FINANCIAL RATIOS AND STOCK PRICES ON DEVELOPED CAPITAL MARKETS1

Abstract

This study empirically tests for the relevance of a set of financial ratios designed to capture issuers' financial performance for the dynamics of stock prices, on a dataset of quarterly values for 495 trading quotes from major European capital markets as well as from S&P 500 market covering a time span between 2003/1 and 2011/1. The research hypothesis is that financial ratios reflecting issuers' financial health matter in the selection of portfolios' structure. We tested this hypothesis in a GMM methodological framework and found that such relationship holds on long run, even if there appears to be some differences in the reactions of European and United States' stocks to financial information.

Headnote

Abstract:

This study empirically tests for the relevance of a set of financial ratios designed to capture issuers' financial performance for the dynamics of stock prices, on a dataset of quarterly values for 495 trading quotes from major European capital markets as well as from S&P 500 market covering a time span between 2003/1 and 2011/1. The research hypothesis is that financial ratios reflecting issuers' financial health matter in the selection of portfolios' structure. We tested this hypothesis in a GMM methodological framework and found that such relationship holds on long run, even if there appears to be some differences in the reactions of European and United States' stocks to financial information.

Keywords: financial ratios; financial assets' valuation; European capital markets; S&P 500 market.

JEL Classification: G11; G12; G15

(ProQuest: ... denotes formulae omitted.)

1. Introduction

The relevance of financial information for financial assets' valuation has generated a large debate in the international literature. The studies regarding this issue emphasize upon the connection between stock prices, as dependent variable, and a set of financial indicators, as explanatory variables. These ratios are considered relevant if they are significantly associated with the dependent variable. Hence, they have the capacity to provide the right information to the investors when evaluating the firm. Financial information, as well as share prices has as purpose to reflect the value of capital and the changes in this value.

The goal of this paper is to seek for empirical evidences to support the relevance of financial ratios for stock prices' dynamics, by examining a set of long-run data from some major capital markets.

The paper is structured as follows: in the next section we briefly review the valuation literature. In section 3 we present the data and the research methodology. Section 4 reports the results. Some conclusions are drawn and some further research directions are suggested in section 5.

2. Literature review

Ball and Brown (1968) and Beaver (1968) were the first to emphasize the relationship between the information disclosed in financial statements and stock prices. They used a particular version of the standard portfolio theory, as well as the capital asset pricing model (CAPM) to analyze the reaction in stock prices subsequent to a company's earnings announcement.

However, during the following years, the mainstream research had focused especially on the Efficient Market Hypothesis. In efficient markets, all fundamental information about the intrinsic value of traded assets and information related to market characteristics should be reflected in prices, without any distortions or omissions. According to Fama (1965) there are four pre-conditions in order for this hypothesis to be achieved: i) there are no transaction costs; ii) there are no information costs; iii) all the participants on the capital market agree with the influence of financial information on financial assets' prices and future earnings. Beginning with the '90, there has been published a series of papers analyzing the relevance of financial information for the evaluation of stock prices.

For instance, Amir et al. (1993) coined the term "value relevance" in the context of the informational content of accounting figures. An accounting figure/ratio is value relevant if it has a significantly strong predicted association with stock prices and stock market indicators such, price-earnings or price to book ratios. Abad et al. (1998) investigated the value-relevance of consolidated versus unconsolidated financial information in Spain and found that consolidated information presents a higher degree of correlation with market value of the firm than unconsolidated information reported by the parent company.

Inoue (1998) evaluated the value-relevance of consolidated and unconsolidated financial information in Japan, using the valuation model based on Ohlson (1995). His results provide evidence that consolidated information is more value-relevant than unconsolidated information after 1995.

The adoption by listed companies of International Financial Reporting Standards - IFRS - issued by IASB (International Accounting Standard Board) was considered a major regulatory change in the history of accounting and the next step in the convergence of national accounting systems (Larson and Street, 2004; Schipper, 2005; Whittington, 2005).The main purpose of the accounting convergence process is to provide reliable, transparent and comparable financial information required by the globalized financial markets. Daske and Gebhardt (2006) provide evidence that the perception of disclosure quality increases around voluntary IAS adoptions, and Barth et al. (2008) report an increase in earnings quality for a sample of firms that adopted IFRS voluntarily. Aharony et al. (2010) investigate the impact of IFRS adoption in 14 European countries, by comparing the price and return-based valuerelevance models to assess how switching from domestic standards affects the informativeness of accounting numbers to investors. Agostino et al. (2008) find that the introduction of IFRS in the EU enhances the value relevance of earnings and book value only for the more transparent banks. Devalle et al. (2009) examine whether the value relevance of financial information increased following the introduction of IFRS for listed companies in five EU countries (Germany, Spain, France, the UK and Italy) for the period starting at 2002. For all companies in their sample they report an increase in the value relevance of earnings and a decrease in the value relevance of book value of equit y.

