Variability in Earnings- Price Ratios of Corpo.equities

8/7/2019 Variability in Earnings- Price Ratios of Corpo.equities

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Variability In-Earnings-Price Ratios Of Corporate Equities

M.P BIRLA INSTITUTE OF MANAGEMENT 1

VARIABILITY IN EARNINGS-PRICE RATIOS

OF CORPORATE EQUITIES

A dissertation

Submitted in partial fulfillment of the requirements for MBA

Degree of Bangalore University

Under the guidance of

Dr. T.V. Narasimha Rao

Submitted by

Nikhil S Shah

REGISTER NUMBER

03XQCM6065

M.P. BIRLA INSTITUTE OF MANAGEMENTASSOCIATE BHARATIYA VIDYA BHAVAN

BANGALORE 560001

2003-2005


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STUDENT DECLARATION

I hereby declare that the project undertaken by me and the report titled

Variability in Earnings-price ratios Of Corporate Equities

submitted to Bangalore University in partial fulfillment of the

requirements for the award of the degree of Masters of Business

Administration, is my original work and not submitted for the award of

any other Degree / Diploma of any University.

Place : Bangalore Nikhil S Shah

Date : 15th June 2005 Register No: 03XQCM6065


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GUIDES CERTIFICATE

This is to certify that this report titled Variability in

Earnings-price Ratios of Corporate Equities is the result of project

work undergone by Mr. Nikhil S Shah bearing the Register Number

03XQCM6065 under my guidance and supervision. This has not

formed a basis for the award of any Degree/Diploma for any

University.

Place : Bangalore

Date : 15th

June 2005 Dr.T.V. NARASIMHA RAO


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PRINCIPALS CERTIFICATE

This is to certify that this report titled Variability in

Earnings-price Ratios of Corporate Equities is the result of project

work undergone by Mr. Nikhil S Shah bearing the Register Number

03XQCM6065 under Dr. T.V.Narasimha Raos guidance andsupervision. This has not formed a basis for the award of any

Degree/Diploma for any University.

Place : Bangalore

Date : 15th

June 2005 Dr. Nagesh.S.Malavalli


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ACKNOWLEDGEMENT

My report would in fact be deficient without the presence of all

mentioned below and many more whose cooperation cannot be put

down in words.

I express my sincere gratitude and appreciation to

Dr. T.V.Narasimha Rao, Professor MPBIM for giving me an

opportunity to do this project.

I would also like to express my thankfulness to

Dr. Nagesh.S.Mallavalli, Principal M.P. Birla Institute of Management,

Associate Bharatiya Vidya Bhavan for giving me an opportunity to

pursue this project.

NIKHIL S SHAH


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CONTENTS

1. ABSTRACT.

2. INTRODUCTION

a. BACKGROUND.

b. PROBLEM AND OBJECTIVE..

c. HYPOTESIS

d. THEORETICAL FRAMEWORK...

3. LITERATURE REVIEW..

4. RESEARCH METHODOLOGY

a. STUDY DESIGN

b. STUDY TYPE.

c. STUDY POPULATION..

d. DATA GATHERING AND INSTRUMENTATION.

e. LIMITATIONS OF RESEARCH

f. DATA ANALYSIS.

5. EMPIRICAL RESULTS

6. CONCLUSIONS

7. BIBLIOGRAPHY...

8. ANNEXURE GLOSSARY..


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ABSTRACT

This study proposes to examine empirica11y the determinants of

the differences in rates of return on corporate equities. The research is

done to track the relationship between each of the independent variables

and the rate of return on equity. In order to find the variables that are

positively related to the dependant variable a multiple regression model

has to be used were data relating to the variables of the sample

companies is calculated by the various procedures and statistical tools.

These tools help to convert raw data into data that can be used to regress

the variables and get the key variables affecting the Rate of Return.

The measured rate of return of corporate equities is a function of:

The Growth in Earnings, Growth in Equity, the Pay-out ratio, Stability of

Income, Stability of the Equity value, Size of the firm and the Debt

Equity Ratio. Due to high correlation between variables the expected

stability of the future income stream, Expected stability of the equity

value have been eliminated.

The results of the research show that size of the firm is one of the

key variables and has a high positive relation with the Rate of return even

when taken individually and when in a group of independent variables.

The growth of earnings is another variable which reflects a positive

relation with Rate of Return. But when taken with size of the firm with

respect to the total assets of the firm it looses its importance and the focus

shifts to the size of the firm. Thus Growth in earnings and Size (Total


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Assets) signify the same information. The other variables do not show

relation with the Rate of Return.

INTRODUCTION

BACKGROUND

This research is mainly done to track the relationship between each

of the independent variables and the rate of return on equity. The Rate of

Return on equity is affected by many variables. This study proposes to

examine empirica11y the determinants of the differences in rates of

return on corporate equities. The importance of the research is to find the

reasons for the variability in the price and earnings of corporate equities

and to find the variables that have a major relationship with returns. The

relevance of this study can be seen from the point of view of Investors

because higher the return more the investors are attracted towards that

equity. The research forms the base forEquity valuation. The purpose of

the various Equity valuation models is to identify whether a stock is

mispriced. Under priced stock needs to be purchased, overpriced stocks

should be traded short.

Studies have been done in the past relating to the methodology and

the determinants affecting the Rate of Return on equity. The major

contributions are from-

SL. FISHER, "Determinants of Risk Premiums on CorporateBonds: This paper has examined the relationship between

previously used measures of default risk and the way in which

investors adjust future promised payments for default risk.


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SF. MODIGLIANI AND M. H. MILLER, "The Cost of Capital,

Corporate Finance, and the Theory of Investment,This empirical

study revisits the determinants of firms' capital structures. The

main focus thereby is on the 'Market Timing Theory', according to

which the current level of the capital structure is the cumulative

outcome of past attempts to time the market, i.e. issuing shares

when equity is overvalued and repurchasing shares in case of

undervaluation.

SB. GRAHAM AND D. L. DODD, Security Analysis, 3rd Ed. New

York 1951: This study tests DeAngelo and Masulis' (1980) and

Masulis' (1983) theory that a firm would seek an "optimum debt

level" and that a firm could increase or decrease its value by

changing its debt level so that it moved toward or away from the

industry average.

SM. F. M. OSBORNE, "Brownian Motion in the Stock Market,"

Jour. op. Research Soc. Am., Mar.-Apr. 1959, 7,145-73.

SH. V. ROBERTS, "Stock Market 'Patterns' and Financial Analysis:

Methodological Suggestions," Jour. Finance, Mar. 1959, 14, 1-10.

SAll these papers have helped the in identifying the key variables to

be considered for research and the methodology to be used for the

purpose of calculating the Earnings-Price Ratios of Corporate

Equities.


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RESEARCH PROBLEM

To determine the variability in earnings and price ratios of the

corporate equities

RESEARCH OBJECTIVE

To track the relationship between each of the independent

variables and the rate of return on equity (y), keeping the other

independent variables constant in a multiple regression analysis.

HYPOTHESIS

The measured rate of return of corporate equities is a function of:

The Growth in earnings, Trend in the market value of the equity, The

pay-out ratio; the ratio of dividends to earnings, The expected stability of

the future income stream, Expected stability of the equity value, Size of

the firm represented by the Total Assets of the firm at the end of the year

and the Debt Equity Ratio.

Mathematically it is represented as:

Y= f (X1 , X2 , X3 , X4 , X5 , X6 , X7 )

Where:

The Dependant Variable:


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Y: Measured Rate of Return

The Independent Variables:

(1) The Growth in earnings (X 1)

(2) Trend in the market value of the equity (X 2).

