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ASCI 
Journal of Management
Volume 23, 1994

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Variability of Earnings:
Price Ratios of Indian Equities
S N Sarma
Dept of Business Management, Osmania University, Hyderabad

This study empirically examines the determinants o)f the differences in rates of return on the Indian corporate equity in general, and on the role of growth variables in this process, in particular.  For this, it traces the relationship between each of the independent variables on the rates of return on equity while holding the other indepedent variables constant in a multiple regression analysis.  It concludes that thej'mancial leverage as measured btl debt-eciuity ratio comes out as a more dominant variable vastly influencing the measured rate of return, followed by pay-out ratio.



Rate of return, risk, and liquidity are the three basic factors considered by any equity investor, and selects those secuiities that conform to the expected riskreturn requirements.  Of the several techniques of security analysis that are available in the literature, the fundamental analysis is more popular and the foremost. it has been the prime concern of the fundamental analysts to determine the appropriate capitalisation rate or equivalently, the appropriate multipliers to use in valuing a particular security's income.  The main factors considered in determining the correct multiplier are: (1) the risk of the security, (2) the growth rate of dividend stream,(3) the duration of any expected growth,and (4) the dividend pay-out ratio.

The focus of the empirical studies generally has been on the reciprocal of these multipliers - P/E ratios.  Broadly, these empirical investigations have attempted either to study and explain: (1) the relative value of P/E ratio represented by the ratio of an equity to 'normal" P/E ratio (Holt, 1942; Malkiel, 1963), or (2) the variability of P/E ratios of equities (Benishay, 1961;Whiteback, Kisor, 1963; Wippern, 1966; Bower, Bower, 1969: Malkiel, Gragg, 1970; Chung, 1974).  The later studies have investigated the determinants of P/E ratios of equities over time as well as cross-section years.  Most of the studies, however, have been based on cross-section analysis.  They attempted to study the impact of one or more of the variables on P/E ratios of equities.  These variables are: growth, dividend pay-out, risk leverage, size, and firm effects.

The empirical studies by Gupta (1981), and Yalawar (199-) are of special relevance in this context, for, they are pioneering studies on the rates of return and risk of the Indian corporate equities.  Another study by Md Obaidulla (1991) indicates that the stock price adjustment to earnings information is biased and inaccurate, and is neither be time-specific nor associated with chance factors.  In his study, Puranik (1992) concludes that the prices of the shares seem to have been influenced, potentially by the factors other than the fundamentals.  However, these studies have not focused on identifying and studying the statistical significance of the important determinants of the rate of return or risk.  No other study seems to have been made to analyse P/E ratios or their reciprocal of different equities of the Indian corporate sector with this focus.

Objectives
This exploratory study attempts to examine empirically the determinants of the differences in rates of return on the Indian corporate equity in general, and on the role of growth variables in this process, in particular.  The method of investigation consists of tracing the relationship between each of the independent variables on the rates of return on equity while holding the other independent variables constant in a multiple regression analysis.  Such an attempt would help investors, brokers, and security analysts (i) in understanding the functioning of the market mechanism in valuing the equity shares; (ii) improving their trading at the market place, and (iii) throwing some light on whether the variables mentioned above are relevant in the Indian context or not.

Methodology
This study consists of a comparison of .30 companies forming Bombay Stock Exchange Sensitive Index (BSESI), in the five years -1986, 1987, 1988, 1989, and 1990 - with each firm constituting an observation in a cross-sectional multiple regression analysis.  The principal source of data has been the BSE Directory.  Wherever the financial year is at a deviation from the normal 12 months period, the data have been annualised so as to bring in comparability in the analysis.  'Me prime reason for choosing the BSESI companies for this purpose is that the shares have been selected on the basis of market activity with due representation to major industries.

It was around 1985, the Government introduced major industrial policy changes, sometimes described as 'liberalisation" or "deregulation", based on the recommendations of the high-powered committees the Narasimham Committee on shift from case by case discretionary physical controls to fiscal and financial control; the Abid Hussain Committee on export-import policy, and the Patel Committee on reform of stock exchanges - and according to all available indications, their positive impact on the economy was becoming visible in all quarters by 1986.  In the light of the emerging and evolving competitive conditions, this study attempts to analyse the determining factors of the differences in the rates of return on corporate equity.  Thus, this study encompasses the post-deregulation period - 1986-90.

