Linking Financial Ratios and Stock Returns

Last Updated: 10 Jul 2021
Pages: 16 Views: 159
Table of contents

Introduction

Financial ratio analysis is a technique for trying to help interpret financial accounts and to determine the intrinsic value of a security by careful examination of key value drivers such as risk, growth, and competitive position. Various ratios can be calculated from the financial accounts. These ratios will then help us to examine the company’s performance over a number of periods by comparing the same ratios in previous years’ accounts and also the accounts of other businesses operating in a similar environment.

Financial ratio analysis provides essential information and serve with a lot of different contexts for different kinds of decisions.

Order custom essay Linking Financial Ratios and Stock Returns with free plagiarism report

feat icon 450+ experts on 30 subjects feat icon Starting from 3 hours delivery
Get Essay Help

Statement of the Problem

The enormous number of financial ratios used by financial managers and financial analysts and their relationship with stock return is the main problem in interpreting the financial statements.

Based on, the ultimate goal of financial managers is to maximize the wealth of their stockholders; financial managers must understand the impact of their managerial decisions on their company’s financial statements and financial ratios concluded which will consequently affect the stock price of their company. Interpreting such a huge number of ratios distracts attention from the most relevant factors that affect stock prices.

Purpose of the study

A number of studies such as Timo Salmi (1990) were conducted to reduce the information load resulting from computing a large number of ratios and categorize those ratios that were believed valuable. This study aims to identify those variables that are most relevant to the stock returns of pharmaceutical sector in Egyptian stock market.

Statement of objectives

This study attempt to achieve the following objective: The most relevant independent variables (financial ratios) with stock returns as a dependent variable.

Financial ratios and stock market

Literature Review

The main goal of our research is to evaluate the relationship between common financial ratios as independent variables and stock returns of the pharmaceutical firms as dependent variable. The relation between financial statement information and stock return was examined by Ou and Penman (1989) who observed returns to investment strategies that are based on a measure that summarizes the information in financial statements to identify the relevant financial ratios.

Their study indicate that the predicted returns can not be explained by return based risk measures and that financial statements capture fundamentals that are not reflected in stock prices. The results of the study suggest that it is possible for investors to make excess profits using publicly available information. More recently, the relation between financial statement information and stock return was extended by Holtausen and larcker (1992) who identify value-relevant fundamentals in the context of a return-fundamentals relation.

Holtausen (1992) examined the ability of accounting information to generate profitable trading strategies (using 60 accounting ratios). The excess returns were observed in the fourth month following the company’s fiscal year end. The results of the study suggest that the trading strategy was able to earn significantly abnormal returns during the period of 1978-1988. The same issue was examined later by Lev and Thiagarajan (1993) who used fundamental ratios as the basis of analysts’ description of different ratios to identify the value relevance of the financial ratios and their usefulness in security valuation.

Afterward, Belkoui (1997) employed the popular financial ratios to show the value relevance, where the popularity of these financial ratios is matched by their usefulness in security valuation. He shows that value relevance of popular financial ratios in both a non contextual setting and a setting conditioned by levels of inflation and growth.

Classification of financial ratios

The classification of financial ratios was studied by Timo Salmi (1990) who split these financial ratios into five somewhat arbitrary groups:

  • Profitability - how good is the business as an investment.
  • Liquidity - the amount of working capital available.
  • Capital Adequacy – measure the leverage percentage.
  • Debt service coverage - how near is the business to bankruptcy.
  • Efficiency - how good is the management of the business.

Each financial ratio has its own signal and its own relation to the stock return. Based on these previous studies, the study selected the most popular financial ratios guided in major financial analysis books such as Mishkin (2001)

An overview of Egyptian stock exchange

EgyptWatch (2002) studied the history of the egyptian stock exchange and mentioned that the Egyptian Stock Exchange is comprised of two exchanges: the Cairo & Alexandria Stock Exchanges (CASE), and is governed by the same board of directors that share the same trading, clearing & settlement systems. The Alexandria Stock Exchange was officially established in 1888 followed by that of Cairo in 1903. The two Exchanges were very active until the 1940s, when the Egyptian Stock Exchange ranked fifth in the world.