(3) The pay-out ratio; the ratio of dividends to earnings (X 3).

(4) The expected stability of the future income stream (X 4).

(5) Expected stability of the equity value (X 5).

(6) Size of the firm represented by the Total Assets of the firm at

the end of the year (X 6).

(7) Debt Equity Ratio (X 7).


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THEORETICAL FRAMEWORK

EQUITY SHARES VALUATION

The valuation task is relatively straightforward in case of bond and

preference share, because benefits are generally constant and reasonably

certain. Equity valuation is different, because the return on equity is

uncertain and can change from time to time. It is the size of the return

and the degree of fluctuation (i.e. risk), which together determine the

value of a share to the investor. Therefore, forecasting abilities of the

analyst are far more crucial in the equity analysis. In fact, active equity

management is based on the notion, explicitly stated or implied, that the

stock market is not totally efficient. Put another way, active equity

management assumes that all historical and current information is notfully and correctly reflected in the current price of every stock.

EQUITY VALUATION MODELS

The purpose of Equity valuation models is to identify whether a

stock is mispriced. Under priced stock needs to be purchased, overpriced

stocks should be shorted. As most modern equity valuation models are

based upon the present value theory, set forth in detail by John B.

Williams in Theory of Investment-Value, in investment analyst must turn


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first to the present value estimation to know the intrinsic value of the

equities.

PRESENT VALUE ESTIMATION

Present value is simply the inverse of future value. If we have

opportunity to receive a given sum in the future, and we know the

appropriate interest rate, we can calculate its value today.

Future ValuePresent value =

(1+i)n

In order to develop a consistent system of security valuation

theory, it has become fashionable to apply the techniques of present value

theory to the equity valuation.

BASIC MODELS

One of the most widely used equity valuation model is the

dividend discount model (DDM). In its simplest form, the DDM defines

the intrinsic value of a share as the present value of future dividend.

There are several variations of the DDM because of different

assumptions about the growth rate of dividend and its relationship to thediscount rate used to calculate present values.

ZERO GROWTH MODEL


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The most basic of all the DDMs is the zero growth model. This

model assumes that dividend will be constant over time, so that the

growth is zero, and that the investors required rate of return is constant.This models is :

D1 + D2 + D3 + D4 +..+..

V0 =

(1+k)1

(1+k)2

(1+k)3

(1+k)4

Where V0 = intrinsic value of equity today or at time period 0.

D1 = dividend per share in period t

K = investors required rate of return

Given D1=D2=D3=.=D assumption, the time subscript can be

dropped. The dividend income stream is essentially a perpetuity, and the

value can be calculated as :

DV0 =

K

This model is more appropriate for an analysis of preference share

because of the constant dividend assumption.

CONSTANT GROWTH MODEL

In this model, the cash dividends are expected to increase at

constant (percentage ) rate each year. In order to find the discounted

present value of the stream of constantly rising dividends, the investors


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can use the simplified equation given below which is the constant growth

model and where :

D

V0 =

( k g)

VALUATION MODEL OF CYCLICAL STOCK

Bauman used, as did Clendenin, the present value concept of

arriving at a stock value by discounting at an appropriate yield rate all

future cash incomes or dividends. He spells out the factors that determine

future dividend income, namely, the growth rate and the growth duration,

and argues that a company with a growth rate in excess of the average

shown in an industry will sooner or later find its growth rate declining to

the average level. How long this transitional period last depends on the

company, the industry, the product , the competition etc. A guide to

follow is to determine the probable position of the company in its life

cycle.

According to Bauman, therefore, in order to make a good estimate

of future dividends, the investor must ascertain

(a) the current growth rate of dividends (and earnings ), and

(b) how long will it take until the growth rate has declined to the

average typical for the majority of corporations.


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MODELS BASED ON PRICE RATIO ANALYSIS

Price ratios are widely used by financial analysts, more so even

than dividend discount models. Of course, all valuation models try to

accomplish the same thing, which is to appraise the economic value of a

companys stock. However, analysts readily agree that no single method

can adequately handle this task on all occasions. The most popular price

ratios methods, used in the financial analysis, are discussed below:

PRICE-EARNINGS (P/E) RATIO

The most popular price ratio used to access the value of equity is a

companys price -earnings ratio, abbreviated as P/E ratio. P/E ratio is

calculated as the ratio of a firms current stock price divided by its annualearnings per share (EPS).

The inverse of a P/E ratio is called an earning yield, and it is

measured as earnings per share divided by a current stock price (E/P).

Clearly, and earnings yield and a price-earnings ratio are simply two

ways to measure the same thing. In practice, earnings yields are less

commonly stated and used than P/E ratios.

Financial analysts often refer to high-P/E stocks as growth stocks.

The reasons high-P/E stocks are called growth stocks seems obvious

enough; however in a seeming defiance of logic, low-P/E stocks are often


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referred to as value stocks. The reason is that low-P/E stocks are often

viewed as cheap relative to current earnings.

PRICE-CASH FLOW [ P/CF ] RATIO

Instead of price-earnings (P/E) ratios, many analysts prefer to look

at price cash flow (P/CF) ratios. A price-cash flow [P/CF] ratio is

measured as a companys current stock price divided by its current

annual cash flow per share.

There are a variety of definitions of cash flow. In this context the

most common measure is simply calculated as net income plus

depreciation, so this is the one we use here. Cash flow is usually reported

in a firms financial statements and labeled as a cash flow from

operations (or operation cash flow).

The difference between earnings and cash flow is often confusing;

largely because of the way that standard accounting practice defines net

income. Essentially, net income is measured as revenues minus expenses.

Obviously this is logical. However, not all expenses are actually cash

expenses. The most important exception is depreciation.

PRICE-SALES (P/S) RATIO

An alternative view of a companys performance is provided by its

price-sales (P/S) ratio. A price-sales ratio is calculated as the current

price of a companys stock divided by its current annual sales revenue

per share. A high P/S ratio would suggest high sales growth, while a low


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P/S ratio might indicate sluggish sales growth.

PRICE-BOOK [P/B] RATIO

A very basic price ratio for a company is its price-book [P/B] ratio,

sometimes called the market-book ratio. A price-book ratio is measured

as the market value of a companys equity issued divided by its book

value of equity.

Price book ratios are appealing because book value represent, in

principle, historical costs. The stock price is an indicator of current value,

so a price-book ratio simply measures what the equity is worth today

relative to what it cost. A ratio bigger that 1.0 indicates that the firm has

been successful in creating value for its stockholders. A ratio smaller than

1.0 indicates that the company is actually worth less than it cost.

The interpretation of price-book ratio seems simple enough, but the

truth is that because of varied and changing accounting standards, book

values are difficult to interpret. For this and other reasons , price-book

ratios may not have as much information value as they once did.

Price-earnings ratio, price-cash flow ratios, and price-sales ratios

are commonly used to calculate estimates of expected future stock prices.

This is done by multiplying a historical average price ratio by an

expected future value for the price-ratio denominator variable.

MARKET CAPITALISATION


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The word "capitalization," or its abbreviation, "cap," is often used

in pricing start-ups, with different meanings in different occasions. The

"Market capitalization" or cap of a company refers to the result obtained

by multiplying the number of equity shares outstanding by the share

value recorded in the books at the end of financial year. This determines

the share of equity in the company and its "worth".

