Over the past few decades there has been a considerable interest in financial ratios and their ability to predict stock returns; financial ratios are widely acknowledged as being accurate in determining the investment potential of a company. In addition to this, they allow for insight into liquidity, liabilities as well as the extent to which a company uses its assets to generate returns. A wide range of literature has evolved over the past few decades, which try to determine the ratios which are most helpful in determining the stock returns. Early studies by Gordon (1959), Bower & Bower (1969) and Zahir (1992) found that stock returns were indeed affected by a number of firm specific variables such as earnings, dividends, risk leverage, size, etc. In light of this, the present study will analyze the effect of some of these variables on stock returns by studying the top 20 companies (by market capitalization) listed at the Bombay Stock Exchange (BSE).
Objectives of the study:
One of the most important motivations behind studying financial markets is the returns that are to be gained from stocks. The financial markets comprise of numerous players who respond to stimuli of various kinds. This hyperactivity is what gives the markets their volatility. Nevertheless, researchers, analysts, investors and traders have tried to study stock returns in the light of the macroeconomic variables, balance sheets, financial ratios, etc.
The forces that move a stock fall into three main categories – Fundamental and Technical. Technical analysis assumes that prices discount all the information available in the market and chart patterns suffice to provide information on the prospects of a stock. Popularized by Charles Dow in the late 19th century, it is extensively used tool by day traders across the globe. Fundamental analysis, on the other hand, focuses on firm level balance sheet and ratio analysis as well as macroeconomic analysis to judge the investment potential of a financial asset. Financial ratio, macroeconomic policy variables, conditions prevailing in the global markets fall into this category. The present study aims to determine the relationship between stock returns and key financial ratios that are used in everyday equity analysis. A good amount of literature is available on similar themes, but none of the studies have focused on the Indian stock market with a view to encompass the major sectors of the economy. This includes the coal industry, the power sector, the pharmaceutical sector, banking sector, etc.
In financial markets, there exists some relationship between equity valuation and financial health, which in turn are indicated by financial ratios.
A considerable amount literature and empirical research has been directed at the financial sector, in particular the behaviour of stock markets. in this respect, the past Century has been dominated by research relating to behavioural finance resulting in notable and seminal material published by the likes of Fama and French (1988) and Campbell and Shiller (1988). As a result of the deluge of research relating to the field, a number of distinct thought of schools have emerged, such as those which prescribe to the fact that stock movements and markets can be predicted to those who argue that stock markets are dynamic and complex, the movements of which are unpredictable and risky (Cambell and Ammer 1993, Cambell and shiller 1988, Papanastasopoulos et al., 2011, Rosenberg et al. 1985). stock market movements have fascinated observers and the emergence of behavioural finance as a discipline in its own right is a testament to the former.
Whilst the movement of stock markets are widely investigated and studied by researchers, the subject area holds a considerable interest to investors given that they face the direct risk in speculating on stock markets. So, to this extent, investors have a vested interest in observing the stock market and the increasing volatility associated with stock markets has resulted in investors seeking more reliable and precise ways of better explaining stock returns (Papanastasopoulos et al. 2011, tsoukalas 2005). Shafana et al. (2013) add to this and suggest that financial markets have serve to establish themselves as cornerstone of a number of economies therefore the behaviour stocks and returns has garnered interest from a number of quarters, extending beyond investors such as financial regulators, policy makers and government and stock market regulators in particular (shafana et al., 2013). in light of this, the subsequent section of the literature review will examine the latter phenomenon in greater detail and focus on the use of financial ratios in understanding stock returns.
Financial ratios are widely agreed to be effective in aiding potential investors in determining the financial health of a firm, the extent to which it effectively utilizes its assets as well as its ability to meet any debt obligations. That said however, the use of financial ratios is not confined to the latter as it is acknowledged by a number of authors that financial ratios can also be applied to stock markets as a tool capable of predicting returns (Lewellen 2004). Kheradyar et al. (2011) also note that financial ratios are especially effective in predicting stock returns given that they pose a lower level of risk when compared to other speculative variables and the observation and historical returns and movements (Bower and Bower 1969, Zahir 1992, Shafana et al. 2013).
Subsequent studies have now revealed that financial ratios are effective in predicting returns and this is further corroborated by growing evidences in its favour.(Fama and French 1992, 1995, and 1998; Kothari and Shanken 1997, Pontiff and Schall 1998, Lewellen 1994).. Historically, the Price to Earnings (P/E) ratio and the price to book value of equity (P/B) ratio have been used by investors for equity valuation.
DATA AND METHODOLOGY:
At the onset of the study, it is important to introduce the variables, both dependent and independent. In this study, we aim to study the relationship between stock returns and financial ratios. Stock returns for the top 20 companies listed at the Bombay Stock Exchange (by market capitalization) have been calculated on a YoY basis (from the beginning of the FY 2012 till the FY 2017). Every asset has some value, either intrinsic or derived (as in the case of derivatives). Proper valuation of equities plays an important role in financial markets. Some analysts use discounted cash flow (DCF) models to value shares, while others use financial ratios. Technical analysts on the other hand believe that prices are mostly driven by investor psychology. Literature suggests that despite the randomness that prevails in the financial markets, there exists some relationship between equity valuation and financial health, which in turn are indicated by financial ratios.
Stock Returns: Stock Returns are defined as the gains or losses made on equity holdings over a period of time. This period may vary over minutes, hours, days, months or years. In our case since we have computed stock returns over different accounting years the formula for stock returns becomes: