On the relationship of stock market valuations, financial ratios and

company earnings: Finnish evidence

Jani KINNUNEN
E-mail: jani.kinnunen@abo.fi
Åbo Akademi University, Turku, Finland
Irina GEORGESCU
E-mail: irina.georgescu@csie.ase.ro
The Bucharest University of Economic Studies, Bucharest, Romania

Abstract. Security market valuations and their fundamentals, such as company earnings, are of the
interest of not only investors, but also company finance managers, as well as central banks due to their
focus on financial stability. Identification of the key financial ratios, which can predict stock market
valuation levels is of crucial importance. In this study, relative stock market valuations, i.e. Price-Earnings,
Price-Sales, Price-Book value, and Dividends-Price ratios, during period 2001-2017, are studied. Firstly,
predictive CHAID decision tree algorithm is applied to investigate the relative importance and impact of
29 financial ratios on the market valuations. Secondly, regression analysis is used to study whether the
growth of two measures of earnings, i.e. sales and net income, can justify the market valuations. The
implications for computerized risk management are discussed and some future research opportunities are
discussed.

Keywords: Company earnings, financial ratios, stock market valuation, CHAID, regression analysis

1. Introduction
Financial stability affects not only investors and company financial managers, but when under shock, whole
economy is under impact and also households may be affected. The purpose is to find stability-relevant
valuation and accounting ratios to be automatically monitored by risk managers and financial supervisors
like central banks.
We present a Composite Value index, CV, which combines information of typical valuation multiples:
P/Earnings, P/Sales, and P/Book value. Along with financial ratios, the effects of past earnings and total
assets on valuation levels are studied.
Justification of high market valuations requires high growth in future earnings or assets to create earnings
as a response to expectations. Chan, Karceski and Lakonishok (2003) studied the persistence and
predictability in earnings growth. Their sample included 2900 US firms on average year between 1951 and
1997. Companies with strong past growth are priced at high, and companies with low past growth at low,
P/E ratios, thus, making the persistence in growth the issue. Markets seemed to believe in the 1990s that
strong earnings growth is persistent. Persistence should exist to justify these distributions. Other factor
justifying this could be risk, but they leave it aside as been unlikely referring to Fama and French (1992)
and Beaver and Morse (1978). And as high P/E ratios should be accompanied with earnings growth in the
long-run, high P/E should predict high earnings to be justified by fundamentals. They also test IBES
estimates as predictors finding them overly optimistic and without ability to forecast in long horizon. They
find that there is no long-term persistence beyond chance and the predictability is low with valuation ratios
in the long run. Fama and French (2000) presented similar evidence on limited short-term and non-existing
long-term predictability.
Our approach is a multimethod study on 500 largest Finnish listed companies 2001-2017 using CHAID
regression trees together with linear and logistic regression analyses.
The rest of the paper is outlined as follows. Section two presents the data together with the computed
financial ratios. Section 3 presents the used methodology and analysis, while section 4 finally discusses the
results with conclusions.

2. Financial ratios and data sample

We use ETLA-Talouselämä database of 500 largest Finnish companies between 2001 and 2017. The data
includes financial year data of income statements and balance sheets together with a set of financial ratios.
Initial dataset had 10191 data records available for analysis. Table 1 describes the used 4 security market
ratios (P/E, P/S, D/P, and P/BV) and the other 29 financial ratios under analysis.