Market Capitalisation = No. of Shares x Book value at

outstanding the end of year

The second use of the term has to do with the rate at which future

flows are to be valued, a rate sometimes called the "discount" or "cap

rate," meaning that that flow of income is to be assigned a one-time value

by being "capitalized." Thus, elementary valuation theory teaches that

one of the most reliable indicators of value, to be assigned to a fledgling

enterprise is a number that capitalizes projected income streams.

THEORIES AFFECTING EQUITY VALUATION

Security Market Line

The set of risk-return combinations available by combining the

market portfolio with risk free borrowing and lending shows the

relationship between risk and return from stocks.

Efficient Market Hypothesis (EMH)

EMH is concerned with information processing efficiency in stock

markets.

An efficient market is one in which


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SInformation is widely available to all investors at low cost

SAll the available relevant information is reflected in short prices

Forms of EMH

SWeak form - stock price reflects all past information on price

movements

SSemi -strong - stock price reflects all other publicly available

information

SStrong - strong price reflects all pertinent information publicly

available or privately held.

Dividend Policy

The determination of the proportion of profits paid to the

stockholder periodically. Optimal dividend policy should strike a balance

between current dividend and the future growth that will maximize the

firms stocks price

The Companys directors will have a policy for

SWhat portion of profits to pay out as dividends and what proportion of

profits to retain for reinvestments

SWhat rate of dividend growth to aim for, with the help of reinvestment

of retained profits.

Their choice of policy might affect their firms stock price

SA high dividend payout gives stock holders more current income

(on which individual stock holders pay income tax)

SA high retention ratio should provide for future earnings and

dividend growth, which ought to improve the current stock price


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and so give the stock holder a capital gain (which will be subjected

to capital gains tax upon sale of stocks)

THE MODEL

This study proposes to examine empirica11y the determinants of

the differences in rates of return on corporate equities. The rate of return

employed is derived for each equity by dividing the average of annual

earnings of nine consecutive years by the market value of the

corresponding equity in the ninth year, and will be referred to as the -

measured rate of return. This empirical1y derived rate is designed to

represent the theoretical ratio of expected income to the market value of

the equity, where expected income is the mathematical expectation

(mean) of a statistical distribution whose values are earnings expected in

future years.

We advance the hypothesis that the measured rate of return of

corporate equities is a function of:

SThe Growth in earnings (X 1)

STrend in the market value of the equity (X 2).

SThe pay-out ratio; the ratio of dividends to earnings (X 3).

SThe expected stability of the future income stream (X 4).

SExpected stability of the equity value (X 5).

SSize of the firm is represented by the total assets of a company

at the end of the year (X 6).

SDebt Equity Ratio (X 7).


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Among the independent variables the first three are "corrective";

they are expected to remove the errors obstructing a valid measurement

of the theoretical concept of a rate of return on equity capital. The

remaining are selected to measure the differential risk or Desirability

of holding corporate equities and as such are explanative.

Our method of investigation consists of tracing the relationship

between each of the independent variables and the rate of return on

equity while holding other independent variables constant in a multiple

regression analysis.

1.The Measured Rate of Return and the Independent Variables

This section will explain why the selected independent variables may be

expected to account for differences in the measured rates of return on

corporate equities, and will give the empirical definitions of the variables

employed in the study. The variables are specified for the firm as a

whole, not for a single share.

A. The Dependant Variable

The measured rate of return: y. The numerator is an average of

earnings after taxes for the cross-section year and the eight preceding

years This average may be expressed as the sum of cross-section years

earnings after tax and earnings of the eight preceding years,

The equity measure in the denominator of the measured rate is the


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arithmetic mean of the high and low values of the equity outstanding in

the cross-section year.

B. The Independent Variable

The Correctors

1. Growth in Earnings (X1):

The numerator of the measured rate of return is defined as a

weighted average of actual past income, without being adjusted for trend

in past income; consequently it may diverge downwards from expected

income when past income growth has been high and upwards when past

growth has been low. Inclusion of the trend in past income as an

independent variable may allow expected income to be more closely

estimated if the market utilizes projections of past income trends for the

determination of expected income.

2. Growth in Equity Value (X2):

The incorporation into the model of past trend in the value of

equity may correct for the absence of a recent re-valuation of expected

income in the measured rate of return. The measure of earnings in the

numerator of the measured rate of return may fail to reflect an upward

change in expected income, while the market value of the equity in the

denominator will reflect it immediately. Consequently the measured rate

may be smaller than the true rate when expected income has risen. A

symmetrical argument holds when expected income has declined. The


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percentage change in income, could be an indication of the extent of the

lag with which measured earnings reflect expected income. The larger

this percentage change is, per unit of time, the less likely is the empirical

representation of earnings to keep up with expected income (the larger

will be the difference between true and measured earnings) and the

greater will be the negative correlation between growth in equity value

and the measure d rate of return.

3. The pay-out ratio X3: Dividend/Earnings.

A notion seems to prevail in the financial literature, that because

investors prefer distribution to retention of earnings, the payout ratio and

the rate of return are negatively correlated. Yet since, on the average,

retained earnings are reflected in stock prices and consequently can be

realized through a sale, there seems to be no a priori reason for preferring

dividend income to capital gains income. Moreover, because of the

capital gains tax, the argument go the other way; retention may be

preferred to distribution.

A more reasonable explanation for a negative correlation between

the payout ratio and the measured rate of return may be provided by

examination of the effect of errors in the measurement of earnings. If

measure earnings are an over estimate and dividends are a stable

proportion of expected income, the rate of return is too high and the pay

out ratio too low. This will introduce into the relationship negative

spurious correlation. The introduction of the payout ratio as an

independent variable multiple regression equation is intended to correct


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for the errors.

The Risk variables

1. Stability of Income (X4):

(a) For any given level of the firm' s capital structure, the larger the

variance of the distribution of expected earnings, the larger is the

probability of failure.

(b) Also, for any level of the capital structure, the larger is this variance

the greater is the cost or inconvenience incurred by the investor in

maintaining a stable level of expenditure, since borrowing or the carrying

of cash balances becomes necessary to counteract income variability. For

both reasons, a high stability of income is a desirable property and will

tend to produce a low price-earnings ratio.

2. Stability of Equity Value (X5):

The usual contention is that, since the precautionary motive for

holding a share of stock is dominant, price variability is shunned. When

they think about the possibility of being impelled to sell in an emergency,

stockholders arc presumed to be more averse to a given likelihood of low

price than heartened by equal likelihood of a high one.

A priori, an opposite hypothesis is also tenable. The speculative

rather than the precautionary motive is dominant: therefore equity


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variability is sought. Stockholders are more encouraged by a likelihood

of a high price than discouraged by an equal likelihood of a low one.

They prefer stocks with variable prices to stocks with stable ones.

3. Size Total Assets of the company (X6):

This is intended as a measure of both liquidity and size.

(a) Barring radical changes in expectations, larger firms tend to have a

higher volume of trading, thereby a more effect market. Con-

sequently the price at which their shares are sold or bought is less

likely to be adversely affected by the transaction of an individual

investor. This becomes especiaJ1y desirable for institutional and

other large holders who deal in large blocks.

(b) A larger firm is known about more than in proportion to its size.

Therefore the less-informed segments of the market will tend to

specialize in holding shares of large corporations. Consequently,

what is equivalent to a once and for all shift in demand in favor of

larger firms shares will become a permanent pattern of the market,

resulting in these shares' prices being relatively higher.

(c) A larger firm is often considered safer simply because its size

represents to many investors better protection against adverse condi-

tions and a smaller probability of failure.

All three arguments suggest that the larger the firm is, the more

desirable are its shares.