On the other hand, Dang and Hakenes (2010) argue that disclosure of information triggers immediate price movements, but it mitigates price movements at a later date, when the information would have become public. Disclosure policy can be interpreted as a tool to "control" interim asset price movements, and to allocate risk inter-temporally. Their study reveal that a policy of partial disclosure (and, hence, of inter-temporal risk sharing) can maximize, but surprisingly also minimize, the market value of the firm. The market's appreciation for large upward value increases is limited; so, a firm should design its disclosure policy to avoid large upward jumps. If the upward potential of a stock is large, the firm should release information gradually, and there is an optimal precision of the disclosure information. In the opposite case, if the cash flow distribution exhibits negative skewness, i.e. if there is a low probability of a large downside risk, a gradual release of information reduces share prices and zero disclosure maximizes the share price instead. Consequently, the prospect of inter-temporal risk sharing increases share prices in some cases, but not in all cases. Disclosure regulation needs to be fine-tuned, and it can differ between firms or assets with different ownership structures, different risk structures, different payoff profiles, and different degree of liquidity.

The research study conducted by Cochrane (2001: 388) states: "Returns are predictable. In particular, (a) Variables including the dividend/price ratio and term premium can in fact predict substantial amounts of stock return variation. This phenomenon occurs over business cycle and longer horizons. Daily, weekly, and monthly stock returns are still close to unpredictable ...".

However, this conclusion is under scrutiny. For instance, it was observed that in testing the connections between the descriptors of issuers' financial health and prices' evolutions, the statistical inference is problematic, since the highl y persistent set of financial ratios displays frequently near-to-unit root properties.

Thus, there can appear uninformative inferences on predictive relations (Valkanov, 2003; Lewellen, 2004).

Another issue concerns the fact that the process b y which the contemporaneous stock price reflects value relevant information (both accounting and nonaccounting) remains unchanged over time. In our opinion, this is a critical hypothesis, since it is equivalent with the absence of any learning process in the investors' decisions, process that would guide the adjustments in the construction and management of financial assets' portfolios. If this is presumed, then it is possible to take into account more sophisticated interlinkages between the evolution of stocks and the financial performance of their issuers. A direct testable consequence for such inter-linkages could be the manifestation of non-linear connections between prices' dynamics and the contents of financial statements. In this sense, there are recent empirical evidence showing convexity in the relationship between prices and accounting information. Empirical tests, although exploratory, provide further evidence of a nonlinear relation between stock price and accounting measures of earnings and book value (see, for instance, Riffe and Thompson, 1998).

In the mean time, it is not completely clear how much predictive power can be attributed to financial ratios.

Fama and French (1988) and Campbell and Shiller (1989) suggest a simple theory of slow mean reversion to explain the predictive power. That is, stock prices cannot drift too far from their fundamentals (e.g., dividend, earnings, and book value) in the long run. The theory of slow mean reversion requires financial ratios to be stationary.

As Chang et al. (2008) notes "The phenomenon of the mean-reversion discussed from the literature explore whether the stock price followed random walk. If the stock prices violate the trend of random walk, one possibility is the stock prices followed mean-reversion process. If the stock prices followed mean reversion in the long-run, the price movements should be predictable from the movements in firm fundamental values. In this sense, determining whether stock prices are meanreversion is a very important issue for investors. Consequently, to analysis equity fundamentals, what is important is to verify whether the stock price moves with its firm's fundamental".

Lamont (1998) argues that fundamentals predict returns in the short run, while prices predict returns in the long run. Supplementary, the prediction relation between returns and financial ratios appears to suffer from structural instability over time. In the late 1990s, the prediction relation seems not robust (see, Goyal and Welch, 2003; Paye and Timmermann, 2006; Lettau and Van Nieuwerburgh, 2008). Also, it should be considered the argument advanced b y Lettau and Van Nieuwerburgh (2008) who are suggesting that the puzzling empirical patterns in return prediction are caused by the changes in the steady-state mean of financial ratios and are estimating regime switching models for the steady-state mean of financial ratios.