Table 1: Financial ratios and their definitions

Security market ratios

1. P/E, Price-Earnings Ratio (Market value / net income)
2. P/BV, Price-Book Value Ratio (Market value / substance value)
3. D/P, Dividend-Price Ratio (Dividends / Market value)
4. P/S, Price-Sales Ratios (Market value / Sales)
Profitability ratios
5. Gross Profit Margin (Gross profit / Sales)
6. EBITDA Margin (Earnings before interest, tax, depreciation, and amortization /
Sales)
7. EBIT Margin (Earnings before interest and tax / Sales)
8. Net Profit Margin (Net income / Sales)
9. EBIT / Owners’ equity (Earnings before interest and tax / Owners’ equity)
10. ROE, Return on Equity (100 * Net income / Owners’ equity)
11. ROA, Return on Assets (100 * Net income / Total assets)
12. ROI, Return on Investment (100 * (Net income + interest) / Equity invested)
13. Investment Turnover (Sales / Equity invested)
Growth ratios
14. 1-yr Assets Growth Rate: ((Total assetst - Total assetst-1) / Total assetst-1)
15. 1-yr Net Profit Growth Rate: ((Net incomet - Net incomet-1) / Net incomet-1)
16. 1-yr Sales Growth Rate ((Salest – Salest-1) / Salest-1)
17. 3-yr Assets Growth Rate ((Total assetst – Total assetst-3) / Total assetst-3)
18. 3-yr Net Profit Growth Rate ((Net incomet – Net incomet-3) / Net incomet-3)
19. 3-yr Sales Growth Rate ((Salest – Salest-3) / Salest-3)
Solvency & asset structure ratios
20. Assets / Equity (Total assets / Owners’ equity)
21. Gearing (Net debt / Owners’ equity)
 22. Net debt / Sales
23. Financing costs / Debt with interest
Liquidity, turnover, & working capital ratios
24. Quick Ratio ((Current assets – Inventory) / Current liabilities)
25. Liquidity, or Current, Ratio: (Financial assets / Current liabilities)
26. Receivable Turnover Rate: (Sales / Accounts receivable)
27. Payable Turnover Rate: (Sales / Accounts payable)
28. Working capital / Equity (Accounts receivable +Inventory – Accounts payable)
29. Net working capital / Equity ((Financial assets + Inventory – Current liabilities) /
Owners’ equity)

In Table 2 shows the correlations of historical (above) and future (belove) growth rates of fundament
measures of Sales, Earnings, and Assets (i.e,, the two most common earnings measures and assets related
to book value) versus the three valuation ratios together with the constructed composite valuation index
built on the other three (but excluding Price/Dividends after trials showing its limited added value for CV).
CV is constructed according to O’Shaughnessy (2011).

Table 2: Correlations of historical growth rates of valuation ratios (over 1, 3, 5, and 10 years)

One can note from Table 2 that the constructed composite index, CV3, has the highest correlations with
other valuation ratios (similar to P/BV and P/S), but different to P/E. Thus, in this paper we focus on CV3
and P/E. Further, historical Earnings seem to correlate mostly with valuations, while also future assets seem
meaningful for valuations. This suggest typical observation that stock market valuations are based on
realized earnings, but it is unclear whether also the future earnings justify these valuation levels, or can
assets justify them (cf, Kinnunen, 2004). We will study this issue in the following sections.

3. Methodology

We will use typical regression and logistic regression analyses together with CHAID regression-tree (Chi-
squared Automatic Interaction Detector) approach.

The CHAID regression-tree approach is used for prediction and detection of interaction between variables
using SPSS software (Breiman et al., 1984). Compared to other tree-methods, CHAID has been
demonstrated accurate with financial ratios and other applied settings (e.g., Delen et al, 2013; Popescu and
Andreica, 2014). The advantage of decision trees is that their output is easy to interpret, and it has a clear
visualization (cf. Milanović and Stamenković, 2016).
The CHAID classification trees (the dependent variable is categorical) compute the Chi- test to determine
the best split at each step. The CHAID regression trees (the dependent variable is continuous) compute the
F-tests at each split. In the construction of a decision tree, the independent variables in a node are selected
aiming to minimize the intra- group variance and to maximize the inter-group variance (Tufféry, 2011).
CHAID algorithm builds non-binary trees. The CHAID algorithm for regression tress consists of the
following three steps:

Step 1: preparing the predictors

The continuous distributions of the continuous predictors are divided into number of subsets with an equal
number of observations;

Step 2: merging the categories

We repeatedly scroll through predictors to determine for each predictor the pair of predictor categories that
are the least significant with respect to the dependent variable. For regression problems an F-test will be
evaluated. If the F-test for a given pair of predictor categories is not statistically significant, then the
predictor categories will merge. This step will be repeated (i.e. the next pair of categories will be found,
which can now include the previously merged categories). If the predictor category pair is statistically
significant, then a Bonferroni test (an adjusted p-value) will be estimated for the set of categories of that
predictor.

Step 3: selection the split value

We choose the split predictor variable with the lowest adjusted p-value, i.e. the predictor variable that
produces the most significant split. If the smallest adjusted p-value (Bonferroni) for any predictor is greater
than a certain split value, then no split will be executed, and that node is a leaf. This process continues until
no separation can be completed (Breiman et al., 1984).