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4. Debt-Equity Ratio X7:

(a) The more heavily a firm' s capital structureis weighted with debt

beyond the optimum, the higher the risk of default. This statement refers

to the movement of a single firm along a schedule relating the debt-

equity ratio to riskiness.

(b) On the other hand, if a firm is at, or approximately at, its optimum

debt-equity ratio, the debt-equity ratio is a decreasing function of risk.

This relationship clearly relates to the equilibrium pattern that will be

attained by a cross-section of firms, such that the lower a firm' s riskiness

the higher is its optimum debt-equity ratio. Thus the debt-equity ratio

may represent either risk or safety, depending on the context in which it

is used. Consequently it becomes important to ascertain whether the;

Debt-Equity Ratio employed in this study in effect reflects deviations

from its optimal position in each firm, or instead is a measure of these

optimal points themselves.

If by holding size and income stability constant, as will be done in

the regressions, we consequently hold fixed the main determinants of the

debt-equity ratio, namely variables to which the debt-equity ratio is

adjusted by management in an attempt to maintain optimal capitalization,then X7 will come to represent deviations from equilibrium. In such a

case we should expect a positive sign for the debt-equity coefficient (i.e.,

the higher the debt the larger the risk of default, the less valuable the


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equity and the larger the rate of return).

REVIEW OF LITERATURE

1. L. FISHER, "Determinants of Risk Premiums on Corporate

Bonds"

In both the theoretical and empirical literature of finance the

relative riskiness of two debt instruments identical in all respects save the

likelihood of default on payments of principal and/or interest has

generally been measured by the difference between the yields to maturity

of the two debt instruments.

In a recent paper Benson and Rogowski argue that the relative

yield spread defined as the yield spread divided by the less risky (or

riskless) yield, is a better measure of default risk, because the value of the

expected loss due to default risk should be "greater the higher are interest

rates." Unfortunately, those using the yield spread or the relative yield

spread as default risk measures have not discussed the relationship

between their default risk measure and the way in which investors adjust

future promised payments for default risk. The purpose of this paper is to

examine this relationship. In Section II the relationship is examined in

the context of a simple model where investors are risk-neutral and where

debt instruments differ only in the probability of default on futurepromised payments, and an alternative measure of default risk is

proposed. Section III uses the results of Section II to explain previous

empirical findings concerning the behavior of yield spreads over time,


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especially the relationship found between default risk and the level of

interest rates.

This paper has examined the relationship between previously used

measures of default risk and the way in which investors adjust future

promised payments for default risk. The paper argues that if investors are

risk-neutral then any default risk measure should depend solely on the

probability of default. The paper then demonstrated that neither the yield

spread nor the relative yield spread satisfy this criterion, with the spread

between risky and riskless yields being positively related to the level of

interest rates and the ratio of this spread to the riskless yield being

negatively related to the level of rates when the probability of default

remains constant. In contrast, the ratio of the yield spread to one plus the

riskless yield was found to be dependent solely on the probability of

default, and was thus judged to be an adequate measure of default risk.


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2. F. MODIGLIANI AND M. H. MILLER, "The Cost of Capital,

Corporate Finance, and the Theory of Investment,

This empirical study revisits the determinants of firms' capital

structures. The main focus thereby is on the ' market timing theory' ,

according to which the current level of the capital structure is the

cumulative outcome of past attempts to time the market, i.e. issuing

shares when equity is overvalued and repurchasing shares in case of

undervaluation. Since the positive evidence for this theory found by

Baker and Wurgler (2002) for the US, this strand of empirical literature is

growing. This paper presents evidence for a sample of 135 Dutch listed

non-financial firms over the period 1983-1997 as well as for a sub-

sample of 45 Dutch firms that did an initial public offering (IPO). The

research methodology follows Kayhan and Titman (2004), who model

capital structure as a mix of market timing, pecking order and capital

structure targeting behaviour. The findings for the Dutch sample do not

find strong and persistent effects of market timing on capitalstructures.

This study applies Kayhan and Titmans (2004) research

methodology to a sample of Dutch listed firms. The variable to be

explained is the change in leverage and the explanatory variables areproxies for pecking order, market timing and trade-off financing

behaviour. More specifically, both financial deficit and internal cash flow

are used as proxy variables for pecking order behaviour. When the


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pecking order theory holds, a negative relation between these variables

and the change in leverage is expected. The effect of equity market

timing on the capital structure of firms is examined by investigating the

relationship between changes in leverage on the one hand and

fluctuations in stock prices and market-to-book values on the other.

Finally, capital structure targeting is examined by testing the relationship

between changes in leverage and deviations from optimal leverage ratios.

As in Kayhan and Titman, the analysis focuses both on the relationships

in the short and in the long term, i.e. its persistence.

In this paper we examine the effects of market timing on capital

structures of Dutch firms during 1983-1997. We allow for capital

structure targeting and pecking order financing. We perform the analysis

on a full sample of 135 firms and a sub sample of 45 IPO firms. IPO

firms differ from the average firms in several respects. Financing needs

of IPO firms are especially high in the first four years after the first stock

quotation. IPO firms also have more growth opportunities and better

operating performance. IPO firms have in common with non-IPO firms

that internally generated cash flow forms the most important source of

funds, followed by debt and external equity.

Firms use relatively more equity after periods of a stock price

increase. However, we do not confirm that a high stock market valuation

of the firm significantly and persistently affects the capital structure.

What we do find, however, is a strong confirmation of earlier evidence

for capital structure targeting and pecking order financing by Dutch

firms. Overleveraged firms tend to bring back their leverage ratios


32/68



towards target levels. When internal cash flows are small and there is a

need for external finance, firms allow their leverage ratios to rise.

3. B. GRAHAM AND D. L. DODD, Security Analysis, 3rd Ed. New

York 1951

DeAngelo and Masulis (1980) demonstrated that the presence of

corporate tax shield substitutes for debt implies that each firm has a

"unique interior optimum leverage decision..." Masulis (1983) argued

further that when firms which issue debt are moving toward the industry

average from below, the market will react more positively than when the

firm is moving away from the industry average. We examine this

hypothesis by classifying firms' leverage ratios as being above or below

their industry average prior to announcing a new debt issue. We then test

whether this has an effect on market returns for shareholders. Our overall

finding is that the relationship between a firm' s debt level and that ofits

industry does not appear to be of concern to the market.

The relationship between capital structure and firm value has been

the subject of considerable debate, both theoretically and in empirical

research. Throughout the literature, debate has centered on whether there

is an optimal capital structure for an individual firm or whether the

proportion of debt usage is irrelevant to the individual firm' s value. In

this study, we test this hypothesis. Employing a sample of 183 debt issue

announcements, we classify firms' leverage ratios as being above or

below their industry average prior to the announcement. To test the

sensitivity of both the industry classification and the components of the


33/68



leverage ratio, we use both Value Line and COMPUSTATas sources of

industry averages and define the leverage ratio in terms of market value

for equity and book value for equity. We then test whether this has an

effect on the stock market returns for shareholders. We do not find a

statistically significant market reaction to announcements of new debt

issues for either group of firms, nor do we find a significant relationship

between a firm' s debt level and its industry' s debt level. This lack of

significance continues when we control for each firm' s anticipated

growth. These results do not support Masulis' (1983) argument that a firm

can increase its value by moving towards the industry' s debt average.

