© All Rights Reserved

0 views

© All Rights Reserved

- Study Guide Chapter 1 %28EC220%29
- Ch10tif(Determining How Cost Behave)
- learner autonomy and vocabulary learning strategies
- Presentation-customer attitude towards the male grooming product in india
- 766900WP0P12200ty0Map0Apr4020130ENG
- Licensed under Creative Common Page 732 http://ijecm.co.uk/ ISSN 2348 0386
- Financial Management Capacities and Financial Sustainability of Community Based Organizations in Turkana County Kenya
- N36-5
- Linear Regression Example Data
- Assignment 2
- [Paper]Intellectual Capital Performance in the Case of Romanian Public Companies
- Practice Midterm2 Fall2011
- Bcg Comp Chapter4
- Consumer Behaviour in Purchase of Cars in India
- free to threes
- 14987124232
- Chapter 6
- armah2017
- Copy of Regression With Variable Explanations
- Coeeficient of Determination

You are on page 1of 9

by Isabelle Martinez, ESUG - University of Toulouse I

Abstract

This research aims at assessing the usefulness of fundamental and macroeconomic information

to the French market.Arelationship between abnormal returns and fundamentals is

analyzed between 1992 and 1997. The empirical findings show that the strength of the

returns-fundamentals association increases when two macroeconomic variables are added

to the explanatory model. The pooled regression R2 varies from 14 to 29% depending upon

whether the abnormal returns are regressed on the fundamentals only or on the fundamentals

and the two macroeconomic variables. The pooled regression R2 is also strongly affected.

This coefficient varies from 14 to29%depending upon whether the stock returns are

regressed on the three factors only or on the three factors and the twomacroeconomic variables.

These results clearly show that financial statements and macroeconomic data provide

informations to value security prices.

1. Introduction

Several functions are commonly assigned to accounting. One of them is the publication of

useful information to enable investors to value securities. Since the seminal work of Ball

and Brown (1968) and Beaver (1968), a large body of financial research has been devoted

to the usefulness of accounting earnings. The market valuation approach is commonly used

to study the association between earnings and stock prices. As outlined by Lev (1989), Cho

and Jung (1991), Dumontier and Labelle (1994) or Martinez (1994), the findings suggest

that market returns are explained in part by accounting earnings. This is why recent research

emphasizes the role of other financial statement information such as inventory or

capital structure (Ou and Penman, 1989; Holthausen and Larcker; 1992, Lev and Thiagarajan,

1993; Riahi-Belkaoui, 1997).

The purpose of our research is to assess to what extent accounting data published by

French firms are useful in security valuation.Weidentify a set of financial variables

(fundamentals)

claimed to be used by investors to evaluate the security prices. Our findings suggest

that the fundamentals are value-relevant to explain stock returns.Wealso show that the

explanation of returns is considerably strengthened when two macroeconomic variables

(the annual change in the Consumers’ Price of Index and the annual change in real Gross

National Product (GNP) are added to the explanatory model.

The next section examines the literature concerning the usefulness of accounting data.

Sections three and four describe the methodology used and the research findings, respectively.

The last section is devoted to concluding remarks.

Research studies can be classified into two groups: the return - earnings research and the

return-fundamentals research.

The return-earnings research aims at assessing the usefulness of accounting earnings

to investors.Arelation is measured between a stock price variation for a given period and an

accounting variable representing earnings generated by the firm during the same period.

The regression is estimated cross-sectionally as follows:

Ri = 1 + iVi +

i (1)

Ri, Vi and i stand for the stock return of firm i, the variable representing earnings generated

by firm i and the regression noise, respectively.

The R-square coefficient measures the degree to which the stock returns are explained

by the accounting earnings. The coefficient i is defined as the effect of one US dollar (or

one French franc) of earnings on stock returns and is typically called the earnings response

coefficient (ERC). Several metrics are commonly used to compute the stock returns1, e.g.

the stock price change during the period, the period’s raw return and the period’s abnormal

return. Three accounting variable measures are also commonly used, namely the earnings

deflated by the beginnings of the period stock price, the unexpected earnings deflated by the

beginning of the period stock price and the unexpected earnings deflated by previous earnings.