Nevertheless, the political turmoil of the mid-1950s led to the demise of activity on the Exchange, which remained dormant throughout the period between 1961 and 1992 (MohieEldin and Sourial, 2000). In 1990, the Egyptian government started on economic reform & restructuring program. The move towards a free-market economy has been remarkably swift and the process of deregulation and privatization has simulated stock market activity.

The Capital Market Authority (2002) played an instrumental role in initiating and leading the effort for the revival of the Egyptian stock market in the period between 1992 and 1996. The Capital Market Authority (CMA) is the regulatory body in charge of enforcing, regulating & ensuring compliance as well as monitoring market performance. Relevant policy actions undertaken by the CMA include introducing all types of investment vehicles, allowing open competition in the pricing of market services; and providing full investor protection.

The main features of the operational framework are fair trading procedures and practices as well as an immediate transfer of ownership of traded securities; optional listing on the stock exchange; quarterly disclosure requirements for companies; adequate protection of minority shareholder rights; and improved data collection schemes. Capital Law 95/1992 has put in place the regulatory framework in which financial intermediaries such as brokers, venture-capital firms, underwriters and fund managers are to operate.

At the senior level, an international advisory committee made up of internationally prominent economists, investment bankers, financiers & investors has been developed in order to ensure that CASE stays closely linked to the int’l arena. This group also provides continuous feedback on its policies. Both the CMA & the CASE monitor market activity to detect possible market manipulation or insider trading. Accordingly, they may suspend offers & bids for institutions suspected of price manipulation.

In the case of an emergency, the CASE and/or the CMA may halt trading and/or place ceilings on floors trading prices (maximum 5% up or down), based on the closing prices of the preceding day. In the case of individuals, mutual funds & international funds, no taxes are levied on dividends, capital gain & interest on bonds. Profits of Egyptian corporations from securities investments are subject to a capital gains tax. 2. 3. 1 Recent developments On 21 July 2002, CASE commenced its new price ceiling system with regard to the most actively traded stocks.

According to the new practice, the five-percent ceiling on daily prices was removed for a set of selected active stocks (currently twelve). This set of stocks comprises 12 out of the most actively traded stocks on CASE. The chosen of this set of stocks was based on meeting some stated criteria decided by CASE (2002):

  • Stocks must be dematerialized.
  • Minimum trading days per company per year is 220.
  • Average number of transactions per stock must be 20.
  • Minimum market capitalization per company amounts to LE 200 million.
  • Minimum free float amounts to 15 percent of the total listed shares.
  • Minimum turnover ratio per company is 10 percent.
  • The company must prepare financial statements for three consecutive years.
  • Transactions conducted on the shares of the company must be executed by at least 20 brokerage firms.
  • The new practice will stipulate the halt of trading on any of the twelve stocks for a period of thirty minutes, forty-five minutes or till the end of the trading session, if the stock prevailing weighted average price exceeds 10 percent, 15 percent or 20 percent respectively over opening price.

When trading is halted, brokers should inform their clients about the temporary suspension, its reasons, duration and should take the necessary actions in order to fulfill their clients requests. Brokers are allowed to cancel, any of their clients’ orders, when trading is halted.

Background of Privatization Program

The Ministry of Public Enterprise (MPE) is dedicated to achieve the long-term goal of complete implementation of Egypt’s overall privatization plan. In 1991 Public Enterprise Law No. 203 was introduced as a transitional measure. Dr. Khatab M. (Minister of Public Enterprise) (2002) has explained his

Ministry’s plans and objectives to facilitate privatization in Egypt and the methods that have been followed in this regard. Also Dr. Mokhtar Khatab has mentioned to the Government of Egypt (GOE) his efforts in undertaking an extensive privatization program whereby state-owned companies are transferred to the private sector through several methods McKinney (1996).

  • The transfer of ownership & control of state-owned enterprise to the private sector through a partial or a full public share flotation on both the domestic or foreign stock exchanges.
  • Direct sale of a controlling interest to domestic or foreign investors. Direct sale of a controlling interest to employees.
  • The law also allows the sale or lease of company assets, unlimited sale of government-owned shares, or liquidation.
  • Primary objectives of the plan are to generate higher productivity and faster (but sustainable) growth, and as a consequence an increase in returns on assets and equity while at the same time raising internal efficiency, improving capital structure and increasing capital expenditure. Since the early 1990s a number of key programs have been put into place to greatly liberalize commerce and trade; and to re-frame the country’s legal, regulatory, judicial, and tax structures.

