Financial Ratios and Stock Return Predictability (Evidence from Pakistan) Muhammad Bilal Khan Faculty of Administrative Sciences Air University Islamabad Tel: +92-334-8819057 E-mail: firstname.lastname@example.org Sajid Gul (Corresponding Author) Faculty of Administrative Sciences Air University Islamabad Mardan 23200 KPK Pakistan Tel: +92-332-8102955 *E-mail: email@example.com Shafiq Ur Rehman Lecturer University of Malakand, Pakistan Tel: +92-333-9842005 E-mail:firstname.lastname@example.org Nasir Razzaq PhD Scholar SZABIST Islamabad Tel: +92-336-5505398 E-mail: email@example.com Ali Kamran Institute of Management Sciences Peshawar Tel:+92-334-8808095 E-mail:firstname.lastname@example.org Abstract The purpose of this research article is to investigate the ability of earning yield (EY), dividend yield (DY) and bookto-market ratio (B/M), to predict stock returns. The sample of the study consists of 100 non-financial companies listed in the “Karachi Stock Exchange”. The duration of the study is 7 years from 2005 to 2011. To find whether EY, DY and B/M ratios can predict stock returns we have used generalized least square and panal data models. The results indicate that DY and EY ratios has direct positive association with stock return where as B/M ratio has significant negative relationship with stock return. Therefore we can say that the above mentioned ratios are able to predict stock returns, furthermore it can be seen that as compare to dividend yield and earning yield the ratio of book to market has the highest predictive power. Moreover when we combine these financial ratios the predictability of stock returns will enhance. Keywords: Financial ratios, Stock return, Karachi Stock Exchange, Dividend Yield, Earning Yield. 1. Introduction Stock Market plays a very significant role in the economic growth of a country. According to A. Schrimpf (2010) there is significant economic aftermath of the existence of stock return predictability. S. Kheradyar et al, (2011), "The Analytics of Economic Time Series”, states that in stocks market share prices move randomly i.e. on certain day share prices are like to go down as they were like to up. Such random behavior worried some of the financial economists and followed by further research. Hence such random movement of share prices lead to a hypothesis called Random Walk Hypothesis. Random walk hypothesis suggest that it is difficult to predict share prices because stock prices evolved, now it will be showing upward trend but after some time such might be showing downward trend. Hence predicting 100% accuracy of stock return is almost impossible. In contrast to Random Walk Behavior is efficient market hypothesis. According to efficient market hypothesis share prices are fairly priced in the stock market or prices of stock demonstrates information in the market is widely and equally available to all and no one in the market can outperform or can beat the market. With the passage of time researchers tries to find out most accurate variables for predicting stock prices, some were tend towards financial and some were towards profitability ratios i.e. book to market ratio, price to earnings ratio,
Research Journal of Finance and Accounting ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online) Vol 3, No 10, 2012
dividend yield, etc some were tend towards cash flow ratios like price to cash flow ratio, cash burn ratio, etc and some focused on macroeconomic variable like interest rate, law and order situation and inflation rate etc. In this research article we have investigated 3 above mentioned ratios to determine whether they predict stock returns. This research study has used the stock return and the above mentioned financial ratios association at two samples as the foundation for the formulation of Eight hypotheses. On the grounds of their appropriate...