FINANCIAL RATIOS TO PREDICT THE STOCK RETURNS OF TRADING AND SERVICES PUBLIC LISTED COMPANY IN
MALAYSIA
Nursyamimi Huda Binti Bohari
HF 5681 Rl5 N974
Bachelor of Finance (Honours) 2012
1012
Pusat Khidmat Maklumat Akademi UNlVERSm MALAYSIA SARAWAK
FINANCIAL RATIOS TO PREDICT THE STOCK RETURNS OF TRADING AND SERVICES PUBLIC LISTED COMPANY IN MALAYSIA
P"~liiMIlili 10002.45012
NURSYAMIMI HUDA BINTI BOHARI
This project is submitted in partial fulfillment of the requirements for the degree of Bachelor of Finance with Honours
(Finance)
Faculty of Economics and Business UNIVERITI MALAYSIA SARA W AK
2012
Statement of originality
The work described in this Final Year Project, entitled "Financial Ratios To Predict The Stock Returns of Trading and Services Public
Listed Company in Malaysia" is to the best of the author's knowledge that of the author except
where due reference is made.
(Date submitted) (Nursyamimi Huda Bohari) 21963
ABSTRACT
FINANCIAL RATIOS TO PREDICT THE STOCK RETURNS OF TRADING
AND SERVICES PUBLIC LISTED COMPANY IN MALAYSIA
By
Nursyamimi Huda Binti Bohari
This research was carried out to study whether the financial ratios can predict the stock
return of trading and services public listed company in Malaysia for the period from
January 2001 to December 2010. Three financial ratios have been selected which
include dividend yield (DY), earning yield (EY), and book to market ratios (BIM) that
have been documented to predict stock returns. This study applies fixed effect model
techniques to estimate the predictive regressions in the form of simple and multiple
models of panel data sets. From the findings, the financial ratios can predict stock return
as book to market ratio has a higher predictive power than dividend yield and earning
yield respectively. Hence, book to market ratio playa significant role in capturing strong
variation in stock returns. Furthermore, financial ratios are able to develop stock return
predictability when the ratios are combined in the mUltiple predictive regression models.
For future study, it is recommended to use more than 10 years and adding more
variables to get a more reliable data and strong results.
iv
I
ABSTRAK
NISBAH KEWANGAN UNTUK MERAMALKAN PULANGAN STOK DAGANGAN DAN PERKHIDMATAN SYARIKAT YANG TERSENARAI DI
MALAYSIA
Oleh
Nursyamimi Huda Binti Bohari
Kajian ini telah dijalankan untuk mengkaji sarna ada nisbah kewangan boleh meramal
pulangan saham syarikat perdagangan dan perkhidmatan awam yang disenaraikan di
Malaysia bagi tempoh dari lanuari 2001 hingga Disember 2010. Penyelidik memilih tiga
nisbah kewangan termasuk hasil dividen (DY), hasil pendapatan (EY), dan buku kepada
nisbah pasaran (B / M) yang telah didokumenkan untuk meramalkan pulangan stok.
Kaj ian ini menggunakan teknik model kesan tetap untuk menganggarkan regresi
ramal an dalam bentuk model yang mudah dan beberapa set data panel. Daripada
keputusan kajian ini, nisbah kewangan boleh meramal pulangan saham dan buku nisbah
pasaran mempunyai kuasa ramalan yang lebih tinggi daripada hasil dividen dan hasil
pendapatan masing-masing. Oleh itu, buku nisbah pasaran memainkan peranan penting
dalam menguasai variasi kukuh dalam pulangan saham. Di samping itu, nisbah
kewangan mampu untuk membangunkan pulangan saham yang diramal apabila nisbah
digabungkan dalam model regresi berganda ramal an. Untuk kajian mas a depan, adalah
disyorkan dengan menggunakan lebih daripada 10 tahun dan menambah lebih banyak
pembolehubah untuk mendapatkan data yang Iebih dipercayai dan hasil yang kuat.
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ACKNOWLEDGEMENT
It is obvious that the development of a project of this scope needs the support of
many people. I'm indeed grateful to the people who helped me during all these two
semester ofhard work and dedicate this acknowledgement to all peoples who supported
directly and indirectly in prepare this final year project. First of all, I would like to thank
to God in giving me strength and spirit in completing this research. Besides that, I would
also like extend my gratitude to my parent, brother, sisters and other family members
who supported and encouraged me all the times.
Thus, I would like to express my special thanks and gratitude to my supervisor,
En. Shahal1ldin Jakpar in giving me the opportunity, advice and chances to explore
various type of financial methods which being very helpful in completing this thesis. In
addition, his support and guidance all the time has being very helpful and mainly
keeping the ship afloat in my balance. Thank you for the commitment and contribution.