Table 1 summarizes various characteristics and findings of a sample of return earnings

studies. The R2 coefficients obtained by regressing stock returns on accounting

earnings are low. They do not exceed 10% except for the French study (Dumontier and Labelle,

1994). There are several drawbacks with previous studies mentioned in table 1:

- Firstly, they link annual earnings to contemporaneous stock returns and use one-year period

data. However, the choice of this particular time period may not be optimal to test the

association between returns and earnings. Some people believe that there is probably a lag

between the period in which value-relevant events occur and the period in which these

events are integrated into earnings (Dumontier and Labelle, 1994). Lev (1989), Warfield

and Wild (1992), Easton, Harris and Ohlson (1992) or Dumontier and Labelle (1994)

recommend

increasing the interval over which the return-earnings relation is examined. Their

results show that the R2 coefficients increase with the interval length. For instance, the R2

coefficient in the Lev’s model is3%for a one-year interval and35%for a five-year interval.

- Secondly, these studies are based upon the pooled data of many firms under the assumption

that the return-earnings relation is homogeneous across firms (i.e. investors react identically

to earnings of all firms). A new line of research introduces also firm characteristics

such as firm size (Atiase, 1985) or stock exchange market (Grant, 1980).

- Thirdly, in these researches, earnings are believed to be the main information item provided

in financial statements. However, the low R2 coefficients obtained by regressing

stock returns on accounting earnings suggest that other financial variables, named fundamentals,

may provide more useful information to investors than the earnings data.

The association between stock returns and fundamentals was first examined by Ou

and Penman (1989). These authors used a statistical search procedure in the determination

of relevant fundamentals. They examined the ability of accounting information to generate

profitable trading strategies by developing amodel to predict the sign of unexpected annual

earnings-per-share (a logit model). The Ou and Penman’s (1989) study was expanded by

Holthausen and Larcker (1992). Later, Lev and Thiagarajan (1993) used a guided search

procedure in the determination of candidate fundamentals. This procedure is based on the

analysts’ claim of the usefulness of financial ratios in security valuation. The authors identified

a set of 12 fundamentals claimed by analysts to be useful, and examined these claims by

estimating the incremental value-relevance of these fundamentals over earnings. Two

cross-sectional regressions were compared. The first is the conventional return-earnings

regression

given by Eq. 1. The second includes the fundamentals as follows:

(2)

where Ri and Sij are the return of firm i and the fundamental j of firm i, respectively.

This regression model assumes that the fundamentals are uncorrelated but this may

not always be the case. The results of Lev and Thiagarajan (1993) show an improvement in

R2. For the 1980s, the 12 selected fundamentals add on average approximately 70% to the

explanatory power of earnings with respect to excess returns. They also show that the

return-fundamentals relation is strengthened when it is conditioned on macroeconomic

variables. Recently, Riahi-Belkaoui (1997) used a similar methodology to examine the role

of fundamentals in stock valuation. The author identified a set of 11 fundamentals and estimated

the regression models with Eqs. 1 and 2 for each of the years from 1973 to 1991. The

results show an improvement in R2 for each year indicating that the fundamentals contributed

significantly to the explanation of stock returns beyond accounting earnings. Similarly

to Lev and Thiagarajan (1993), Riahi-Belkaoui (1997) extended the analysis to evaluate the

impact of changes in inflation and GNP growth and showed that the significance of fundamentals

is conditioned by macroeconomic variables.

The aim of our study is to extend the work of Lev and Thiagarajan (1993) and Riahi-

Belkaoui (1997) to the French market, by using principal components analysis (PCA) on

the original set of fundamentals. This strategy will allow the determination of a small

number of uncorrelated factors to be included in the regression model, unlike previous studies

which assume a priori uncorrelated fundamentals.

3. Methodology

Following the procedure of Lev and Thiagarajan (1993) and Riahi-Belkaoui (1997), we

identified a set of candidate fundamentals used by analysts to evaluate firms’ performance

and estimate future earnings. These signals are the different financial ratios summarized in

appendix 1: profitability, growth, activity and financial structure ratios.