This study tests DeAngelo and Masulis' (1980) and Masulis' (1983)

theory that a firm would seek an "optimum debt level" and that a firm

could increase or decrease its value by changing its debt level so that it

moved toward or away from the industry average. Our results do not find

support for the argument. We defined industry using two different

databases (Value Line and COMPUSTAT) and calculated the leverage

ratio based on book and market values for equity, but the results did not

change. Our overall conclusion is that the relationship between a firm' s

debt level and that of its industry does not appear to be of concern to the

market. A single post-event interval (day 2 to 90) depicted a slow,

negative effect following the debt issue (a 3.2% loss). The High Debt

firms had significant negative market reactions for several intervals;

however, the difference between this group and the Low Debt firms was

not statistically significant. These results suggest, overall, that the market

does not consider industry averages for leverage as discriminators for


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firms' financial leverage.

4. M. G. KENDALL, The Analysis of Economic Time Series. I,"

Jour. Royal Stat. Society (Ser. A), 1953, 116, 11-25.

The purpose of the lecturer is twofold. On one side, in negative

terms, it is formal because I am trying to provide reasons for refusing the

Slutzkys statement that economic cycles could be generated by random

causes, namely, by a purely random process in time. On the other side,

positively, economic cycles can be explained in the framework of

economic theories or laws.

In short, the methodological approach I am trying to present, is

firstly deductive, because the starting point is deductive, namely, an

economic theory, as it was established by economists as Cournot and

Marshal. Then I will proceed inductively by using time series data andstatistical methods to determine quantitatively the coefficients of static

theories. I want to make a distinction between theory (synonymous of

law) and hypothesis. A theory would be a simple statement, what let us to

predict necessarily the sign of the slope. For a demand theory, means a

relationship between quantity and price, namely a relation between a

single cause and effect whose slope should have necessarily a negative

sign. By a hypothesis of demand I mean a multiple relationship, between

an effect and several causes, for instance, between quantity, price and

income. It has a significant cause. It is impossible to predict in advance


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the sign of the slope of a hypothesis. For example, income should have a

positive sign, but price, would have a negative slope. What is the sign of

the average?

By measurement of an economic theory I mean to provide answer

to the three following issues:

1) To verify the sign of the slope, namely, if positive or negative

2) To measure the value of slope (for instant, of the elasticity of

demand or supply);

3) To bring out empirical evidences about the constancy or variability

of slope in time.

The conclusion of these findings appears to be immediate. By

measuring cycles, it is possible to attempt measurement of economic

theories.

OTHER REFERENCES

1. M. F. M. OSBORNE, "Brownian Motion in the Stock Market,"

Jour. op. Research Soc. Am., Mar.-Apr. 1959, 7,145-73.

2. H. V. ROBERTS, "Stock Market ' Patterns' and Financial Analysis:

Methodological Suggestions," Jour. Finance, Mar. 1959, 14, 1-10.

3. Moody' s Handbook of Widely Held CommonStocks. New York

1955-1958.

4. Moody' s Industrial Manual. New York 1953-1958.5. Standard & Poors' Stock Guide. New York 1953-1958.


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RESEARCH METHODOLOGY

STUDY DESIGN:

The design used in this research is experimental design. In this

study an attempt has been made to experiment the MODEL

VARIABILITY IN EARNINGS-PRICE RATIOS OF CORPORATE

EQUITIES taking fifty companies of NIFTY as the sample.

STUDY TYPE:

The research is a Quantitative as it involves a collection of

secondary data of fifty companies for a term of 9 years and applying

statistical tools to get the results.

STUDY POPULATION

S&P CNX NIFTY

S&P CNX Nifty is a well diversified 50 stock index accounting for

23 sectors of the economy. It is used for a variety of purposes such as

benchmarking fund portfolios, index based derivatives and index funds.

S&P CNX Nifty is owned and managed by India Index Services

and Products Ltd. (IISL), which is a joint venture between NSE and

CRISIL. IISL is India' s first specialised company focused upon the index


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as a core product. IISL have a consulting and licensing agreement with

Standard & Poor' s (S&P), who are world leaders in index services.

SThe average total traded value for the last six months of all Nifty

stocks is approximately 58% of the traded value of all stocks on

the NSE

SNifty stocks represent about 60% of the total market capitalization

as on March 31, 2005.

SImpact cost of the S&P CNX Nifty for a portfolio size of Rs.5

million is 0.07%

SS&P CNX Nifty is professionally maintained and is ideal for

derivatives trading

SAMPLE COMPANIES

CONSTITUENTS LIST OF S&P CNX NIFTY

Company Name Industry

ABB Ltd. Electrical Equipment

Associated Cement Companies

Ltd.Cement And Cement Products

Bajaj Auto Ltd. Automobiles - 2 And 3

Wheelers

Bharat Heavy Electricals Ltd. Electrical Equipment

Bharat Petroleum Corporation Ltd. Refineries


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Bharti Tele-Ventures Ltd. Telecommunication - Services

Cipla Ltd. Pharmaceuticals

Colgate-Palmolive (India) Ltd. Personal Care

Dabur India Ltd. Personal Care

Dr. Reddy' s Laboratories Ltd. Pharmaceuticals

GAIL (India) Ltd. Gas

Glaxosmithkline Pharmaceuticals

Ltd.Pharmaceuticals

Grasim Industries Ltd. Cement And Cement Products

Gujarat Ambuja Cements Ltd. Cement And Cement Products

HCL Technologies Ltd. Computers - Software

HDFC Bank Ltd. Banks

Hero Honda Motors Ltd.Automobiles - 2 And 3

Wheelers

Hindalco Industries Ltd. Aluminium

Hindustan Lever Ltd. Diversified

Hindustan Petroleum Corporation

Ltd.Refineries

Housing Development Finance

Corporation Ltd.Finance - Housing

I T C Ltd. Cigarettes

ICICI Bank Ltd. Banks

Indian Petrochemicals Corporation

Ltd.Petrochemicals

Infosys Technologies Ltd. Computers - Software


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Larsen & Toubro Ltd. Engineering

Mahanagar Telephone Nigam Ltd. Telecommunication - Services

Mahindra & Mahindra Ltd. Automobiles - 4 Wheelers

Maruti Udyog Ltd. Automobiles - 4 Wheelers

National Aluminium Co. Ltd. Aluminium

Oil & Natural Gas Corporation

Ltd.Oil Exploration/Production

Oriental Bank Of Commerce Banks

Punjab National Bank Banks

Ranbaxy Laboratories Ltd. Pharmaceuticals

Reliance Energy Ltd. Power

Reliance Industries Ltd. Refineries

Satyam Computer Services Ltd. Computers - Software

Shipping Corporation Of India

Ltd.Shipping

State Bank Of India Banks

Steel Authority Of India Ltd. Steel And Steel Products

Sun Pharmaceutical Industries Ltd. Pharmaceuticals

Tata Chemicals Ltd. Chemicals - Inorganic

Tata Consultancy Services Ltd. Computers - Software

Tata Iron & Steel Co. Ltd. Steel And Steel Products

Tata Motors Ltd. Automobiles - 4 Wheelers

Tata Power Co. Ltd. Power

Tata Tea Ltd. Tea And Coffee

Videsh Sanchar Nigam Ltd. Telecommunication - Services


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Wipro Ltd. Computers - Software

Zee Telefilms Ltd. Media & Entertainment

RELEVANCE OF THE SAMPLE CHOOSED:

INDIA INDEX SERVICES & PRODUCTS LTD. (IISL)

India Index Services & Products Ltd. (IISL) is a joint venture

between the National Stock Exchange of India Ltd. (NSE) and CRISILLtd. (formerly the Credit Rating Information Services of India Limited).

IISL has been formed with the objective of providing a variety of indices

and index related services and products for the capital markets.

