Accounting Numbers as a Predictor of Stock Returns: A Case Study of NSE Nifty

Simranjeet Sandhar*
In order to survive and grow in the global economy, it is necessary to know the factors affecting the capital market. This study is carried out to see how this phenomenon is taking place in India. It is an attempt to predict investors return through company financial analysis. Company analysis is the last leg in the economy, industry, company analysis sequence, which interprets a companys past and present financial health and predicts its future condition. The study findings indicate that the ratios are not the best predictors to choose a company in a portfolio or for investing in a particular company, as the profitability of the company can be affected by several other factors.

Introduction
Fundamental analysis is essential for market efficiency; it involves two different approaches in the search for mispriced securities. The first approach involves estimating the intrinsic value and comparing the same with the prevailing market price to determine whether the security is underpriced or fairly priced or overpriced. The second approach involves estimating a securitys expected return, given its current price and intrinsic value and then comparing it with the appropriate return of securities with similar characteristics. Company analysis is the last leg in the economy, industry, company analysis sequence. It can be categorized into two parts: (a) a study of financials, and (b) a study of other factors. In company analysis, investors assimilate several bits of information related to the company and evaluate the present and future values of the stock. Risk and return are associated with the purchase of stock in order to take better investment decisions. The present and future values of a company are affected by a number of factors. They are:

The Competitive Edge of the Company

Large companies are successful in meeting the competition. Once the companies obtain the leadership position in the market they seldom lose it. Over the time, they would have proved their ability to withstand the competition and have a sizeable share in the market. The competitiveness of a company can be gauged with the help of its market share, growth of sales and stability of sales.
* Senior Lecturer, Amity Global Business School, 601, Metro Towers, Vijay Nagar, Indore 452010, India. E-mail: sandhar_simranjeet@yahoo.co.in

2010 IUP. All Rights a Predictor Accounting Numbers as Reserved. of Stock Returns: A Case Study of NSE Nifty

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Earnings of the Company

Sales alone do not increase the earnings; costs and expenses of the company also influence the earnings of the company. Further, earnings do not always increase with sales. The companys sales might have increased, but its earnings per share may decline due to the rise in costs. Even though there is a relationship between sales and earnings, it is not a perfect one. Sometimes, the volume of sales may decline, but the earnings may improve due to the rise in the unit price of the article. Hence, investors should not depend only on the sales, but should also analyze the earnings of the company. Investors should be aware that income of the company may vary due to various factors such as changes in sales, changes in costs, depreciation method adopted, depletion of resources in the case of oil, mining, forest products, gas etc., inventory accounting method, replacement cost of inventories, wages, salaries and fringe benefits, income taxes and other taxes.

Capital Structure
The equity holders return can be increased manifold with the help of financial leverage, i.e., using debt financing along with equity financing. The effect of financial leverage is measured by computing leverage ratios. The debt ratio indicates the position of the long-term and short-term debt in the company finance. The debt may be in the form of debentures and term loans from the financial institutions.

Management
Good and capable management generates profit to the investors. The management of the firm should efficiently plan, organize, actuate and control the activities of the company. The basic objective of the management is to attain the stated objectives of the company and safeguard the interests of the equity holders, the public and the employees. If the objectives of the company are achieved, investors will have a profit. A management that ignores profits does more harm to the investors than the one that over emphasizes it.

Operating Efficiency
The operating efficiency of a company directly affects its earnings. An expanding company that maintains high operating efficiency with a low break-even point earns more than the company with high break-even point. If a firm has a stable operating ratio, the revenues also would be stable. Efficient use of fixed assets with raw materials, labor and management would lead to more income from sales. This leads to internal fund generation for the expansion of the firm. A growing company should have a low operating ratio to meet the growing demand for its product.

Financial Analysis
The best source of financial information about a company is its own financial statement. This is a primary source of information for evaluating the investment prospects in a particular company stock. Financial statement analysis is the study of a companys financial statement from various viewpoints. The statement gives the historical as well as current information
34 The IUP Journal of Accounting Research & Audit Practices, Vol. IX, Nos. 1 & 2, 2010

about the companys operations. Historical financial statements help in predicting the future. The current information aids to analyze the present status of the company. The two main statements used in the analysis are: (1) balance sheet, and (2) profit and loss account. Investors can use various simple analysis such as comparative financial statements, trend analysis, common size statements, funds flow analysis, cash flow analysis, and ratio analysis.

Study of Financials
Going Beyond the Numbers
Analysis of financial statistics must be supplemented with an appraisal, mostly of a qualitative nature, of the companys present situation as well as its prospects and the quality of its management.