In this stream of literature, our study is focused on the influence of financial information on stock prices in the case of some important capital markets. In particular, we study the relevance of financial ratios and stock prices' dynamics using a dataset of quarter values for 495 symbols traded on major European capital markets and on US capital market.

The prior discussion of the literature leads to our research hypothesis about the value relevance of financial information: H: The financial ratios designed to capture the financial health and performance of issuers matter in the selection of portfolios' structure.

3. Data and methodology

The data are covering a time span between the first quarter of 2003 and the first quarter of 2011 for 254 symbols traded on FTSE 100, CAC 40, DAX, OMX Finland markets and 241 symbols traded on the S&P500 market.

Table 1 displays the main statistics of the data. The corresponding values of the distributional parameters suggest that there is some cross-section heterogeneity in the sample. Thus, the estimation methodology should account for such heterogeneity.

A formal description of our research hypothesis can be synthesized as:

... (1)

Here, the dependent level of prices (quarterly close prices) variable is linked to a set X of the considered explanatory variables. ηi is the unobserved time-invariant specific effects; δt captures a common deterministic trend; Z is a set of instruments for the dependent and explanatory variables and [varepsilon]it is a random disturbance assumed to be normal, and identically distributed (IID) with E ([varepsilon]it)=0; Var ([varepsilon]it) =σ2 >0 .

In order to estimate this model, we apply a so-called GMM-System methodology. The GMM-System methodology - as proposed by Arellano and Bover (1995), Blundell and Bond (1998, 2000) and Windmeijer (2005) - is used since estimators like fixed and random effects, IV or standard GMM may yield to biased results. Also, since a small panel sample may produce "downward bias of the estimated asymptotic standard errors" in the two-step procedure (Baltagi, 2008: 154), we use the "Windmeijer correction" for the estimated standard errors.

Windmeijer (2000, 2005) observes that part of downward bias which can appear for the standard errors in small samples is due to extra variation caused by the initial weight matrix estimation being itself based on consistent estimates of the equation parameters. In order to correct this bias, it is possible to calculate biascorrected standard error estimates which take into account the variation of the initial parameter estimates. We employ a version of this correction applicable for GMM models estimated using an iterate-to-convergence procedure.

There are several advantages of the GMM-System over other static or dynamic panel estimation methods. Among these: static panel estimates, as the OLS models, are subjected to the problem of dynamic panel bias (Bond, 2002); in our database, we have in the full sample 495 trading symbols (N) analyzed over a period of 33 quarters (T) and the literature includes several arguments for dynamic panel model being specially designed for a situation where "T" is smaller than "N" in order to control for dynamic panel bias (Bond 2002; Baltagi 2008); the problem of the potential endogenity can be easier addressed in dynamic panel models than in static and OLS models, since all variables from the regression which are not correlated with the error term (including lagged and differenced variables) can be potentially used as valid instrumental variables; the dynamic panel model is able to identify short and long-run involved effects (Baltagi 2008). In our estimation, the data are transformed by using the orthogonal deviations method. Orthogonal deviations, as proposed by Arellano (1988) and Arellano and Bover (1995), express each observation as the deviation from the average of future observations in the sample for the same individual, and weight each deviation to standardize the variance. For this transformation, it can be noticed that if the original errors are serially uncorrelated and homoskedastic, then the transformed errors will be serially uncorrelated and homoskedastic as well.

4. Results

The GMM-System tries to simultaneous estimate the Equation 1 together with a respecification designed to eliminate the country-specific effects by using first differences of the involved variables as:

... (2)

The system-GMM approach estimates equations (1) and (2) simultaneously, by using lagged levels and lagged differences as instruments. The presence of both lagged levels and differences is justified by Arellano and Bover (1995) and Blundell and Bond (1998) which showed that lagged levels can be poor instruments for first-differenced variables, particularly if the variables are "persistent". For comparative purposes, we are reporting the results of a GMMDifference approach (Arellano and Bond, 1991).