IISL has a consulting and licensing agreement with Standard and

Poor' s (S&P), the world' s leading provider of investible equity indices.

OBJECTIVES OF IISL

IISL pools the index development efforts of CRISIL and NSE into

a coordinated whole - India' s first specialised company focused upon the

index as a core product. IISL has the following objectives:

STo develop, construct and maintain indices on Indian equities and

commodities that serve as useful market performance benchmarks and

are the underlying indices for derivatives trading

STo develop related products and services which can be used by

investors for managing their exposures in the equity and commodity


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markets

STo provide data and information on the trading activity in the Indian

stock markets

STo provide market participants with value added research on the

Indian equity and Commodity markets

All the erstwhile indices of NSE and CRISIL, such as Nifty, Nifty

Junior, Defty, CRISIL 500, CRISIL Midcap 200 index etc. have been

transferred to IISL which now maintains, develops, compiles and

disseminates the indices.

The indices of IISL are now known under the following names:

S.No. Old Name New Name

1 Nifty S&P CNX Nifty

2 Defty S&P CNX Defty

3 Crisil 500 Equity Index S&P CNX 500 Equity Index

4 Nifty Junior CNX Nifty Junior

5 Crisil Midcap 200 CNX Midcap 200 Index

6 Crisil PSE CNX PSE Index

7 Crisil MNC CNX MNC Index

PSE indicates Public Sector EnterprisesMNC indicates Multinational Corporation


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NATIONAL STOCK EXCHANGE OF INDIA LIMITED

THE ORGANISATION

The National Stock Exchange of India Limited has genesis in the

report of the High Powered Study Group on Establishment of New Stock

Exchanges, which recommended promotion of a National Stock

Exchange by financial institutions (FIs) to provide access to investors

from all across the country on an equal footing. Based on the

recommendations, NSE was promoted by leading Financial Institutions at

the behest of the Government of India and was incorporated in November

1992 as a tax-paying company unlike other stock exchanges in the

country.

On its recognition as a stock exchange under the Securities

Contracts (Regulation) Act, 1956 in April 1993, NSE commenced

operations in the Wholesale Debt Market (WDM) segment in June 1994.

The Capital Market (Equities) segment commenced operations in

November 1994 and operations in Derivatives segment commenced in

June 2000.

LIMITATIONS OF THE RESEARCH


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SSample restricted to 50 companies.

SData considered for nine years only.

SThe research is subject to a time span of three months.

SResults arrived at, are generalized for the entire sample.

DATA GATHERING PROCEDURES AND

INSTRUMENTATION

DATA GATHERING PROCEDURE

The major data relevant for this research is secondary data which

has been collected from Bangalore Stock Exchange ( BGSE ).

DATA COLLECTED:

SBalance sheets and Profit and loss account statements for the fifty

companies for a term of ten years

SDaily Stock prices, high and lows, equity history and the dividend

history for the fifty companies for a term of ten years

TOOLS USED IN EXTRACTING REQUIRED INFORMATION

FROM DATA:

Mean, Standard Deviation, Geometric Mean, calculation of yearly

Highs and Lows were the tools and techniques applied on the data

collected for the fifty companies in order to use the data as different


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variables in the research.

INSTRUMENTATION

The Dependant Variable

The measured rate of return: y.

The numerator is an average of earnings after taxes for the cross -

section year and the eight preceding years (2004 to 1996 in this case).The equity measure in the denominator of the measured rate is the

arithmetic mean of the high and low values of the equity outstanding in

the cross-section year.

For one year:

Current Year Earnings (PAT)

Rate of Return = -----------------------------------------------------------

Average of Current years High and low

After calculating Rate of Return for every year for each company the

average Rate of Return for each company is calculated giving one

average Rate of return for each company. These values are further used

as dependant variables for calculation of the multiple regression.

The Independent Variables

The Correctors

Growth in Earnings (X1):

The trend in earnings, X1, is computed by dividing the Geometric


45/68



Mean of value change in earnings after taxes on time, for the nine years

preceding and including the cross-section year, by the arithmetic mean

earnings of the same period (this Geometric Mean is used later to

compute X4). This division by mean earnings, which is equivalent to a

deflation by size, is performed to obtain a measure independent of the

dimensions of the firm: a measure of rate of growth uncorrelated with the

size of the firm rather than one absolute growth.

[GM of value change in EAT for 9 Years 1]

Growth in Earnings = -------------------------------------------------------------------

Mean of EAT For 9 Years

GM : Geometric Mean

Growth in Equity Value (X2):

The measure of X2, trend in equity value, is computed in a manner

parallel to the computation of X1. It is the Geometric Mean of averages of

High and Low changes (used in computing X5, stability of equity, ) of the

equity values in the nine consecutive years preceding and including the

cross section year, divided by the arithmetic mean of these same equity

values. Here again the division by average equity provides a measure that

is comparable cross-sectional and year of the association between growth

and size of firm. This measure denotes past rate of growth in equity or

the yearly capital gain per average unit value of equity-holding for the

period

[{Geometric Mean of (high + low/2) changes} 1]


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Growth in Equity = -----------------------------------------------------------------------

Mean of high & low for 9 Years

The pay-out ratio (X3) [dividend/earnings]:

The measure employed for X3 is the arithmetic mean of three

consecutive annual observation of (dividends paid X 100/ earnings), the

last observation being in the cross section year.

[ D0/E0 * 100 + D1/E1 * 100 + D2/E2 * 100 ]

Payout Ratio = -----------------------------------------------------------------

3

Where:

D0 and E0 represent Dividend and Earnings in year 2004-2005

respectively


respectively


respectively

The Risk variables

1. Stability of Income (X4):

The measure used for X4. is a ratio, the numerator of which is

computed Geometric Mean of value change in earnings after taxes on


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time, for the nine years preceding and including the cross-section year

(same as X1 numerator); its denominator is the standard deviation of the 9

observations, on time. If time be t, earnings y, m the sample moment, and

n the number of observations, then the denominator will be expressed

symbolically as:

_______________________________________

myy - (myt2 / mtt) / n - 2

t = Time

Y = earnings

m = sample moment

n = Number of observations

Stability of Equity Value (X5):

The measure used for X5 is a ratio. Its numerator is the arithmetic

mean of 18 market observations of the firm' s equity value: the high and

the low for each of 9 consecutive years, ending in the cross-section year.

Its denominator is the standard deviation around the linear regression of

these same 18 equity values on time. If time is t, equity y, m the

sample moment, and n the sample size, the denominator will be written

as:

________________________________________

myy - (myt2 / mtt) / n - 2


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t = Time

Y = equity

m = sample moment

n = sample size

(Where n = 18, distributed 2 per year).

Size Total Assets of the company (X6):

This is intended as a measure of both liquidity and size. The larger

the firm is, the more desirable are its shares. The data required here is the

Total Assets of all the companies listed in the Nifty Index for a span of

nine years. To regress the total Assets value with the rate of return

(dependant variable) the average of total assets is to be considered.

[ T0 + T1 + T2 + T3 + T4 + T5 + T6 + T7 + T8 ]

Average of T.A = ----------------------------------------------------------

9

Where

T. A = Total Assets

T0 , T1 , T2 , T3 , T4 , T5 , T6 , T7 , T8 are the total assets of the company

for the nine years including the cross-section year.

Debt-Equity Ratio X7:

The measure used for X7 is the book value of debt at the end of the

cross-sectional year divided by the total value of Equity at the end of the

year


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Total Debt

Debt Equity Ratio = ---------------------------

Total Equity

REGRESSION ANALYSIS:

After the formulation, instrumentation and calculation of values for the

seven independent variables, with the help of formulae mentioned above,

they have to be regressed with the values of Rate of return. This

regression will give us the relations of the various independent variables

with the dependant variable.