The multiple regression analysis is the most appropriate statistical technique to assess and delineate the individual and combined effect of a set of independent variables on a dependent variable, and, therefore, has been employed in this study.  In fact, this study adopts the model employed by Benishay where he advanced the hypothesis that the measured rate of return of corporate equities as a function of. (1) the trend in earnings, (2) the trend in market value of the equity, (3) the pay-out ratio, (4) the expected stability of the future income stream, (5) the expected stability of the equity value, (6) the size of the firm, and (7) the debt-equity ratio.  Among the independent variables, the first three are expected to remove the errors obstructing a valid measurement of the theoretical concept of the rate of return on equity capital, and as such are "correctors", and the remaining shall measure the differential 'risk" or desirability of holding corporate equities and- as such are "explanatives".  Notationally, the model can be presented as under:


 

Benishay tested his model by running cross-sectional linear regressions, in which logarithmic values were used for Y, X3, X4, X5, and X6, and actual values for the other variables.  In the proces X3, X4, X5 and X6 are conceived to be having multiplicative effect in non-logarithmic form, and the rest being additive on the dependent variable.  Actual values of all variables are considered in this study to avoid this multiplicity of the expected relationship between dependent and independent variables.  Whereas, we have computed all variables for the cross-sections, Benishay used 1954 computations of XI, X2, X4, and X5, for 1954, and 1955 regressions, and their 1956 computations were used both in 1956,and 1957 regressions.

It may perhaps be useful to deduce the a priori relationships between the independent and the dependent variables at this stage.  The dependent variable, measured rate of return 'Y, is a nonnalised rate of return where the numerator is a weighted average of EAT for the cross-section year, and the eight preceding years, and the denominator is the arithmetic mean of the high and low values of equity outstanding in the cross-section year.

The growth in earnings, "Xi", is expected to have a negative correlation with the measured rate of return.  As the numerator in "Y" is not adjusted for trend in past income, it may diverge downwards from the expected income when the past income growth has been high, and upwards when it has been low.  A high positive correlation in growth of EAT between two past adjacent periods can be a good predictor of the future growth rate in earnings, and as such may be related negatively to the measured rate of return.

A recent revaluation of the expected income in the measured rate of return can be corrected through incorporating the past trend in the value of the equity, (X2).  The measure of earning in the numerator of "Y" may fail to reflect the change in the expected income, while the market value of the equity in denominator will reflect immediately.  Consequently, the measured rate may be smaller than the true rate when the expected income has risen and vice versa.  The larger this percentage change is, per unit of time, the less likely is the empirical representation of earnings to keep up with the expected income and the greater will be the negative correlation between growth in equity value and the measured rate of return.

Theoretically, dividend pay-out ratio is expected to be negatively influencing the measured rate of return, especially in a market of "short-sighted" (Chandra, 199-) nature.  Because the investors prefer distribution to retention of earnings, the payout ration (X3), and the rate of return are negatively correlated.  The explanation for such relationship may be provided by an examination of the effects of errors in the measurement of earnings.  Two types of errors are possible: (1) a difference between the expectation of the population of annual book earnings and expected income, due either to a consistent accounting bias in the measurement of earnings or to the fact that measured earnings however unbiased "ex-post", may lag behind the expected income when the latter has changed abruptly; (2) the difference between the earnings measured on the basis of a limited sample and containing therefore a transitory element, and their population mean.  The introduction of X3 thus intended to correct for these errors.
 

The larger the variance of the distiibution of the expected earnings, (X4), the greater will be the probability of failure of the firm, and the cost or inconvenience incurred by the investor in maintaining his level of expenditure.  Thus, a high stability of income is a desirable property and will tend to produce a low price-earnings ratio.

The speculative rather than the precautionary motive is dominant and, therefore, an equity variability is sought.  The stock-holders are more encouraged by a likelihood of a high price than discouraged by an equal likelihood of a lower one.  If the equity-holders have a preference for the stability of equity value, (X5), then it will have a negative coefficient.

Size, (X6), of the firm measured in terms of market value is expected to be negatively associated with the rate of return.  Of the risk variables D/E ratio, (X7), a measure of financial leverage or risk, is expected to have a positive coefficient.

The results emerging out of Benishay's study affirmed the above a prior! reasoning excepting for the financial leverage.  His observation with regard to this element was that it is "difficult to interpret" as the coefficients of leverage had negative sign.  The conclusions of the other mentioned studies are more or less close to those of Benishay's.

Empirical Results
The regression results are presented in Table I which contains the coeffleicnts, "t" ratios of independent variables, and the adjusted R2, the measure for explanation power of the model.  As can be gathered from Table 1, three regressions for each year have been conducted in order to compare the performance of the two growth variables and to choose the better corrector.  The first one is inclusive of all the seven independent variables, whereas the second, and third, are exclusive of X1, and X2, respectively.  The equations demonstrate a high level of predictive power as reflected by the adjusted R2 excepting for the year 1990.  Such results, for that year, are not totally unexpected since it was during this year that the stock markets were extremely volatile for more than one reason.  The markets were not receiving, on the fundamental front, good news.  General industries like fertilisers, and tyres were not performing well, and the corporate results that were announced were not very encouraging.  This year had also witnessed the markets with a lopsided trading.  In fact, notwithstanding the high margins imposed by BSE as much as 75 per cent of the volume on BSE was accounted by ACC, TELCO, 'NSCO, Bombay Dyeing, and RIL, during June 1990.  In addition, this year saw many socio-political turmoils in the country, apart from the panic conditions emerging due to fears of a major conflict in the Gulf.