Table 2 reports the estimation results. In order to check for the robustness of these estimations, the Sargan test is reported as well. The dynamic panel data can be considered valid if the estimator is consistent and the instruments itself are valid. Generally, there is a greater relevance of financial ratios for the European capital markets compared to the United States. Thus, for Europe we found that the current liabilities ratio, current liquidity and capital ratio are statistically significant, meaning that changes in the level of these ratios generate stock prices' changes, unlike the U.S. capital market, where the specified ratios do not play an important role.

We consider that a possible explanation for such an increased relevance of these ratios - especially of current liquidity - consists in the different financing strategies used by entities on the capital markets we have analyzed: in European case, during the selected time span, had prevailed the loans from credit institutions, while for the United States, financing was market based (by issuing shares, bonds, and so on), with investors giving more importance to entities' operating activities. Nevertheless, there can be identified some ratios, such as management and profitability ratios, that are similar in terms of statistical significance, both for the European capital markets, and for the U.S.

In a detailed analysis, these results suggest that:

· Current liquidity is positively correlated with price evolution. In other words, if the issuers keep in the composition of current assets a bigger share of highl y liquid items, the investors consider that the risk premium built into prices is lower. At the same time, if the issuer, as a result of past and current investments, holds a lower value of fixed assets, the stocks become more attractive and the demand for these increases;

· Asset management ratios indicate how effectivel y a company uses its assets. An increase in these ratios induces a decrease in future stock prices;

· Profitability ratios have a positive impact on stock prices. Constant returns reported by the issuer determine an increase in investors' confidence in the health of operating activity and in its ability to generate future returns, consequently leading to an increase in market prices for shares. It can be noted that both gross ratios and net ratios have positive influence on the evolution of future prices. Increased fiscal pressure causes a restriction of the dividend-allocation base, which means a decrease in yields. It results that such an increase will reduce the investors' preference for the inclusion of these shares in their own portfolios (at least if the issuer is adjusting the policy of distributing dividends). Harris (1999: 33) shows that "at least one substantial part of dividend tax is included in the share value. This aspect, however, should not be contrary to the often emphasized role of the signaling factors in the company's decisions. In terms of signaling, for example, tax capitalization suggests that, if the rest of the factors are constant, the higher the expectations of future earnings are, the more internal funds available to finance investments will be and is more likely that a company can pay dividends without having to issue new expensive shares". Then the net margin ratio which takes into account the net income after taxing would have a positive influence on yields;

· The results show that the Diluted EPS indicator (including extraordinary operations) is positively associated with the increase in prices. This result is similar to that obtained by Chang et al. (2008) for the Taiwan market, "stock prices move in the same direction as the EPS indicator, but not necessarily equally". As far as it concerns the EPS analysis, in the case of Europe, it appears that this variable is relevant for prices' dynamics. Conversely, for the United States, the indicator considered to be relevant is Diluted EPS (including extraordinary operations). This aspect can be explained by the very different financing policies practiced in the two areas. In the United States, the issuance of bonds convertible into shares or options of share repurchase are tools often used by companies, but which influence the basic EPS. Diluted EPS takes into account all these elements, having a larger impact on the overall analysis of a company;

· The level and structure of cash flows influence the expected market value of the issuers. Thus, a current positive variation of the cash flows from operating activities reflects a growth potential of the market value and this will increase the relative preference of investors for the shares of these companies, with positive effects on the yields obtained.

5. Conclusions and further research

The objective of this study was to provide some empirical evidences for supporting the hypothesis that financial ratios matter in the selection of portfolios' structure. After testing this hypothesis in a GMM-system methodological framework, we found that such relationship holds on long run, even if there appears to be some differences in the reactions of the European and United States stocks to financial information.

Overall, the image emerging from these outcomes is that management ratios are negative and more relevant, both for European capital markets and for the U.S., whereas current liabilities ratio, current liquidit y and capital ratio are less relevant in U.S. than in Europe. In the mean time, profitability ratios are similar in terms of statistical significance for the analyzed capital markets.

Some possible further research directions can be developed by: evaluating the results' robustness to changes in the estimation methodology and by considering a more heterogeneous sample.

Footnote

1 Acknowledgement: This work was supported by the project "Post-Doctoral Studies in Economics: training program for elite researchers - SPODE" co-funded from the European Social Fund through the Development of Human Resources Operational Programme 2007-2013, contract no. POSDRU/89/1.5/S/61755.

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