I do take this opportunity to acknowledge my friends, course mates and seniors whom
have shared their experience and ideas from development of their own thesis and
provide invaluable amount of guidance for my research. Finally, I would like to thank
the faculty as well, for being kind enough to donate the resources and being helpful all
the time.
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Pusat Khidnat Maklumat Akademik UNIVERSm MALAYSIA SARAWAK
TABLE OF CONTENTS
LIST OF TABLES ............................................................................. ix
LIST OF FIGURE ................................ .. ................. . ...................... ... x
CHAPTER 1: INTRODUCTION
1.0 Introduction...................... . ....................... . ..... . ....................... 1
1.1 Background of Study........ . ......................................................... 1
1.1.2 Definition of term.............................................................3
1.2 Theoretical Framework ............................................................... .4
}.3 Problems Statement ............................. .. .....................................6
1.4 Research Objectives ...................................................................7
1.5 Significance of Study.......................... . .......................................7
1.5.1 Significant of Relative Financial Ratios ...............................................8
1.6 Conclusions .............................................................................9
CHAPTER 2: LITERATURE REVIEW
2.0 Introduction...................... . ..................................................... 10
2.1 Financial Ratios and Stock Return .................................................. 10
2.1. 1 Dividend yield (DY) and Stock Return ..................................... 11
2.1. 2 Earnings yield (EY) and Stock Return .................................... 12
2.1. 3 Book-to-Market Ratio (B/M) and Stock return ......................... 13
2.2 Summary of Literature Review .... ... .................................................... 15
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CHAPTER 3: RESEARCH METHODOLOGY
3.1 Introduction.............. .. ............................. ..... .........................24
3.2 Conceptual Fran1ework ....... ...................... . ............ ... ..................... 24
3.3 Research Design ..................................................................... 25
3.3.1 Sampling Design ............................................................. .25
3.3.2 Data Collection ..................... ..... ....................................26
3.3.3 Structures of stock return independent variable ................... .. ......27
3.4 Analysis ofData.......... . ............... ... ................ .. .. .. ............. . .....28
3.5 Fixed Effect Model ......... .. .. ... ........ .. . ... .. .. ...................................... 29
3.6 Predictive regressions ................................................................. 32
3.7 Hypothesis ........................ .. ........... ..... .............................. ....35
CHAPTER 4: FINDINGS
4.0 Introduction.. . ................. .. ................ ... .................................. 36
4.1 Empirical Result. ...... . ......................................... ................................... 36
4.1.1 Descriptive Statistic and Correlation Coefficient.. ............................ .36
4.1.2 Correlations between stock return and key variables .........................37
4.1.3 Predictive Regression ......... ... ................... .......... .................. ..... ........ 38
4.1.4 Fixed-Effects Modef ...........................................................................40
4.1.5 Multiple Regressions ..........................................................................45
4.2 Discussions ......................... .... .................................... ... .........47
4.2.1 Discussion of the Hypothesis and Findings ...............: ................... .47
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CHAPTER 5: CONCLUSION AND RECOMMENDATION
6.0 Introduction........................................................................... 51
6.] Summary................................................................................51
6.2 Conclusion .................................................................................53
6.3 Recommendation............................... . ........................................54
6.4 Limitation of Study................................... . .................................55
REFERENCES
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LIST OF TABLES
Table 1: List of variables...... ...... ............................. .. .........................27
Table 2: The descriptive statistics of the variables .......... .... ..........................34
Table 3: Correlations between stock return and key variables ... ....... ..... ...... .... 35
Table 4: Dividend yield predict stock returns ........................................................36
Table 5: Earning yield predict stock returns ....................... . .....................36
Table 6: Book to market ratio predict stock returns .................................... 37
Table 7: The Simple Predictive Regression Result. ............ . . . ............. ..... ...37
Table 8: White Standard Errors for LSP, DY, MBR and EY ..........................38
Table 9: Standard Errors Clustered by Time .................... . .......................39
Table 10: Standard Errors Clustered by Firm ....................................................39
Table 11: Firm Fixed Effects Model ..... ........................................................... .41
Table 12: Lagram-Multiplier test for serial correlation ....... . .... . ........................ .42
Table 13: The Multiple Predictive Regression Result. ................................... .43
IX
LIST OF FIGURES
Figure 1: Theoretical Framework ... ... . .... . .... .. ... . ...... . . .. ...... .... .... .. .. .... ............ . ..4
Figure 2: Conceptual Framework........ . ...... . ................ ... ............... .. ...... .. ..25
x
CHAPTER!