An equally important focus of the plan is the creation of new jobs that an expanding economy will provide for the workforce. Over the past five years, the GOE has achieved very gratifying results in macroeconomic terms. This is due to the creation of policies to remove trade barriers, the reform of trade and financial markets, and the reform of the legal taxation and regulatory frameworks, Field (1995)

Updates on the Situation of the Privatized Companies

The Government of Egypt (GOE) has designed a balanced privatization program, which includes the following share sales strategies.

The Egyptian Ministry of Public Enterprise Sector (2001) revealed that: •Public Offerings on the Cairo and Alexandria Stock Exchange 37 companies have so far been approved by the GOE for privatization and have been sold through Initial Public Offering (IPO) or second offerings. The sales of these companies netted 5. 6 billion pounds which represents 36% of privatization proceeds to date. 16 companies have achieved partial privatization netting the government nearly 1. 76 billion LE.

Sale to Anchor and Strategic Investors 3 companies have been privatized by this method, accounting for 6. 4 billion pounds LE in proceeds to the government. Sales to anchor investors have amounted to 42% of the total privatization proceeds thus far.

Employee Stock Ownership Programs (ESOPs)

  • The GOE has approved the allocation through the sale of 10 percent of the public enterprises’ share offerings to the employees as part of the "Employee Stock Ownership Program". In other cases, and according to the particular circumstances of each company, the majority of shares have been sold to its management and employees.
  • To date, mainly medium-sized companies in the public works sector have implemented this scheme. So far, 30 Employee Shareholder Association (ESA) sales transactions have taken place bringing in 870 million pounds LE.
  • Lease Management Contracts In this method, Companies were offered for management by the government to the private sector with an option to buy at a future date. This alternative is not very different to the anchor investor approach if and when the managing company exercises its option to buy. Five contracts of this type are currently active.

Pharmaceutical sector overview

The government has set a 40% ceiling (maximum that could be privatized), 10% of which is reserved for Employee Shareholder Associations (ESA), on the privatization of any public pharmaceutical company. The restriction relates to the government’s desire to maintain control of the industry for its significant role in society, The Egyptian Ministry of Public Enterprise Sector (2001). The first five companies that have been privatized: Alexandria, Cairo, Memphis, Arab and Nile pharmaceuticals. These companies have already been 40% privatized. The privatization plan then expanded to cover 11 companies at the end of June 2002.

Pharmaceutical Industry Highlights

Total exports made by Egypt to the whole world includes a lot of commodities which are classified to (Fuels Products, Cotton, Raw Materials, Semi finished commodities and finished commodities). Central Bank of Egypt (2002) revealed that Pharmaceutical products are considered as part of finished commodities, they represent 3% of finished commodities and 1. % of the total export. Also, Pharmaceutical products play a significant role in Egypt’s import. They represent 4% of the total import and 21% of their classification division (consumer goods).

The government has set a relatively low tariff on imported drugs, which averages around 5%. The main reason for this comparatively low duty is the state’s policy of making medicine available to the bulk of the population at the cheapest possible price. 3. 3 Pricing Policy Prior to the reform program in 1991, the government’s major consideration when setting prices for drugs was to make medicine affordable to the bulk of the population regardless of a company’s cost structure. The focus on the social role of medicine, rather than the profitability of pharmaceutical companies, is the main reason behind this policy.

The Drug Policy & Planning Center (DPPC) is the main regulatory authority controlling the pharmaceutical industry. The center is in charge of drug registration and pricing. The DPPC (2002) uses a “Cost Plus Formula” to price drugs. The formula stipulates a price equivalent to the products cost plus a certain profit margin. The profit margin is 25% for nonessential products, and 15% for essential products. It is noteworthy that once a product has been priced, it is seldom eligible for re-pricing to account for increasing costs.