Estimate the Expected Earnings Per Share (EPS)

Based on how the company has done in the past, how it is faring at present, and how it is likely to do in future, investment analysts estimate the future (expected) EPS. An estimate of EPS is an educated guess about the future profitability of the company.

Establish a Price Earnings (PE) Ratio

The other part of the valuation exercise concerns the Price Earnings (PE) ratio which reflects the price investors are willing to pay per rupee of EPS. In essence, it represents the markets summary evaluation of a companys prospects.

Management in Company Analysis

Before one can complete company analysis and make a final decision or an investment action, one needs to determine whether the management is capable of carrying out its policies so that its expectations are fulfilled. Management should have clear-cut goals and suitable strategies for achieving them. Obviously, among the key end points that measure the managements success will be EPS, dividends, and the share price. In order to assess the likelihood of a management achieving its desired end point of the analysis, an analyst can take a number of steps. First, the analyst can look at the past performance of the management to see if his past expectations and managements past hopes have been fulfilled. Second, through interviews with the management he can obtain information pertaining to their background, experience, motivations; and their outlook on aspects such as the firms future research and development expenditures, plans for product improvement, marketing strategy, future competition, sales and profits. During the course of these interviews and based on the first-hand observations of the firm in operation, the analyst must take note of the managements ability to plan, organize, select, motivate, and control personnel.

Literature Review
Starting with Ball and Brown (1969), a large body of accounting literature explores the relation between accounting information and stock returns. The general conclusion emerging from
Accounting Numbers as a Predictor of Stock Returns: A Case Study of NSE Nifty 35

research in this area is that accounting information explains a surprisingly low proportion of the variation in stock returns. In summarizing early evidence, Lev (1989) finds that earnings can explain not more than 10% of the variation in stock returns and concludes that earnings are of limited usefulness to investors. More recently, Liu and Thomas (2000) extend the early research to incorporate changes in expectations of future abnormal earnings and are able to explain upto 30% of the variation in stock returns. Yet, a major portion of the variation in stock returns remains unexplained by fundamental variables such as cash flows and earnings. This study investigates the ability of Mertons (1987) model of capital market equilibrium under incomplete information to explain the remaining variation in stock returns. Merton shows that, holding fundamentals constant, firm value increases with the degree of investor recognition of the firm. The key behavioral assumption invoked by Mertons (1987) model is that investors only use securities that they know about when constructing their optimal portfolios. Arbel et al. (1983) find evidence of the predicted negative relation. However, Chen et al. (2002) provide contradictory evidence of a positive relation between changes in investor recognition and future returns. Investor recognition may help explain a number of anomalies in stock returns. Prior research shows that corporate financing and investing activities are negatively related to future stock returns (Ritter, 2003; and Titman et al., 2004) and that short-horizon stock returns exhibit positive momentum (Jegadeesh and Titman, 1993). Bennett and Sias (2006) explore the hypothesis that three factors are primarily responsible for the observed changes in a company-specific risk: changes in the market weights of riskier industries, changes in the relative role of small-capitalization stocks in the market, and measurement error associated with changes in within-industry concentration. Empirical tests revealed that each factor contributes to the changes in company-specific risk over time and that these three factors combined largely explain changes in company-specific risk over the past 40 years. Lamont (1998) observes that the aggregate dividend payout ratio forecasts aggregate excess returns on both stocks and corporate bonds in the post-war US data. Both high corporate profits and high stock prices forecast low excess returns on equities. When the payout ratio is high, the expected returns are high. The payout ratios correlation with business conditions gives it predictive power for returns; it contains information about the future stock and bond returns that was not captured by other variables. The payout ratio is useful because it captures the temporary components of earnings. The dynamic relationship between dividends, earnings and stock prices shows that a positive innovation in earnings lowers the expected returns in the near future, but raises them thereafter. Romagnoli (2007) assesses whether the monthly returns of the listed shares of the Italian banks are predicted by changes in balance sheet indicators. The sample covers the period from January 1997 to June 2003. Estimates use both unadjusted and risk-adjusted returns. Results show that the stock returns of Italian banks are positively related to past profitability, liquidity, and asset quality, while they are not significantly affected by banks capital ratios. Furthermore, in the sample period, an increase in the traditional lending activity leads to higher stock returns.
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Martikainen (1989) aims at finding out which economic dimensions of the firm are reflected in stock price behavior in the Finnish stock market. Based on the previous studies, four economic dimensions are chosenprofitability, financial leverage, operating leverage, and corporate growth. Twelve financial ratios are then selected to represent these four dimensions. All Finnish listed firms for the entire study period, 1974-1986, are included in the empirical analysis. All the four expected dimensions mentioned above were found in the empirical classification pattern of ratios. On the cross-sectional level, profitability and financial leverage are found to be the determinants of stock price behavior. Corporation growth is merely connected to the risk of the common stock. Somewhat weaker results concerning the association between stock price behavior and operating leverage factor may be due to difficulties in measuring operating leverage on an empirical level. When studying the intra-year explanatory power of the financial ratios, it was reported that the explanatory power of financial ratios tends to increase when the reporting day approaches, and starts to decrease after the releasing day of financial statement numbers. Empirical evidence strongly indicates that financial ratios represent pricing relationships in a substantive manner. According to Helwege et al. (1995), record low dividend yields and record high marketto-book ratios in the recent months have led many market watchers to conclude that these indicators now suggest differently from what they have been in the past. Their study examined the relationship between the traditional market indicators and stock market performance, and then addressed two popular claims that the meaning of these indicators has changed in recent years. The first is that dividend yields are permanently lower now than in the past, because firms have increased their use of share repurchases as a tax-advantaged substitute for dividends. The second claim is that the implementation of Financial Accounting Standard (FAS) 106 for retiree health liabilities has seriously depressed the reported book values of many companies since the early 1990s, artificially raising their market-to-book ratios. Their study concluded that, even after adjusting for these factors, the current level of market indicators is a cause for concern. Agudo and Marzal (2004) concentrate on the financial analysis of investment performance taking Sharpes ratio as a basic point of reference, as well as giving further consideration to the use of this performance measure as an approximation to a utility index. They also propose certain changes to Sharpes ratio which would, on the one hand, avoid the appearance of inconsistent assessments and, on the other, provide an approach to the use of Sharpes performance measure as a utility index. All of the measures discussed in the study are applied to a sample of Spanish investment funds.