INTRODUCTION
1.0 Introduction
This chapter gives an overview of the background of the study, the definition
terms, theoretical framework of study, problem statement, research objective,
significant of study, significant of Relative Financial Ratios, limitation of study and
conclusion. The main purpose of this research is to find out whether the financial
ratios such as earning yield, dividend yield and book-to- market ratios can predict the
stock return of trading and services public listed company in Malaysia.
1.1 Background of study
One of the most important sources for companies to raise money is the stock
market. This allows business to go public or raise extra capital for expansion. The
liquidity that an exchange provides allows investors the ability to sell securities
rapidly and easily. This is an attractive feature of investing in stocks compared to
other less liquid investments such as real estate. Hence, central banks tend to keep an
eye on the behaviour and control of the stock market and in general on the smooth
operation of financial system functions.
The stock return in this entry refers to the return on the portfolio of all stocks
that are traded on the equity market in the KLSE. The return is compute- as the price
1
of the stock at the end of the year plus the dividends received during the year divided
by the price at the beginning of the year. A financial ratio is a relationship that
specified about a company's activities such as the ratio between company's current
liabilities and current assets or between its turnover and debtors. The ratios could
help to take those details to recognize the financial strengths and weaknesses of the
company.
Cross-sectional return predictability has been well documented for the U.S.
market and many other equity markets around the world whereby the stock returns
can be predicted by various firm characteristics such as dividend yield, market to
book ratio and earnings yield. It has been long debated for the cause of such
predictability. This study acquire a huge set of return-predictive firm characteristic
variables that are documented and examined in the U.S. market on whether these
variables can predict stock return in the Malaysia market.
According to Kendall, he states that stock prices seem to wander randomly
over time and test whether the past prices can use to predict the future price change
(Chin & }-long, 2008). After that, the studies expand to include others predictive
variables such as financial variables. However, the evidence is mixed. Even thought
there are many empirical researches on the predicting power of financial ratios on
stock return, most of the studies are focused on the developed market like United
States stock market which is similar studies on emerging market like how Malaysia
market are scanted. Kheradyar, Ibrahim & Mat Nor, (2011) pointed that the stock
return predictability contributes to achieve the maximum return with the least risk
2
that will attract international investors who have a critical role in Malaysia's
economic growth. To date, academic researchers in this area are still growing in
Malaysia.
To be predictive of cross sectional stock returns at their predictability on
Malaysian stock return, this study specifically identify three firm specific variables.
The variables that have been uses are earning yield (EY), dividend yield (DY) and
book-to-market ratio (B/M).
1.1.2 Definition of term
Dividend can be defined as the allocation ofa firm's income to its shareholders.
The payments of dividends are made by a company to its shareholders. The money
can be put into two uses when a company earns a profit. It can either be paid to the
shareholders of the company as dividend or can be re-invested in the business as
retain earnings. Dividend is usually settled on a cash basis as a payment from the
company to the customer. Many companies offer a dividend reinvestment plans
which automatically use the cash dividend to purchase additional shares for the
shareholders and they can also take the form of shares in the company.
Many investment managers use the earnings yield to determine optimal asset
allocations. The earning yield shows the percentage of each dollar invested in the
stock that was earned by the company. Besides that, earning yield is not an indicator
3
of the actual return on investment, it is based on the earning per shares and not the
divided received by shareholder.
Book-to-market value or known as price to book ratio is an approach of
measuring the relative value of a company contrast to its stock price or market value.
In addition, it is an essential figure to potential investors and analysts because it
gives a simple method ofjudging whether a company is over or undervalued. A good
investment opportunity means that the business has a low book to market ratio.
1.2 Theoretical Framework
Figure 1: stock return predictability with financial ratios.
Dividend Yield (DY)
Earning Yield Financial ratios Stock return (EY)
Book-to-market ratio (BIM)
(Sources: Kheradyar & Ibrahim, 2011)
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Pusat Khidmat Maklumat Akademik UNlVERSm MALAYSlA SARAWAK
The figure shown above is the theoretical framework of stock return
predictability with fmancial ratios based on three key dimensions in financial ratios.
Most of the researchers such as Kheradyar & Ibrahim (2011), Fama & French (1988),
Lewellen (2000), Chin & Hong (2008) & Kothari & Shanken (1997) applied these
three variables in financial ratios which are dividend yield, earnings yield and book
to market ratios because these variables are the most effective and useful on stock
return predictability in order to cover a wide range ofprediction.