The heavy drop in the value of the Egyptian pound was mirrored in an increasing raw material costs burdening the Egyptian Pharmaceutical companies, which import around 80% of their raw material requirements. In order to save the profit margins from the aftermath of the devaluation, the Ministry of Health finally agreed to raise the prices of five products for each pharmaceutical company starting February 2002. 3. 4 GATT and TRIPS Egypt is a signatory to the General Agreement on Tariffs and Trade (GATT) which will come into effect for the pharmaceutical sector in Egypt in 2005.

The agreement is likely to have serious repercussions for the pharmaceutical industries of developing countries including Egypt. The agreement calls for the abolition of both quantitative and qualitative barriers to entry for pharmaceutical products, thus eliminating any governmental protection of the industry. Under GATT, Egyptian companies have to abide by the restrictions imposed by patents and property rights for a period of 20 years. Based on the Egyptian commitment with the agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS), which is part of the GATT, President of Egypt published The Law No. 2 for year (2002), calling for the Protection of any invention whether industrial or intellectual. The agreement will result in the extension of a patent to 20 years and will grant protection to the product and the production process.

Methodology and empirical models

Data Set

In our study, we select all the pharmaceutical companies quoted in the Egyptian stock exchange which consists of 11 pharmaceutical companies representing the pharmaceutical sector. We covered the period from 1996 to 2001. Analyzing six continuous years of data, strengthen and support results and give our conclusion stability and reasonability.

Kompass Egypt Financial Year Book and the Egyptian Capital Market Authority were the prime sources for our data set. Additionally, for the purpose of this analysis, we calculate the returns using annually prices of securities for years starting from 1996 to 2001.

Selection of Financial Ratios (Independent variables)

According to the literature, we determine the most useful financial ratios that could be functional in security valuation by analyzing and comparing several papers and texts were analyzed and compared.

  • The reasons behind the selection of these financial ratios:
  • Their talent in theoretical explanation of fundamental relationships and signals experienced by the firms.
  • The importance of their existence in published annual reports.
  • Surveys proved that chief executive officers and other senior executives are concerning popular financial ratios for various types of decision making.

The following table provides the most common financial ratios that might affect stock returns.

For each financial ratio, we provide the way of calculation, the hypothesized positive or negative relationship with stock returns.

Research findings

We present results of a regression model where independent variables in the regression equation are chosen in two ways (both general and step wise regression). Multicollinearity tests the correlation among two or more of the independent variables (financial ratios) used in the regression equation. Multicollinearity is a problem because it increases the likelihood of rounding errors in the calculation of the beta estimates and standard error, and also it may produces confusing and misleading (signs of beta parameters are different from those signs expected) results (Mendenhall, 1996).

Also, T-test of the individual Betas (financial ratios) indicates that the most active ratios in determining stock returns are Current Ratio (CTR), Interest Coverage Ratio (IC) and Profit Margin Ratio (PM) with a significant level of 99%, 99% and 95% respectively. To check on the signs of the beta coefficient, the dependent variable (stock return) was regressed on each of the independent variables (financial ratios) and the signs of the resulting betas were checked against that of the original equation.

There are three ratios which are Current Ratio, Receivable Turnover and Return on Assets that had different signs from the original regression equation The positive coefficient estimated for Current Ratio with stock returns is not expected because conservative policies that tend to keep current asset higher than current liability have lower risk and also have lower expected return than the aggressive policies. So we conclude that rational investors put more confidence in low risky stocks and look forward for stable stocks more than the temporary profitable stocks.

Interest coverage ratio has also explained about 12% of the variance in the yearly return of pharmaceutical sector. Interest coverage ratio is regarded as a measure of a company’s creditworthiness because it shows how much income there is to cover interest payments on outstanding debt. Profit margin ratio explained about 7% of the variance in the yearly return of pharmaceutical sector with R square 7%.

Stepwise multiple regression model yielded a reduced equation containing only three companies (independent variables) explaining about 77% of the variance in the yearly return of pharmaceutical sector as a dependent variable: the analysis yielded three good predictors as demonstrated at table (5), the results proved that Beta value of Memphis Pharmaceutical and Chemical Industries was 0. 73 and it is significant at 99% level. Additionally, Memphis Company alone explained about 47% of the variance in the yearly return of the pharmaceutical sector.

