Linking Financial Ratios and Stock Returns

Chapter I INTRODUCTION Financial ratio analysis is a technique for trying to help interpret financial accounts and to determine the intrinsic value of a security by careful examination of key value drivers such as risk, growth, and competitive position. Various ratios can be calculated from the financial accounts. These ratios will then help us to examine the company’s performance over a number of periods by comparing the same ratios in previous years’ accounts and also the accounts of other businesses operating in a similar environment (Most common benchmarks are industry leaders and industry averages). Financial ratio analysis provides essential information and serve (Investors, Stockholders, lenders, corporation management, Fundamental analysts†¦. ) with a lot of different contexts for different kinds of decisions. 1. 1 Statement of the Problem The enormous number of financial ratios used by financial managers and financial analysts and their relationship with stock return is the main problem in interpreting the financial statements. Based on, the ultimate goal of financial managers is to maximize the wealth of their stockholders; financial managers must understand the impact of their managerial decisions on their company’s financial statements and financial ratios concluded which will consequently affect the stock price of their company. Interpreting such a huge number of ratios distracts attention from the most relevant factors that affect stock prices. 1. 2 Purpose of the study A number of studies such as Timo Salmi (1990) were conducted to reduce the information load resulting from computing a large number of ratios and categorize those ratios that were believed valuable. This study aims to identify those variables that are most relevant to the stock returns of pharmaceutical sector in Egyptian stock market. 1. 3 Statement of objectives This study attempt to achieve the following objective: -The most relevant independent variables (financial ratios) with stock returns as a dependent variable. Chapter II FINANCIAL RATIOS AND STOCK MARKET 2. 1 Literature Review The main goal of our research is to evaluate the relationship between common financial ratios as independent variables and stock returns of the pharmaceutical firms as dependent variable. The relation between financial statement information and stock return was examined by Ou and Penman (1989) who observed returns to investment strategies that are based on a measure that summarizes the information in financial statements to identify the relevant financial ratios. Their study indicate that the predicted returns can not be explained by return based risk measures and that financial statements capture fundamentals that are not reflected in stock prices. The results of the study suggest that it is possible for investors to make excess profits using publicly available information. More recently, the relation between financial statement information and stock return was extended by Holtausen and larcker (1992) who identify value-relevant fundamentals in the context of a return-fundamentals relation. Holtausen (1992) examined the ability of accounting information to generate profitable trading strategies (using 60 accounting ratios). The excess returns were observed in the fourth month following the company’s fiscal year end. The results of the study suggest that the trading strategy was able to earn significantly abnormal returns during the period of 1978-1988. The same issue was examined later by Lev and Thiagarajan (1993) who used fundamental ratios as the basis of analysts’ description of different ratios to identify the value relevance of the financial ratios and their usefulness in security valuation. Afterward, Belkoui (1997) employed the popular financial ratios to show the value relevance, where the popularity of these financial ratios is matched by their usefulness in security valuation. He shows that value relevance of popular financial ratios in both a non contextual setting and a setting conditioned by levels of inflation and growth. 2. 2 Classification of financial ratios The classification of financial ratios was studied by Timo Salmi (1990) who split these financial ratios into five somewhat arbitrary groups: †¢Profitability – how good is the business as an investment. Liquidity – the amount of working capital available. †¢Capital Adequacy – measure the leverage percentage. †¢Debt service coverage – how near is the business to bankruptcy. †¢Efficiency – how good is the management of the business. Each financial ratio has its own signal and its own relation to the stock return. Based on these previous studies, the stu dy selected the most popular financial ratios guided in major financial analysis books such as Mishkin (2001) 2. 