To compute profitability ratios, we used two different approaches. The « accounting

approach » is based on the book value of assets and the «monetary approach » ignores

accumulated

depreciation and amortization. The later enables the correction of accounting data.

Indeed, it is frequent for managers to manipulate accounting data by means of depreciation

and amortization, with the unique aim of improving or lowering accounting earnings. Al-though

we hypothesized that the monetary approach is more relevant than the accounting

approach to value securities, we used the two approaches to test this hypothesis.

Moreover, we split each profitability ratio (return on invested capital, return on assets

and return on equity) into two parts: the margin and the turnover ratios. Because the product

of several variables lose information according to this principle, we hypothesized that the

margin and turnover ratios provide more information than the profitability ratios. Finally,

we selected a set of 28 fundamentals claimed by analysts to be useful to value securities.

To examine empirically the usefulness of our candidate fundamentals, we proceeded

to two steps. In the first, we usedPCAto study the set of fundamentals. In the second, we

assessed

the usefulness of accounting and macroeconomic information.

The goal of the PCA is to represent the relationships among the 28 retained fundamentals

parsimoniously. That is, we aimed at obtaining a relatively small number of uncorrelated

factors useful in characterizing the set of candidate fundamentals.

In PCA, factors are estimated as linear combinations of the observed variables (fundamentals):

F a X j jk k

k

(3)

where ajk is the score coefficient for the factor Fj and the observed variable Xk.

Then, two regressions were estimated. In the first, stock returns are regressed on the

factors previously obtained with Eq. 3. This regression model is estimated cross-sectionally

as follows:

R F i j ij i

j

0 (4)

Ri is the annual stock return of firm i computed as the annual average of weekly raw returns.

The errors are assumed to be normally distributed, independent, random variables with zero

mean and standard deviation.

The second regression includes two macroeconomic variables: the annual change in

the Consumers’ Price Index (an inflation indicator) and the annual change in real GNP (a

state-of-the-economy variable). That is based on the results of Lev and Thaigarajan (1993)

and Riahi-Belkaoui (1997) which showed that the association between stock prices and

accounting

information is strengthened when it is conditioned on macroeconomic variables.

The second regression model is estimated as follows:

R F INFL GNP i j ij i

j

0 (5)

where INFL and GNP are the annual change in the Consumers’ Price Index and the annual

change in real GNP, respectively.

4. Results

The sample firms were selected for the period 1992-1996 according to the availability of

consolidated accounting data on the Dafsapro database and the availability of weekly security

prices on the Datastream File. Financial firms were not included in our analysis because

accounting standards are not the same than for non-financial firms. Finally, our

sample set contained 50 industrial firms summarized in appendix 2.

In the first step, we used PCA to study the fundamentals. Regardless of the Scree Test

rule, the first three principal factors were retained to represent the set of 28 original variables.

Table 2 contains the initial statistics for each factor. The three factors account for

60% of the total variance. The proportion of the total variance explained by each factor is

30.2%, 21.9% and7%respectively. To judge how well the three-factor model describes the

original variables, we computed the proportion of variance (called the communality) of

each variable explained by the factor model. The communalities for the variables are shown

in Table 3. A majority of accounting variables is correctly represented by the three-factor

model (communalities > 0.5).

Table 4 contains the coefficients (called factor loadings) used to express a variable in

terms of the factors. These coefficients indicate how much weight is assigned to each factor.

To identify the first three factors, variables that have large loadings for the same factor are

pooled together while variables that have small factor loadings (< 0.5 in absolute value) are

omitted. Thus, factor 1 is the factor with the largest loading (in absolute value) for the margin

and turnover ratios given by the decomposition of the profitability ratios (return on invested

capital, return on assets and return on equity) and for the equity and the total assets

turnovers. Factor 2 is composed by the return on invested capital, the return on assets, the

return on equity and the leverage ratio. Finally, factor 3 is the factor with the largest loading

(in absolute value) for the rate of working capital requirements and the financial balance ratio.