The second good predictor is Cairo Pharmaceutical and Chemical Industries while its Beta value was 0. 60 and it is significant at 99% level. Cairo Company alone explained about 21% and together with Memphis Company explained about 68% of the variance in the yearly return of the pharmaceutical sector. The third and last predictor is Alexandria Pharmaceutical and Chemical Industries with a Beta value of -0. 52 and significant at 99% level. Alexandria Company explained alone about 9% of the variance in the yearly return.

Summary and Conclusion

The relationship between financial ratios and stock returns has been a popular issue in the area of accounting and finance for a long time, so we found that it is a good issue to discuss on the Egyptian stock market. Here, an analysis is undertaken to show the value relevance of the financial ratios and their usefulness in security valuation in the Egyptian pharmaceutical sector. In our research, we use step-wise multiple regressions between financial ratios and stock returns, also between pharmaceutical companies’ returns and pharmaceutical sector returns.

The results from using step-wise and multi regression indicate that Current Ratio (CTR), Interest Coverage Ratio (IC) and Profit Margin Ratio (PM) respectively, are the most relevant ratios in determining stock returns. Additionally, Memphis Pharmaceutical and Chemical Industries is the most relevant company in explaining the variance of the pharmaceutical sector return as a whole. Finally, it seems that Current Ratio (CTR), Interest Coverage Ratio (IC) and Profit Margin Ratio (PM) play a significant role in formulating investment decisions in the Egyptian stock market (specifically, Pharmaceutical sector).

Egyptian rational investors put more confidence in low risky stocks and look forward for stable stocks more than the temporary profitable stocks. 5. 3 Further Research The study was conducted on Egyptian pharmaceutical sector and taken all pharmaceutical companies (11 companies) that have been quoted in Egyptian stock exchange, covered the period from 1996 to 2001. Replicating the study on other sectors in Egypt such as (Agriculture, Food & Beverages, Construction, Banks…) at different times could be very useful. The study could be also replicated on the valuable Egyptian market indices such as (Case 30, IFCG, MSCI, EFG Hermes).

These studies could help in determining more clearly the relationship between financial ratios as independent variables and stock returns as dependent variable.