A look at the table reveals the following:
 

    1.  It can be gathered from the table that the adjusted R2 is the highest for the second equation where X1 is excluded during the study period excepting for 1989.  It implies that growth in equity value is considered to be a better corrector.  It could also be because of a possible positive correlation between X2 and X1 and that the exclusion of X1 is improving the predictability of equation.
    2. Coefficients for X1, growth in earnings, have a negative sign for 1986, 1989, and 1990, and their "t" values are significant only for 1989.  This signifies that for the major period, X1 acted as a non-signiflcant corrector with an expected negative sign.  This indicates a relatively low positive correlation between growth in earnings in two consecutive time intervals.
    3.  It is very strange to note that the coefficients for X2  are positive in variance with the a priori reasoning, and mostly their 't" values are statistically non-significant.  Theoretically, the sign of coefficients and the statistical insignificance of their "t" ratios are not anticipated.  However, the adjusted R2 is improved when X2  is the only growth variable used in the equation.  This is like a riddle difficult to interpret.
    4. The pay-out ratios, X3, coefficients are negative and their "t" values are significant all through the study period, indicating that the higher the pay-out ratio the higher is the value of the firm.  This strengthens the contention that investors prefer distribution to retention of earnings.
    5. The coefficients for stability in earnings and stability in equity values have a positive sign and are barely significant.  It indicates that the market has an aversion to, rather than a preference for, the stability of equity values and earnings.
    6. Since the larger firms are better known, investors consider shares of such companies safer, and hence they are more in demand, and can be easily sold without significantly affecting the market price.  We expected a negative coefficient, and it has been so, for the first three years of the study.  But the "t" ratios are not significant, except for 1988.  Thus, even the size of the firm does not seem to be a dominant variable in the model.
    7.  When D/E ratios represent deviations from their equilibrium value then it ought to be positively associated with the rate of return.  Of all the variables, D/E ratio, X7, emerged as the most significant variable and its coefficients as expected are positive all through the study period.  This indicates that lower the debt equity ratio the higher the measured rate of return or a higher value for the equity is associated with lower debt.  It means that the investors are expecting a higher compensation for the component of financial risk.

Table 1: Regression Coefficients and their 't' Ratios
 


 
Conclusions
In the context of the Indian stock market, it appears that the financial leverage as measured by D/E ratio to be a more dominant variable vastly influencing the measured rate of return, followed by pay out ratio.  This conclusion is not totally unexpected in the light of the short-sighted, and speculative driven stock market (Patel, 1984; Gupta, 1991).

This may further be tested by increasing the sample size, probably redefining certain variables, and following exactly the methodology of Benishay lock , stock, and barrel.  This is desired for two reasons: (1) the sample size, although statistically considered to be large, is not large enough to be representative, and (2) the sample scrips might have induced some bias on the results, for, they are mostly speculative, overtly or covertly, in nature.  However, the result should help in designing the methodology for future research.


References
Benishay H (I 96 1): Variability of earnings-price ratios of corporate equities.  American Economic Review Mar, 81-94.

Bower R A, Bower D M (1969): Risk and the valuation of common stock.  Journal of Political Economy May Jun, 107-18.

Chandra P (199-): Valuation of Equity Shares in India.  New Delhi, Sultan Chand and Sons.

Chung P S (1974): An investigation of firm effects influencing analysis of earnings to price ratios of industrial common stocks.  Journal of Financial and Quantitative Analysis.  Dec, 1004-29.

Gupta L C (1981): Rates of Return on Equities: The Indian Experience.  New Delhi, Oxford University Press.

----,(1991): The Volume of the Nature of Speculation on Indian Stock Exchanges: Regulatory Implications.  Expert Study of Trading in Shares in Stock Exchanges.  New Delhi, Society for Capital Market Research and Development, Aug., pp 1-21.

Holt C (1962): The Influence of growth duration on share prices.  Journal of Finance Sept., 465 75.

Malkiel G (1963): Equity yield, growth, and the structure of share prices.  American Economic Review Dec, 10004-31

-----,Gragg J G (1970): Expectations and the structure of share prices.  American Economic Review.  Sept., 467- 94.

Md Obaidulla (1991): The price earnings ratio analysis in Indian stock markets.  Decision July-Sept, 183-90.

Patel G S (1984): High Powered Committee on Stock Exchange Reforms.  New Delhi, Govt. of India. p.66 (About 90 per cent of the trading activity on most of the stock exchanges was of a purely speculative nature).

Puranik A (1992): Consistency of share price trends with corporate fundamentals: A test. Chartered Accountant -Aug., 99-106.

Whiteback Y.S, Kisor M (1963): A new tool in investment decision-making.  Financial Analysis ,Journal May June, 55-62.

Wippern R F (1966): Financial structure and firm value of firm.  Journal of Finance Dec, 615-34.

Yalawar Y B (199-): Bombay Stock Exchange Rates of Return and Efficiency. [Unpublished research report], Bangalore, IIM.