After the PCA, conclusions are three-fold:

- Firstly, the most important variables for our study are the ratios which constitute the three

principal factors, namely the profitability ratios (the return on invested capital, the return on

assets and the return on equity and their decomposition into margin and turnover ratios), the

leverage ratio, the rate of working capital requirements and the financial balance ratio.

- Secondly, the monetary approach seems to be more relevant than the accounting approach.

The factor loadings are indeed slightly higher when the profitability ratios are computed

using the monetary approach. For example, the factor-one loadings are for the return

on assets of 0.90 and 0.88 depending upon whether the monetary approach or the accounting

approach is used.

- Thirdly, the margin and turnover ratios reflected by factor 1 appears to be more relevant

than the profitability ratios reflected by factor 2. Indeed, the first factor explains about 30%

of the total variance against 21% for the second factor. This result can be related to several

studies such as Hopwood and McKeown (1985), Bublitz and Ettredge (1989), Swaminathan

and Weintrop (1991) which show that the variables used to compute earnings (taxes,

operating charges and products,...) provide supplementary information beyond earnings.

In the second step, we tested the relationship between stock returns and the three principal

factors obtained previously. The regression model given by Eq. 4 was estimated for

each of the years from 1992 to 1996 and across all years. Table 5 contains the regression results.

For every year (except 1994), the adjusted R2 is statistically significant (0.05 level)

and varies from8%to 35%. Factor 2 contributes significantly to the explanation of stock return

variance (the regression coefficients are positive and statistically significant at 0.05

level, except for 1994). This result indicates that the fundamentals (return on invested capital,

return on assets, return on equity and leverage ratio) represented by factor 2 are the most

informative for explaining stock prices.

The regression model given by Eq. 5 combines the three principal factors and the two

macroeconomic variables, GNP and INFL. Across-years coefficient estimates and R2 are

reported in Table 6. The R2 is strongly affected by adding the macroeconomic variables. It

is two times higher than the R2 obtained when the three factors appear alone in the pooled

regression on stock returns. Factor 2 that was statistically significant in Eq. 4 is also significant

in Eq. 5 and the two macroeconomic variables provide additional information to explain

the return variability. For the inflation indicator and the state-of-the-economy

variable, the coefficient estimates are statistically significant at 0.05 level. These coefficients

are negative and positive, respectively. This was expected because the security market

appears to decrease in case of inflation and to rise in case of economical growth.

5. Concluding remarks

This paper aimed at assessing the usefulness of financial statement information to the

French market. The identification of value-relevant fundamentals was guided by analysts’

descriptions. Our study differs from previous works because the association is not directly

tested between stock returns and fundamentals. The fundamentals identified as valuerelevant

were processed by a principal components analysis. This allows us to determine a

small number of uncorrelated factors to be included in the regression on stock returns. This

way, the analysis was not affected by multicollinearities in the data. The empirical findings

showed that the relationship between returns and the first three factors (used to represent the

fundamentals claimed by analysts to be useful) is statistically significant for each of the

years from 1992 to 1996. The adjusted R2 varies from 8% to 35%. According to the tstatistics,

the factor with the largest loading (in absolute value) for the return on invested

capital, the return on assets, the return on equity and the leverage ratio is value-relevant to

explain return variability. In order to complete the regression on stock returns, we added

twomacroeconomic variables (an inflation indicator and a state-of-the-economy variable).

The pooled regressionR2 is also strongly affected. This coefficient varies from 14% to 29%

depending upon whether the stock returns are regressed on the three factors only or on the

three factors and the two macroeconomic variables. These results clearly show that financial

statements and macroeconomic data provide informations to value security prices.