References

  1. Barber, B. , Lyon, J. , and Tsai, C. , (1999), “Improved Methods for Tests of Long-Run Abnormal Stock Returns“, Journal of Finance, 54 (1), 165-201.
  2. Baraber, B. , and Lyon, J. , (1997), “Detecting Long-Run Abnormal Stock Returns: The Empirical Power and Specification of Test Statistics“, Journal of Financial Economics, 43 (3), 41-72.
  3. Brav, A. , and Gompers, P. , (1997), “Myth or Reality? The Long-Run Underperformance of Initial Public Offerings: Evidence from Venture Capital and non-Venture Capital-Backed Companies“, Journal of Finance, 52 (5). Capital Law 95/1992, “Intermediation Companies”, (CMA. gov. eg), Available: http//www. cma. gov. eg /En-nf/index4. html, (Accessed: 2003, January 20).
  4. CASE, (2002), “What’s New”, (Egyptse. com), Available: http://www. egyptse. com, (Accessed: 2003, February 7). Central Bank of Egypt (2002), “Proceeds of commodity Exports and Imports by degree of processing”, (CBE. org. eg), Available: http//www. cbe. org. g, (Accessed: 2003, February 9).
  5. Charles, P. J. , (2002), “Investments Analysis and Management”, Seventh edition, John Wiley & Sons Inc. , NY: Third Avenue.
  6. David, I. , and Pitman, (2001) “Foundation for SME Development: Key Financial Ratios” Available: www. google. com , (Financial Ratios). EgyptWatch, (2002), “Egypt Stock Market”, (Egyptwatch. com), Available: http://www. egyptwatch. com/en/Finance/Indicators/stock. doc (Accessed: 2003, February 16).
  7. Eugene F. B. , and Joel H. H. , (1998), “Fundamentals of financial management”, eightth edition, The Dryden Press. Field, M. (1995), "The Slow Road to Privatization", Euromoney, Middle East Markets Supplement, November 12-13.
  8. Foster, G. (1974). “Financial statements Analysis: A New Approach”, Englewood Cliffs, NJ: Prentice Hall.
  9. Gibson, C. H. (1982a), “How Industry Perceives Financial Ratios”, Management Accounting. April, p. 13-19
  10. Gibson, C. H. (1982b), “Financial Ratios in Annual Reports”, The CPA Journal, September, p. 18-29
  11. Holthausen, R. W. , and Larcker, D. F. , (1992), “The prediction of stock return using financial statement information,” Journal of Accounting and Economics, Vol. 15, p. 373-412.
  12. John M. R. and Jeanne Y. H. (1998), “The power of cash flow ratio”, Journal of Accountancy, October, p. 53-55, 56-58, 60-61.
  13. Khatab, M. , (2002), “Minister’s Message”, Available: www. mpe-Egypt. gov. eg Kompass Egypt Financial Yearbook (2002 – 2003), Pharmaceutical & Health Care, Published by Fiani & Partners, Cairo, Egypt.
  14. Kothari, S., and Warner, J., (1997), “Measuring Long-Run Horizon Security Price Performance", Journal of Financial Economics, 43 (3), 30-40.
  15. Lev, B., and Thiagarajan, S., (1993), “Fundamental Information Analysis,” Journal of Accounting Research. Autumn, p. 190-250.
  16. McKinney, B. M. (1996), "Recent Development in Egyptian Investment Policies and Programs, and Pending Reform Legislation" Middle East Executive Reports, 19 (7), 9-12.
  17. Mendenhall, W., and Sincich, T. , (1996), “A Second Course in Statistics Regression Analysis”, Fifth edition, Prentice Hall.
  18. Mishkin, F. S. (2001), “The Economics of money, banking, and financial markets”, Sixth Edition, Adison Wisely, Boston.
  19. MohieEldin, M. and Sourial, M. S. , Institutional Aspects, Distributional Characteristics and Efficiency of Egyptian Securities Market, in Arab Stock Markets: Recent Trends and Performance, edited by Riad Dahel, (Cairo: AUC Press, 2000), 1-44.
  20. Ou, J., Penman, S. 1989. “Financial statement analysis and the prediction of stock returns,” Journal of Accounting and Economics, Vol. 11, p. 295-330.
  21. Peter S. R. , (1999), “Commercial bank management”, fourth edition, McGraw-Hill Companies, NY: Avenue of the Americas.
  22. Riahi-Belkaoui, A. (1997). “Value relevance of popular financial ratios,” Advances in Quantitative Analysis of Finance and Accounting, Vol. 5, pp. 193-201. Ross, Westerfield, and Jaffe, (2002) “Corporate Finance”, Sixth edition, McGraw-Hill Companies, NY: Avenue of the Americas.
  23. The Capital Market Authority, (2002), “CMA Public Information Center”, (CMA. ov. eg), Available: http://www. cma. gov. eg/En-nf/index5. html (Accessed: 2003, January 20).
  24. The Drug Policy and Planning Center, (2002), Pharmaceutical Industry Statistics, (DPPC. gov. eg), (Accessed: 2003, February 10)
  25. The Egyptian Ministry of Public Enterprise Sector, (2001),
  26. Privatization Program performance from the start to February 2001, (Cairo: MPES), http://www. mpe-egypt. gov. eg/privatize. asp#methods. (Accessed: 2003, February 16)
  27. The Law No. 82 for year (2002), “Trade-Related Aspects of Intellectual Property Rights (TRIPS)”, Pharmacy and Medicine, March 2003, Vol. 24, p. 44-55
  28. Timo S. , Ilkka V. , Paavo Y.O. (1990), “On the Classification of Financial Ratios”, published on the Word Wide Web as http://www. uwasa. fi/~ts/sera/sera. html
  29. Walsh, F. J. (1986), “The Relative Information Content of Accruals and Cash Flows: Combined Evidence at the Earnings Announcement and Annual Report Release Date” Journal of Accounting Research, p. 165-200

Cite this Page

Linking Financial Ratios and Stock Returns. (2018, Sep 20). Retrieved from https://phdessay.com/linking-financial-ratios-and-stock-returns/

Don't let plagiarism ruin your grade

Run a free check or have your essay done for you

plagiarism ruin image

We use cookies to give you the best experience possible. By continuing we’ll assume you’re on board with our cookie policy

Save time and let our verified experts help you.

Hire writer