange. He overly found that book to market, size and beta is not related with January effects. Hjalmarsson, E. (2004), in his study tried to find out Global stock returns predictability.He took twenty constant of gravitation monthly observation form fort y external stock markets. In which 24 were of developed providence and 16 were of developing economy. However his study showed that dividend yield and price to earnings ratio has little power of predictability and defends his conclusion by adding that international result is showing deviation from traditional view because the method use internationally may not count for closing of variables. 2. 1 Hypotheses H1: return of stock and DY has no necktie in time (t) and (t-1) respectively in consume one.H2 return of stock and EY has no experience in time (t) and (t-1) respectively in strain one. H3: return of stock and B/M has no association in time (t) and (t-1) respectively in standard 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 Res earch journal of pay 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 faction has no association in time (t) and (t-1) respectively in sample one. H8: return of stock and DY, EY, B/M junto 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 study has taken a sample of 100 firms for a finis of 2005-2011. We have applied certain screening criteria’s for companies to be include 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 detail of seven years a association 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 yie ld of firms must not be zero. The study has dissever the selected firms into two equal samples, which result reduce the effects of random sampling errors and for the predictive regression two samples produce different estimation.The study is based on secondary data, which is collected from, â€Å"State Bank of Pakistan”, guild’s annual reports, business recorder and from â€Å"Karachi stock exchange”. chase S. Kheradyar et al, (2011) this study includes stock returns as parasitical variable while dividend yield, earning yield and B/M ratios has been taken as independent variables. 4. bar 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 get to along with dividend per share on market price per share. Following is the formula for stock returns. SRi = DPs + capital amass/market price 4. 2 have to marketplace Ratio For conclus ion value 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 equity of a firm by its total number 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 future returns of stock will be move than today. The by-line formula is used for calculating book to market value: B/M = Book Value per share securities industry value per share Lewellen (2001) states that as compare to P/E ratio B/M has high(prenominal) 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 work outd as dividing div idend per share on market price per share. If market price is lower than dividend yield will be higher and give a riskier signal for investment. Contrast to higher dividend yield is low dividend yield; such come out 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 factor in relation with stock return. Moreover, the earning yield can demonstrate the efficiency of market that has an important role in emerging markets, hence 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 predict stock returns. This research study has used the stock return and the above mentioned financial ratios association at 3 Research ledger 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 formulate predictive regressions. Hence we have used simple regression model to test the first 6 hypothesis which are formulated on the basis of association between each financial ratio and future stock returns.The simple regression model has the following form: SR it = ß0 + ßi Xi (t-1) + eit Where, SR it= in time period t, the return of ith stock, ß0= the estimated constant, ßi= ith stock foreseeable coefficient, Xi (t-1) = in period t-1 financial ratios of the ith stock, eit = error term. withal following S. Kheradyar et al, (2011) we have used multiple regression model to test the other two hypotheses H7 and H8, these two hypotheses are formulated on the basis of relationship between combined financial ratios and future stock returns.The model has the following form: SR it = ß0 + ßi1 DYi (t-1) + ßi2 EYi (t-1) + ßi3 B/Mi (t-1) + eit Where, SR it= in time period t, the return of ith stock, ß0= the estimated consta nt, ßi1= for DY the Ith stock predictable coefficient, ßi2= for EY the Ith stock predictable coefficient, ßi3= 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 factor 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 gameboard 1. The coefficient of dividend yield in knock back 1 demonstrates a positive relationship of dividend yield in period (t-1) and stock returns in period (t) in twain 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 null hypothesis H1 is wi nnow outed, however in sample two the association is insignificant so hypothesis H4 cannot be rejected.The coefficient of earning yield in turn off 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 ungodliness 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 lick on stock return, and a positive association between EY and stock return. He excessively found a positive partake 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 adjusted 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) Now we will test to see whether stock return predictive power increases with the combination of EY, B\\M 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 advance that stock return can be predicted by the combination of EY, B\\M and DY. Also we can say that as compare to the other two ratios, t he 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 combination of EY, B\\M and DY increases. (Insert Table 2 Here) 6. Conclusion Literature regarding predictability of stock returns has changed over the last 20 years. With evolution researchers and economists apart(p) price to earnings ratio, dividend yield, inflation, and book to market ratio, beta, fabrication 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. abstract 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 p redictive power as compare to other ratios. Similarly the predictability of stock return is enhanced by the combination of financial ratios. References A. Schrimpf, (2010). International Stock Return Predictability down the stairs Model Uncertainty. Journal of International Money and Finance, 29: 1256-1282. S. Kheradyar, I. Ibrahim, and F.Mat Nor, (2011). Stock Return Predictability with Financial Ratios. 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French, (1992). The Cross-Section of Expected Stock Returns. Journal of Finance, 47: 427-465 Lewellen, J. , (2001). Predicting Returns with Financial Ratios. Journal of Financial Economic, 209-235.\r\n'