There is one major drawback at this stage of research that is all the 50

companies are not taken for regression because of non availability of data

restricting the multiple regression only to 32 companies. This is also

because of the number of variables taken. If one company has data for six

variables and not for the seventh one then that company has to be

removed from the sample of 50 companies. Another reason for this

limitation is the companies that have issued IPOs in the recent past and

do not have data for 9 years. Keeping in mind these factors the sample of

32 companies will give the right results as there is adequate and relevant

data available for these companies.

In the table below we can see the 32 companies that satisfy therequirements of the seven independent variables and the one dependant

variable in the final form which has to be used for multiple regression

and derive at the results of the tests.


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EMPIRICAL RESULTS

This study consists of a comparison of 50 companies in the nine

years, with each firm constituting an observation in a cross-sectional

multiple regression analysis. The firms were chosen with the additional

criterion of having common but no preferred stocks. This step was

necessary because of obstac1es involved in an unambiguous computation

of the stability of equity value, growth in equity value, and the pay-out

ratio when both common and preferred equities are outstanding.

The principal sources of data are the comparable income

statements for nine consecutive years preceding and including the cross-

section year, Balance sheets, Profit and loss account statements, Daily

Stock prices, high and lows, equity history and the dividend history

provided most of the raw data.

Multiple regression has been done using SPSS Software. The results

got from regressing the seven variables with the dependant variable are

as follows:

The variables (X1)Growth in earnings & (X4) Expected stability of

the future income stream are very highly correlated, also variables (X2)

Trend in the market value of the equity & (X5) Expected stability of the

equity value are very highly correlated. Both of these are because of them


51/68



sharing common numerators in their calculations respectively. When all

these seven variables are used, the result was all the variables were

eliminated from the regression.

In both set of variables any one variable had to be eliminated thus

the variables; Stability of Income (X4) and Stability of Equity Value

(X5) haven been eliminated from the multiple regression analysis leaving

five independent variables to be regressed with the Rate of Return (the

dependant variable).

TABLE 1

Results of the Simple Regression

TABLE 2


MODEL a b1 b2 b3ADJUSTED R

SQUARE

F

VALUE

Y = a + b1x13.411

(4.645)**

1884.008

(2.413)**0.135 5.823

Y = a + b2x22.220

(3.367)**

194.598

(0.233)-0.3 0.054

Y = a + b3x32.103

(1.566)

0.004363

(0.144)-0.033 0.021


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**= t value significant at 5% level

a:Constant b1: Growth in Earnings b2:Growth in Equity

b3: Payout Ratio b4:Total Assets b5:Debt Equity Ratio

Further Table 1 and Table 2 shows the results of simple regression of all

the five variables independently with the Rate of Return (y).

SThe Growth in earnings (X1): The value ofb1is highly positive and

the t value of b1 is 2.413 reflecting a positive relation between b1

(Growth in Earnings) and y(Rate of Return).

STrend in the market value of the equity (X2): Though there is a

positive value obtained for b2 the t value of b2 is 0.233 showing

negligible deflection. This reflects no relation between b2 (Growth in

Equity) and y(Rate of Return).

SThe pay-out ratio; the ratio of dividends to earnings (X3): Though

there is a positive value obtained for b3 the t va lue of b3 is 0.144

showing a negligible deflection. This reflects no relation between b3

(pay-out ratio) and y(Rate of Return).

SSize of the firm represented by the total assets of a company at the

end of the year (X6): The value of b4 is highly positive and the t

MODEL a b4 b5ADJUSTED R

SQUARE

F

VALUE

Y = a + b4x4

0.340

(0.855)

0.0003613

(8.671)** 0.705 75.179

Y = a + b5x51.904

(2.332)**

1.611

(0.687)-0.017 0.472


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value ofb4 is 8.671 reflecting a significant positive relation between

b4 (Size of the firm) and y(Rate of Return).SDebt Equity Ratio (X7): Though there is a positive value obtained for

b5 the t value of b5 is 0.687 showing a negligible deflection this

reflects no relation between b5 (Debt Equity Ratio) and y (Rate of

Return).

When all the variables are taken together in the multiple regression

excluding Stability of Income (X4) and Stability of Equity Value (X5).

The results are now matched against the theoretical contentions. For

convenience, we shall refer to a partial regression coefficient simply as a

coefficient and to the changes in the t-ratios of these partial regression

coefficients simply as changes in the coefficients. The results are shown

in Table 3 and Table 4.

TABLE 3


TABLE 4


MODEL a b1 b2 b3ADJUSTED

R SQUARE

F

VALUE

Y = a + b1x1 + b2x23.322

(4.476)**

2083.108

(2.567)**

735.402

(0.925)0.130 3.326

Y = a + b1x1 + b2x2

+ b3x3

3.297

(2.331)**

2081.883

(2.514)**

737.708

(0.904)

0.0006167

(0.021)0.099 2.141


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**= t value significant at 5% level

a: Constant b1: Growth in Earnings b2: Growth in Equity

b3: Payout Ratio b4: Total Assets b5: Debt Equity Ratio

SWe start by noting the comparative regression performance of two

correctors, growth in earnings and growth in equity, and then choose

for further use one of the two, which a study of the regressions reveals

to be the more successful corrector. Our criterion of success is mainly

the extent of the negative relation between the growth measure and

the measured rate of return: the stronger is this relation, the more

successful is the growth measure. We make this choice because we

believe that entering both growth variables in the same, regression

When the first two variables b1 (The Growth in Earnings) and b2

(Trend in the market value of the equity) the results are that b1has a

high t value 2.567 showing that there is high deviation showing a

positive relation with the dependant variable that is the Rate of

Return. On the other hand b2has a t value 0.9 25 showing that it has

no relation with the Rate of Return. would be illegitimate.

MODEL a b1 b2 b3 b4 b5 ADJUSTEDRSQUAREF

VALU

Y = a + b1x1 +

b2x2 + b3x3 + b4x4

-0.637

(-0.682)

424.599

(0.836)

436.681

(0.955)

0.02846

(1.734)

0.000358

(7.919)**0.719 20.822

Y = a + b1x1 +

b2x2 + b3x3 + b4x4

+ b5x5

-0.443

(-0.451)

427.064

(0.833)

440.465

(0.954)

0.02788

(1.681)

0.00036

(7.823)**

-0.891

(-0.695)0.713 16.435


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SWhen three variables b1 (The Growth in Earnings), b2 (Trend in the

market value of the equity) and b3 (The pay-out ratio) the results are

that b1 has a high t value 2.514 showing that it has positive relation

with the dependant variable that is the Rate of Return. On the other

hand b2 and b3 have t values of 0.904 and 0.021 respectively

showing less deviation from the value of zero. This shows it has no

relation with the Rate of Return. The overall picture tells us that by

introducing a new variable b3 there is a fall in adjusted r2

and there is

also a fall in the F-Value. This shows that the variable has effected on

the relationship ofb1 with Rate of Return

SWhen four variables b1 (The Growth in Earnings), b2 (Trend in the

market value of the equity), b3 (The pay-out ratio) and b4 (Size of the

firm represented by the total assets of a company at the end of the

year)the results are that b1,b2 and b3have t value s of 0.836, 0.955

and 1.734 respectively showing that it has no relation with the Rate of

Return. On the other hand b4 has a high t value 7.919 showing that

it has positive relation with the dependant variable that is the Rate of

Return. This also highlights the fact that Growth in Earnings and Size

of firm represented by total assets signify the same information

because when the b4 variable is introduced the t value of b1comes

down and a high positive value is shown by b4.