The first key is the dividend yield which is the allocation of a firm's income to
its shareholders. Kheradyar & Ibrahim (2011) found that the predictive power of
dividend yield is greater than earnings yield. This can be supported by Fama &
French (1988), Campbell & Shiller (1988) and Cochrane (1992) that they find
dividend yield is a significant predictor of stock returns. In addition, they also find
that predictability rises as the return horizon rises. The second variable is earnings
yield which is to determine optimal asset allocations. Earning yield can reveal the
efficiency of market that has main role in emerging markets and also as the empirical
predictor of stock return. Third variable is book to market ratios. The consequences
state that security with high ratio between its book value and its market value
constantly obtains the lower return then those with low ratio. Most of the researchers
such as Kheradyar & Ibrahim (2011) use panel data and also fixed effects as well as
generalized least square model (GLS) to predict the predictive regression. They also
reported that when the ratios are combjned in the multiple predictive regressio n
models, the financial ratios are able to improve stock return predictability.
5
1.3 Problems Statement
In this study, one of the problems is that stock returns are unpredictable and
difficult to forecast (Allen & Bujang, 2009). This can be support by Goyal and
Welch (2003), whereby they conclude that most variables would not be able to help
an investor in predicting historical equity premium mean. Most would have outright
hurt. None deserves an unqualified endorsement.
Based on the researches, it is found that stock return in Malaysia is weaker in
predictability. This is because it is found an intriguing contradiction of our empirical
evidence with conventional perception. It is frequently considered that return
predictability is an indication of market inefficiency. The market with higher return
predictability should be at the one with higher degree of market inefficiency in cross
country comparisons. Furthermore, it is unlikely to explain the findings as the
Malaysia market is usually perceived to be much less efficient. This can be approved
by Hijalmarsson (2004) who found that financial ratios are not useful in predicting
the Malaysian stock return.
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1.4 Research Objectives
General Objective
The main objective of the study is to determine whether financial ratios such as
earning yield, dividend yield and book-to- market ratios can predict the stock return
of trading and services public listed company in Malaysia.
Specific Objectives
1. To determine whether earning yield can predict the stock returns in Malaysia.
2. To determine whether dividend yield can predict the stock returns in Malaysia.
3. To determine whether book-to-market ratios can predict the stock returns in
Malaysia.
4. To determine whether the combination of earning yields, dividend yield and
book-to-market ratios can predict the stock returns in Malaysia.
1.5 Significant of Study
In this study, it is important to identify that the reason of investment is to
understand a positive return over a given time period. Through this study, they will
know whether the stock returns in Malaysia can be predicted by financial ratios.
Recently, Malaysia applied some liberalizes in the stock market. It is an attractive
feature of investing in stock contrast to other less liquid investment such as real
7
estate. The price of shares and other assets is a significant part of the dynamic of
economic activity and it can influence or be a gauge of social mood.
It is very important for academic alike and investors for the question of return
predictability. For academic, return predictability has large implications for general
equilibrium models that are able to explain the returns and risks in the fmancial
markets. The presence of return predictability wiU guide to a different optimal asset
allocation rules for the investors. Failing to make portfolios conditional on this
information could lead to huge welfare losses.
1.5.1 Significant of Relative Financial Ratios
That is important to compare a firm's performance relative to
• Its industry or industries
• The aggregate economy
• Its past performance (time-series analysis)
When comparing a firm's financial to industry ratios, investors may not want
to use the average or mean industry value when there is a wide variation among
firms in the industry. The comparison to the aggregate economy is significant
because almost all firms are influenced by the economic fluctuation. Hence, this
study that considers the economic environment helps investors to understand how a
firm reacts to the business cycle and whether they should improve the estimation of
the future performance of the firm during subsequent business cycles. It is possibly
8
the most significant comparison which relates a firm's performance to that of its
industry. Different industries affect the firms within them differently but the
relationship is always significant. Lastly, the past performance or time series analysis
which is to examine a firm's relative performance over time is to fmd out whether it
is progressing or declining and it is helpful when estimating future performance.
1.7 Conclusion
This chapter discusses the introduction, background of the study, definition
of term used in this study, the theoretical framework from previous study, problem
statement, research objectives, significance of study and limitation of the study. This
chapter also describes the past and current issues that are related to this study. The
next chapter will discuss the previous research related to this study and the theory
which is related to the issues of informal learning spaces.
9
CHAPTER 2
LITERA TURE REVIEW
2.0 Introduction
The main purpose of this chapter is to present the related literature review on
stock return predictability with financial ratios and also whether financial ratios on
the stock return can be predicted or not. The chapter starts with a brief literature on
financial ratios and stock return as well as the previous study on the predictability of
stock return. At the end of this chapter, the researcher summarizes the literature
review of the previous study.