- Study Guide Chapter 1 %28EC220%29Uploaded byAnjaliPunia
- Ch10tif(Determining How Cost Behave)Uploaded byMary Grace Ofamin
- learner autonomy and vocabulary learning strategiesUploaded byEbrahim Azimi
- Presentation-customer attitude towards the male grooming product in indiaUploaded byidrisi
- 766900WP0P12200ty0Map0Apr4020130ENGUploaded byxyz84
- Licensed under Creative Common Page 732 http://ijecm.co.uk/ ISSN 2348 0386Uploaded byyudi916
- Financial Management Capacities and Financial Sustainability of Community Based Organizations in Turkana County KenyaUploaded byOasis International Consulting Ltd
- N36-5Uploaded bygpnasdemsulsel
- Linear Regression Example DataUploaded bySunny
- Assignment 2Uploaded byRehana Anwar
- [Paper]Intellectual Capital Performance in the Case of Romanian Public CompaniesUploaded byishel
- Practice Midterm2 Fall2011Uploaded bytruongpham91
- Bcg Comp Chapter4Uploaded bygaurav1249
- Consumer Behaviour in Purchase of Cars in IndiaUploaded byHarihar Panigrahi
- free to threesUploaded byapi-408200501
- 14987124232Uploaded byDrishti Dehradun
- Chapter 6Uploaded bySarah Sally Sarah
- armah2017Uploaded byanandarona
- Copy of Regression With Variable ExplanationsUploaded byLaurens Willard
- Coeeficient of DeterminationUploaded byLa Bội Nhi
- co-relational researchUploaded byMofreh Amin
- 1-s2.0-S1815566917300036-mainUploaded byAgus Wijaya
- hw 2 eco 205Uploaded byVinh Pham
- Dynamics of Group Dan TeamUploaded byAnonymous C3YiImTA
- Data Analysis of Electrostatic Charge in Finish Ball MillsUploaded byMeteor Itis
- L2D 008097-Urban Sprawl, Lan Values and the Density of DevelopmentUploaded byGustika Farheni Wulanasri
- Full TextUploaded byroyalbrahman
- 5017a123Uploaded byTakeIt!
- ecmc6Uploaded byajayikayode
- Attention for Counterproductive Work BehaviorUploaded byKharim Beine

- National Space Transportation System OverviewUploaded byBob Andrepont
- Seven Deadly Sins of Strategy ImplementationUploaded bymatloobilahi
- 238628041 Strategic Procurement Plan TemplateUploaded byMuhammad Adeel
- Egypt at Its Origins-2008Uploaded byTeSoTras
- Educational Curriculum & Methods, Cabell's Directories of Publishing Opportunities, www.nationalforum.com, National FORUM Journals, Dr. William Allan Kritsonis, Editor-in-Chief (Since 1983) Over 5,000 publishedUploaded byAnonymous sewU7e6
- 4a4a3PM Session 1 Introduction.pptUploaded byPooja Neemey
- argument paper rubricUploaded byapi-229668693
- World Economic Forum Jan 2013 DAVOS Global Risks AssessmentUploaded byInterconti Ltd.
- Sahay Chpt 1Uploaded byCharleneKronstedt
- Data Analytics Continuous AuditingUploaded byAditya
- haddad2018-converted.docxUploaded byGabriel Han
- reading lesson plan ashes of rosesUploaded byapi-302136012
- Statistics Question Bank VtUploaded byjainravi88
- How to Set and Achieve GoalsUploaded bymassagekevin
- beth cavener emotion analysis lesson planUploaded byapi-385924845
- Challenges of Car Park Design in NigeriaUploaded byDelkan16
- Metallurgical Accounting v140403.1Uploaded byCristian Alvayai
- Airport AdvertisingUploaded byDallas LI
- Risk Factors for Anal Sphincter Tear During.6Uploaded byMelian Anita
- Updated Vadiraj CvUploaded byVadiraj Rao
- Experimental_Scenarios.docUploaded byAnonymous vVEu59idvH
- 01 Front.docUploaded bysairam sai
- ShortestPathsUploaded byShivam Pandey
- Scholarship GuideUploaded byIntikhab
- 0.T Y Project Format 2008-09Uploaded byRishikesh Chakor
- A Practical Guide to GMM (With Applications to Option PricinUploaded byBen Salah Mouna
- Introduction to Social Network MethodsUploaded bySEEPSocial
- ThesisUploaded byUniwatt Energy
- Passive and Modal.pdfUploaded byAdnan Zafar
- CCAFS multi-stakeholder scenarios: a tool for guiding policy actions and investmentsUploaded byirri_social_sciences