SWhen all five variables b1(The Growth in Earnings), b2(Trend in the

market value of the equity), b3 (The pay-out ratio), b4 (Size of the firm

represented by the total assets of a company at the end of the year)


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and b5 (Debt Equity Ratio)the results arrived at are b1,b2 and b3have

t values of 0.833, 0.954 and 1.681 respectively showing that it has

no relation with the Rate of Return. On the other hand b4 still has a

high t value 7.823 showing that it has positive relation with the

dependant variable that is the Rate of Return. b5 has a t value of

-0.695 showing that it has a negative relation to the dependant

variable the Rate of Return.

Note:

If the t value is higher than 2.00 it represents positive relation between

the regressed variables

CONCLUSIONS

SThe strongest result is in the case of X6, the size variable. Its

performance constitutes a handsome realization of expectations: it is

consistent and the most significant statistically. It indicates a negative

relation with the rate of return in all cross-sections firmly establishing

that, ceteris paribus, the market prefers larger to smaller firms.

SThe Return is significantly related with the size of the firm as

represented by the total assets. This model accounts for 72% of the

total variance in the dependant variable. If the sign of the regression

coefficient is positive indicating that there is a direct relationship

between the size of the firm and return from equity. Apparently

investors require a high rate of return from large firms and a lower

rate of return from smaller firms.

SThe growth in earnings and total assets signify the same information


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and Size of firm represented by Total Assets and Growth in Earnings

are the key variables affecting the Rate of Return.

SThe debt-equity ratio relationship is unwarranted to conclude that a

high debt equity ratio is an indicator of a desirable characteristic, since

in context of this study the debt-equity ratio could be mainly a

measure of size thereby obliterating its use as a measure of risk. One

possible improvement would be to enter in the regression the sum of

equity and debt, thereby insuring that the debt-equity ratio does not

serve in fact as a measure of size.

SThe F-values show the best model fit with respect to the relations

between the independent and the dependant variables. From the values

derived we can see that the model y = a + b1x1 + b2x2 + b3x3 + b4x4

best fits into the relation as it has the highest value of all the models

checked in this research.

SAnother obvious empirical improvement over the method used in this

study would be to define equity in the denominator of the debt-equity

ratio as an average of a few years preceding the cross-section year

itself. This might rid the debt-equity ratio of a random component,

which is built into the empirical definition by using only the cross-

section-year average for equity. .

SThe function of the growth variables was visualized as the correction

of the measure of expected income in the numerator of the measured

rate return. In this capacity their coefficients were expected to have

negative signs. The growth variables performed as was expected.

SFinally, it is hoped that this study will stimulate awareness of


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difficulties involved in the measurement of both the dependent and

independent variables and that the distinction between corrective and

explanatory variables may be employed advantageously in further

work.

BIBLIOGRAPHY

SBangalore stock Exchange

Swww.nseindia.com

Swww.google.com

Swww.investopedia.com

SThe Journal of Finance

Swww.valuepro.net

Swww.stern.nyu.edu


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SSecurity Analysis and Portfolio Management V.K.Bhalla

ANNEXURE

GLOSSARY

RETURNThe gain or loss on a security in a particular period, consisting of

income plus capital gains relative to investment. It is usually quoted as a

percentage.

EXPECTED RETURN

The average of a probability distribution of possible returns,

calculated by using the following formula:


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ACTUAL RETURN

The actual gain or loss of an investor. This can be expressed in the

following formula: expected return (ex-ante) plus the effect offirm-specific and economy-wide news.

SYSTEMATIC RISK

The risk inherent to the entire market or entire market segment.

Also known as "un-diversifiable risk" or "market risk."

PORTFOLIO

The group of assets - such as stocks, bonds and mutuals - held by

an investor.

UNSYSTEMATIC RISK

Risk that affects a very small number of assets. Sometimes referred to as

specific risk.

CAPITALIZATION In accounting, it is where costs to acquire an asset are included in

the price of the asset.

The sum of a corporation' s stock, long-term debt and retained

earnings. Also known as "invested capital".

A company' s outstanding shares multiplied by itsshare price, better

known as "market capitalization".

According to the Appraisal Institute, it is a method used to convert

an estimate of a single year' s income expectancy into an indication of

value in one direct step, by dividing the income estimate by an


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appropriate rate. Also known as the cap rate. The relationship between

Cap Rate (R), Income (I), and Estimated Value (V) is as follows:

V = I / R

I = V x R

R = I / V

COMMON STOCKHOLDER

A security that represents ownership in a corporation. Holders of

common stock exercise control by electing a board of directors and

voting on corporate policy. Common stockholders are on the bottom of

the priority ladder for ownership structure. In the event of liquidation

common shareholders have rights to a company' sassets only after bond

holders, preferred shareholders, and other debt holders have been paid in

full.

COMPOSITE INDEX

A grouping of equities, indexes or other factors combined in a

standardized way, providing a useful statistical measure of overall market

or sector performance over time. Also known simply as a "composite".

DEBT/EQUITY RATIO

A measure of a company' s financial leverage calculated by

dividing long-term debt by shareholders equity. It indicates what

proportion of equity and debt the company is using to finance its assets.

Note: Sometimes investors only use interest bearing long-term debt


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instead of total liabilities.

A higher debt/equity ratio generally means that a company has

been aggressive in financing its growth with debt. This can result in

volatile earnings as a result of the additional interest expense.

DIVIDEND

Distribution of a portion of a company' searnings, decided by the

board of directors, to a class of its shareholders. High-growth companies

don' t offer dividends because all their profits are reinvested

to help sustain higher-than-average growth.

DIVIDEND PAYOUT RATIO

The percentage of earnings paid to shareholders in form of

dividends.

Calculated as:

The payout ratio provides an idea of how well earnings support the

dividend payments. More mature companies will typically have a higher

payout ratio.


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EARNINGS

The net income of a company during a specific period. Generally,

but not necessarily, referring to after-tax income.

EARNINGS PER SHARE EPS

The portion of a company' s profit allocated to each outstanding

share of common stock. Calculated as:

Companies usually use a weighted average number of shares outstanding

over the reporting term. This is the single most popular variable in

dictating a share' s price. EPS indicates the profitability of a company.

EQUITY

Stock or any other security representing an ownership interest.

On the balance sheet, the amount of the funds contributed by the

owners (the stockholders) plus the retained earnings (or losses). Also

referred to as "shareholder' s equity".

In the context of margin trading, the value of securities in a margin

account minus what has been borrowed from the brokerage.

In the context of real estate, the difference between the current market

value of the property and the amount the owner still owes on the

mortgage. Thus, it is the amount, if any, the owner would receive after

selling a property and paying off the mortgage.

EQUITY RISK PREMIUM


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The extra return that the stock market provides over the risk free

rate to compensate for market risk.

HURDLE RATE

The minimum amount of return that a person requires before they

will make an investment in something

INDEX

A statistical measure of change in an economy or a securities

market. In the case of financial markets, an index is essentially an

imaginary portfolio of securities representing a particular market or a

portion of it. Each index has its own calculation methodology and is

usually expressed in terms of a change from a base value. Thus, the

percentage changes is more important that the actually numeric value.

For example, knowing that a stock exchange is at, say, 5000 doesn' t tell

you much. However, knowing that the index has risen 30% over the last

year to 500

Documents

Variability in Earnings- Price Ratios of Corpo.equities