2.1 Financial ratios and Stock return
Kheradyar, Ibrahim & Mat Nor (2011) found that financial ratios on the
predictability of stock returns literature contained a specific characteristic because
the ratios have a strong theoretical background based on the predictive models.
There are three financial theories or theoretical basis that supports these financial
ratios. First, when the stock prices are overprice, the ratios shows lower value and
predict low stock returns. This is because each ratio has stock price in the
denominator. Second, the ratios must be positively related to discount rate because
the ratios follow the time variation in discount rates. Finally, the most part of the
ratios movements which are caused by the price changes in the denominator results
in the statistical properties of the ratios to have a big crash on the test of stock return
10
predictability. Therefore, the financial theoretical basis supports the three financial
ratios.
Forty years ago, Fama (1970) observed that the stock return were
unpredictable because of the overall efficiency of the markets. On the other hand,
many research studies documented the predictability of stock return based on various
predictors. Hence, the understanding of predictability is more debatable.
Stock returns are predictable in both cross-sectional and over time. Broadly
speaking, this dissertation investigates whether the empirical patterns in stock returns
are consistent with an efficient capital market. At the aggregate level, the yield
spread between low and high grade debt, aggregate dividend yield, and aggregate
book-to market predict time-variation in expected returns. Furthermore, the
researcher argue that the volatility of stock prices is too high to be explained by a
model with constant discount rates, providing indirect evidence that expected returns
change over time. At the firm level, the size and book-to-market together explain
much of the cross-sectional variation in average returns.
2.1.1 Dividend yield (DY) and Stock return
The dividends are computed as the sum of dividend paid from the companies
in the index during a given year. According to Fama & French (1988), dividend yield
has the predictive power on stock return because they find that dividend yield t
statistic between 2.20 and 3.21 depending on the definition of returns by predicting
11
the monthly NYSE returns from 1941- 1986. The article of Lewellen (2004), studies
whether financial ratios can predict aggregate stock return. He focuses on dividend
yield because it receives the most attention in the literature. To avoid the
complications arising from overlapping returns, he focuses exclusively on short
horizon test using monthly return regressed on lagged dividend yield. The result is
dividend yield predicts both equal and value-weighted NYSE return and typically
significant at the 0.001 level with many t-statistics greater than 3.0 or 4.0.
The empirical study by Ang & Bekaert (2007) reported that dividend yield
predicts only at short horizons along with the short rate and do not have any long
horizon predictive power. The short rate strongly negative predicts returns at a short
horizon.
2.1.2 Earnings yield (EY) and Stock return
According to Graham & Dodd (1934) on the standard process of the era, the
price to earnings ratio is evaluated by stock price for more than seventy years ago.
McWilliam (1996) & Basu (1977) found that the proof of a return advantage to a low
price-to-earnings ratio and point out that stocks have special risk-return
characteristics with negative price to earnings ratios (Fama & French, 1992).
In addition, Block (1999) shows that the price-to-earnings ratio is probably still
the most well known valuation measure today which frequently cited by the media
and used by investors and analysis. Because of the price-to-earnings ratio effects on
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the value strategy of market investor, the difference in the price-to-earnings ratio are
related to the main variables such as expected earning-risk, dividend payout,
expected earnings-growth and dividend per share. The previous study by Tian &
Zheng (2008) recognized that transforming the dividend discount model to the
theoretical calculation model was the main factor that effects the price-to-earnings
ratio. Campbell & Shiller (1988) argued that for the excess stock returns in addition
to the dividend yield, the earnings yield has the independent forecasting power.
Ariff(1998), Choudhury (2003) & Hjalmarsson (2004) reported that predicting
the Malaysian stock return is not useful in financial ratios but Lau (2002) revealed
that earning price ratio was statistically significant and has positive relationship with
stock return in Malaysia.
2.1.3 Book-to-Market Ratio (BIM) and Stock return
Khan (2009) studies the effects of price per earnings ratio and market to book
ratio on stock return. The result shows that coefficient of independent variables are
statistically insignificant. This means that stock return is not depending on any of the
two independent variables. Thus, the coefficients of determination in each case are
very low which insignificant coefficients. Qouted from Fama & French (1992),
"The market to book ratio effects is even stronger than the size effect for a sample of
NYSE, AMEXand NASDAQ stocks during the period 1963-1990".
The DJIA book to market ratio was a better predictor of market returns than earlier
examined variables such as dividend yield and interest rate spreads (Pontiff & Schall,
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