Objectives of the Study

The main objective of this study is to provide investors with information and the factors that have to be considered while investing their hard-earned money. The basic objective is to study the linkages between financial strength of individual companies and stock market returns. The following hypotheses were formulated to analyze the significant impact of the financial
Accounting Numbers as a Predictor of Stock Returns: A Case Study of NSE Nifty 37

ratios on stock returns. To identify the financial strengths, different ratios such as profitability, liquidity, leverage and valuation ratios were used. H01: There is no significant impact of book value ratio on stock returns. H02: There is no significant impact of current ratio on stock returns. H03: There is no significant impact of dividend per share ratio on stock returns. H04: There is no significant impact of dividend payout ratio on stock returns. H05: There is no significant impact of adjusted EPS ratio on stock returns. H06: There is no significant impact of total debt equity ratio on stock returns. H07: There is no significant impact of gross profit margin ratio on stock returns. H08: There is no significant impact of long term debt equity ratio on stock returns. H09: There is no significant impact of net profit margin ratio on stock returns. H010: There is no significant impact of quick ratio on stock returns.

Methodology
Rather than using large samples and following a rigid protocol to examine a limited number of variables, case study methods involve an in-depth, longitudinal examination of a single instance or event: a case. They provide a systematic way of looking at events, collecting data, analyzing information, and reporting the results. As a result, the researcher may gain a sharpened understanding of why the instance happened as it did, and what might become important to look at more extensively in future research. Case studies lend themselves to both generating and testing hypotheses (Flyvbjerg, 2006). This research is a case study of NSE where Nifty was selected for the purpose of analysis. The performance of Nifty was analyzed keeping company analysis perspective in view. Data was collected from secondary sources, i.e., the stock prices were collected from the site of nseindia.com, and the financial statements were collected from the sites of the respective companies. The study period taken was from January 1, 2001 to December 31, 2007. Data was analyzed using ratio analysis, which was used to evaluate a companys performance such as liquidity ratio, leverage ratio, profitability ratio, and valuation ratio. Regression analysis was applied to study the effect of ratios on stock market returns.

Results and Discussion

It can be seen that almost all the ratios (Table 1) during the entire study period have insignificant relationship with the index returns, i.e., there is no significant impact of the ratios on stock returns.
38 The IUP Journal of Accounting Research & Audit Practices, Vol. IX, Nos. 1 & 2, 2010

Table 1: Yearly Regression Statistics

Variables (2002) Book value ratio and stock returns Current ratio and stock returns Dividend per share ratio and stock returns Dividend pay out ratio and stock returns Adjusted EPS ratio and stock returns Total debt equity ratio and stock returns Gross profit margin ratio and stock returns Long-term debt equity ratio and stock returns Net profit margin ratio and stock returns Quick ratio and stock market returns Variables (2003) Book value ratio and stock returns Current ratio and stock returns Dividend per share ratio and stock returns Dividend pay out ratio and stock returns Adjusted EPS ratio and stock returns Total debt equity ratio and stock returns Gross profit margin ratio and stock returns Long-term debt equity ratio and stock returns Net profit margin ratio and stock returns Quick ratio and stock market returns Variables (2004) Book value ratio and stock returns Current ratio and stock returns Dividend per share ratio and stock returns Dividend pay out ratio and stock returns Adjusted EPS ratio and stock returns Total debt equity ratio and stock returns Gross profit margin ratio and stock returns Long-term debt equity ratio and stock returns Net profit margin ratio and stock returns Quick ratio and stock market returns 0.308 0.092 0.555 0.025 0.052 0.221 0.003 0.026 0.038 0.197 0.010 0.159 0.227 1.186 2.076 58.3 87.5 82.2 24.4 95.5 34.7 10 44.7 88.9 47.4 Insignificant Insignificant Insignificant Insignificant Insignificant Insignificant Insignificant Insignificant Insignificant Insignificant 0.204 0.077 0.471 65.5 77.7 49.6 3.0 76.7 29.8 78.3 41.9 68.3 47.2 Insignificant Insignificant Insignificant Significant Insignificant Insignificant Insignificant Insignificant Insignificant Insignificant FValue 0.221 0.014 0.354 0.713 Beta tValue Value 0.090 0.023 0.121 0.160 0.470 0.117 0.595 0.844 Level of Significant/ Sig. (%) Insignificant 64.2 90.7 55.7 40.6 62.7 21.1 61.2 28 74.3 38.5 Insignificant Insignificant Insignificant Insignificant Insignificant Insignificant Insignificant Insignificant Insignificant Insignificant

0.241 0.096 0.491 1.655 0.259 1.286 1,263 0.97 0.513 1.190 0.222 1.091 0.109 0.062 0.331 0.779 0.167 0.883

0.081 0.048 0.285 0.474 0.123 0.470 0.221 0.476 3.160

0.089 0.052 0.299 1.124 0.193 1.060 0.077 0.047 0.451 0.671 0.146 0.819 0.170 0.070 0.412 0.529 0.122 0.727

0.912 0.172 0.955 2.844 0.271 1.686

1,912 0.172 0.955 0.020 0.023 0.140 1,524 0.120 0.724

Accounting Numbers as a Predictor of Stock Returns: A Case Study of NSE Nifty

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Table 1 (Cont.)
Variables (2005) Book value ratio and stock returns Current ratio and stock returns Dividend per share ratio and stock returns Dividend pay out ratio and stock returns Adjusted EPS ratio and stock returns Total debt equity ratio and stock returns Gross profit margin ratio and stock returns Long-term debt equity ratio and stock returns Net profit margin ratio and stock returns Quick ratio and stock market returns Variables (2006) Book value ratio and stock returns Current ratio and stock returns Dividend per share ratio and stock returns Dividend pay out ratio and stock returns Adjusted EPS ratio and stock returns Total debt equity ratio and stock returns Gross profit margin ratio and stock returns Long-term debt equity ratio and stock returns Net profit margin ratio and stock returns Quick ratio and stock market returns Variables (2007) Book value ratio and stock returns Current ratio and stock returns Dividend per share ratio and stock returns Dividend pay out ratio and stock returns Adjusted EPS ratio and stock returns Total debt equity ratio and stock returns Gross profit margin ratio and stock returns Long-term debt equity ratio and stock returns Net profit margin ratio and stock returns Quick ratio and stock market returns 0.221 0.003 0.916 1.109 0.197 0.010 0.090 0.166 1.186 2.076 0.957 1.686 24.4 95.5 34.6 29.9 34.6 55.9 11 40.6 95.5 34.7 Insignificant Insignificant Insignificant Insignificant Insignificant Insignificant Insignificant Insignificant Insignificant Insignificant 0.347 0.098 0.589 55.9 95.5 2.0 6.0 1.1 34.6 47.6 34.6 79.3 35.9 Insignificant Insignificant Significant Insignificant Significant Insignificant Insignificant Insignificant Insignificant Insignificant FValue Beta Value tValue Level of Significant/ Sig. (%) Insignificant 86.2 23.2 0.2 11.0 7.1 65.5 29.9 55.5 22.0 7.3 Insignificant Insignificant Significant Insignificant Insignificant Insignificant Insignificant Insignificant Insignificant Insignificant