4. Results from regression analysis and CHAID decision tree algorithm

Table 3: Predicting P/E and CV by linear regression analysis (only final models shown)
From Table 3, one can see that P/E is not predictable, but CV is more so: For Price-Earnings 3,7% (7.1%
with all 30 historical variables); Composite Value Index (CV) 27.1% (45.5% with all historical variables).

Figure 1: Predicting P/E by CHAID

Interpretation of Figure 1 can be summarized node by note as follows.

Node 0: ROE is the best predictor of categorized P/E.

Nodes 1-4: If ROE <= -0.6, then ROE is the only statistically significant predictor.

Node 5: If ROE > 10.7, then the next best predictor is Payable TOR.

Nodes 6-7: If Payable TOR is => 57.2, then the Payable TOR is the only statistically significant predictor.

Nodes 8-10: If Payable TOR > 57.2, then Interest coverage if the only statistically significant predictor
Thus, the primary independent variables used to split the DT are ROE, Payable TOR, and Interest
Coverage.

Figure 2: Predicting CV by CHAID

Interpretation of Figure 1 can be summarized node by note as follows.

Node 0: Net profit margin is the best predictor of CV3.

Node 1: If the net profit margin < 0.22, then the net profit margin is the only statistically significant
predictor of CV3.

Node 2: If Net profit margin [0.22, 4.53], then the next best predictor is Payable TOR (nodes 5-7).

Node 3: If Net profit margin (4.53, 10.72], then the next best predictor is Interest coverage
(EBIT/Int.exp) (nodes 8-9).

Node 4: It Net profit margin >10.72, then the Net profit margin is the only statistically significant
predictor of CV3.
Thus, the primary independent variables used to split the DT are Net profit margin, Payable TOR and
Interest coverage (EBIT/Int.exp).

Table 4 and Table 5 shows the results for the regression analysis on growth rates of fundamentals. Table 4
shows prediction P/E and CV by historical growth rates using linear regression analysis and Table 5
shows prediction of P/E and CV by future growth rates logistic regression analysis.

Table 4: Predicting P/E and CV by history using linear regression analysis

It is seen from Table 4 that P/E can be predicted somewhat (R square = 0.04) only by historical 1-year and
10-year Earnings growth (Net_profit_growth), while CV levels are predictable (R square = 0.044) by past
5-year and 10-year Sales growth (Sales_growth) and 10-year Asset growth (Asset_growth_10YR).

Table 5: Predicting P/E and CV by future using logistic regression analysis

It is seen on the left side of Table 5 that P/E can be predicted by future Earnings, statistically significantly
by 1, 5 and 10-year Earnings (top and low level, while on high and medium level statistically
insignificantly) and by 3-year Assets statistically significantly (again only top and low level). On the right
side of Table 5, one can see that CV is predictable by all fundaments, Earnings 1-10 years, Sales (1-5 years)
and Assets (1-10 years), mainly again top and low levels, but Assets also for medium level.

4. Conclusions

Market level valuations was studied by 500 largest companies in Finland, 2001-2017 and a Composite
Value index was constructed and compared to Price/Earnings ratio by how well they can be explained
(predicted) by typical financial ratios and growth of Earnings, Sales and Total Assets

There are evidence on justification of market valuation levels: (i) limited evidence by Earnings growth
(ii) no evidence by Sales growths and (iii) some evidence by Assets growth.

The yearly data shows that the constructed composite index is predictable better than Price-Earnings ratio
and its level is justified by Earnings and Assets. At companies, when trying to affect own companies
valuation levels, earnings and asset management should take into account that while historical earnings are
what investors follow, the reached valuation levels should be justified by future Earnings and/or Asset
growth, and if it is not, valuation levels are likely to lower, which can have negative effects, e.g., on debt
markets. Monitoring the relations of valuation levels and financial ratios should be automatized with proper
functions to compare them to those of competing companies’ ones.

For future research, we suggest extending data to include P/S, P/BV and D/P ratios and instead of yearly
data, monthly/daily data from bigger markets than Finland would allow better generalization. On
methodology extensions can be done to include neural networks and machine learning methods, which may
be useful to find the complex relationships and dynamics. Building a decision support system on the
presented as well as more advanced methods and thicker data would be valuable for risk management
purposes with respect to market valuations and financial ratios.

[for the final paper the authors will extend literature review and comparison of results to the literature]

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