0.030 0.028 0.173 1.474 0.191 1.214 10.557 0.457 0.221 3.44 0.254 0.285 3.249 0.470 1.855

2.122 0.249 1.457 1.109 0.166 1.686

2.122 0.249 0.470 1.556 0.196 1.247

3.402 0.283 1.844

0.003 0.010 0.057 9.514 3.658 7.170 0.457 0.296 0.412 3.084 1.913 2.678

0.916 0.169 0.957 0.518 0.119 0.720

0.916 0.169 0.957 0.070 1.609 0.264

0.864 0.153 0.930

0.916 0.169 0.957 0.347 0.221 0.713 0.003 0.098 0.254 0.160 0.010 0.589 0.470 0.844 2.076

0.912 0.172 0.955

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The IUP Journal of Accounting Research & Audit Practices, Vol. IX, Nos. 1 & 2, 2010

Implications and Suggestions

There may be situations where an industry appears to be very attractive, but a few companies within it might not be doing all that well; similarly, there may be one or two companies that may be doing exceedingly well, while the rest of the companies in the industry might be facing difficulties. An investor will have to consider both the financial and nonfinancial factors so as to form an overall impression about a company. Investors should analyze the following factors while making an investment decision:

Market leaders who dominate their product segment; Company that registers consistent growing earnings; and Revenue growth that exceeds the industry average.
For a complete analysis and interpretation of industry performance, both quantitative and qualitative analyses should be carried out at the state as well as national level. To better examine the industrial performance, the stages of product life cycle that the industry is expected to go through can also be analyzed. A detailed study can be done regarding employment data analysis, input-output analysis and earnings data analysis. Internal and external strengths and weakness of an industry can also be evaluated. A detailed study can be done on comparative analysis of the competition within a sector that will help in identifying those companies that have an edge and those most likely to keep it. Several other factors, such as nature of the product, nature of the competition, government policies, availability of labor, research and development can also be considered while analyzing the industry performance

Conclusion
Investing in various types of asset classes is an interesting activity that attracts people from all walks of life, irrespective of their occupation, economic status, education and family background. Investors always wish to invest in a combination of stocks that yield the highest value and have the lowest risk. Keeping this objective in mind, this study was developed. Its basic aim was to facilitate the investors with the factors which they consider while making an investment in a companywhether those factors really benefit them or whether there are certain other factors which they should consider while choosing the profitable companies to be invested in the long run. Company analysis is a way of expressing relationships between a firms accounting numbers and their trends over time that analysts use to establish values and evaluate risks. This is a type of benchmarking based on which one can measure the performance of an organization. The study results indicate that ratios are not the best predictors of a good company that can be included in a portfolio or for investing in a particular company, as all the important ratios which are analyzed in the study do not have any significant impact on the actual returns of the companies. However, the study also reveals that ratios, such as dividend per share, dividend payout, EPS, and gross profit margin, can give some direction to the investors in forming the portfolios which could yield better returns to them, as these ratios have somewhat more significant relationship with the actual returns. On the whole, companies such as ONGC, National Aluminum, Bharti Airtel, Infosys, SBI, HCL,
Accounting Numbers as a Predictor of Stock Returns: A Case Study of NSE Nifty 41

etc. are some of the companies which appear to be more attractive for the investors in many ways as their profitability ratios are comparatively higher than those of the other companies. Ratios are simple measures that can be effectively used for comparisons. These tools allow vital comparisons that are not possible when dealing with a single number. The insights gained through the ratio analysis will assist in gaining vital understanding. Limitations of the Study: This study is stock price dependent. Therefore, with the passage of time, the stock prices will change which will automatically change the results of the study. The study has only considered the secondary data. The research part of the study has only considered stock price fluctuations taking all the other things as constant. Q

References
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14. Ritter J R (2003), Investment Banking and Securities Issuance, in Constantinides G, Harris M and Stulz R (Eds.), Handbook of Economics and Finance, pp. 255-306, North-Holland, Amsterdam. 15. Romagnoli Angela (2007), Balance-Sheet Ratios and Stock Returns: An Analysis for Italian Banks, Bank of Italy Temi di Discussione, Working Paper No. 648, available at http://ssrn.com/abstract=1075242 16. Titman S, Wei K and Xie F (2004), Capital Investment and Stock Returns, Journal of Financial and Quantitative Analysis, Vol. 39, No. 4, pp. 210-240.

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