3 An overview of Egyptian stock exchange EgyptWatch (2002) studied the history of the egyptian stock exchange and mentioned that the Egyptian Stock Exchange is comprised of two exchanges: the Cairo & Alexandria Stock Exchanges (CASE), and is governed by the same board of directors that share the same trading, clearing & settlement systems. The Alexandria Stock Exchange was officially established in 1888 followed by that of Cairo in 1903. The two Exchanges were very active until the 1940s, when the Egyptian Stock Exchange ranked fifth in the world. Nevertheless, the political turmoil of the mid-1950s led to the demise of activity on the Exchange, which remained dormant throughout the period between 1961 and 1992 (MohieEldin and Sourial, 2000). In 1990, the Egyptian government started on economic reform & restructuring program. The move towards a free-market economy has been remarkably swift and the process of deregulation and privatization has simulated stock market activity. The Capital Market Authority (2002) played an instrumental role in initiating and leading the effort for the revival of the Egyptian stock market in the period between 1992 and 1996. The Capital Market Authority (CMA) is the regulatory body in charge of enforcing, regulating & ensuring compliance as well as monitoring market performance. Relevant policy actions undertaken by the CMA include introducing all types of investment vehicles, allowing open competition in the pricing of market services; and providing full investor protection. The main features of the operational framework are fair trading procedures and practices as well as an immediate transfer of ownership of traded securities; optional listing on the stock exchange; quarterly disclosure requirements for companies; adequate protection of minority shareholder rights; and improved data collection schemes. Capital Law 95/1992 has put in place the regulatory framework in which financial intermediaries such as brokers, venture-capital firms, underwriters and fund managers are to operate. With respect to the managerial framework of CASE, a coherent organizational structure with a clear division of authority & responsibilities was established, creating new divisions & departments such as Publications & Public Relations, Research, Surveillance & Market Control, and Information Technology. Additionally, in May 1998, CASE signed a contract with EFA Software Ltd. , to deliver the new electronic trading, clearing & settlement system that will replace the existing one. The Board of Directors also set up several committees with specific responsibilities. At the senior level, an international advisory committee made up of internationally prominent economists, investment bankers, financiers & investors has been developed in order to ensure that CASE stays closely linked to the int’l arena. This group also provides continuous feedback on its policies. Both the CMA & the CASE monitor market activity to detect possible market manipulation or insider trading. Accordingly, they may suspend offers & bids for institutions suspected of price manipulation. In the case of an emergency, the CASE and/or the CMA may halt trading and/or place ceilings on floors trading prices (maximum 5% up or down), based on the closing prices of the preceding day. In the case of individuals, mutual funds & international funds, no taxes are levied on dividends, capital gain & interest on bonds. Profits of Egyptian corporations from securities investments are subject to a capital gains tax. 2. 3. 1 Recent developments On 21 July 2002, CASE commenced its new price ceiling system with regard to the most actively traded stocks. According to the new practice, the five-percent ceiling on daily prices was removed for a set of selected active stocks (currently twelve). This set of stocks comprises 12 out of the most actively traded stocks on CASE. The chosen of this set of stocks was based on meeting some stated criteria decided by CASE (2002): †¢Stocks must be dematerialized. †¢Minimum trading days per company per year is 220. †¢Average number of transactions per stock must be 20. †¢Minimum market capitalization per company amounts to LE 200 million. Minimum free float amounts to 15 percent of the total listed shares. †¢Minimum turnover ratio per company is 10 percent. †¢The company must prepare financial statements for three consecutive years. †¢Transactions conducted on the shares of the company must be executed by at least 20 brokerage firms. The new practice will stipulate the halt of trading on any of the twelve stocks for a period of thirty minutes, forty-five minutes o r till the end of the trading session, if the stock prevailing weighted average price exceeds 10 percent, 15 percent or 20 percent respectively over opening price. When trading is halted, brokers should inform their clients about the temporary suspension, its reasons, duration and should take the necessary actions in order to fulfill their clients requests. Brokers are allowed to cancel, any of their clients’ orders, when trading is halted. 2. 3. 2 Background of Privatization Program The Ministry of Public Enterprise (MPE) is dedicated to achieve the long-term goal of complete implementation of Egypt’s overall privatization plan. In 1991 Public Enterprise Law No. 203 was introduced as a transitional measure. Dr. Khatab M. (Minister of Public Enterprise) (2002) has explained his Ministry’s plans and objectives to facilitate privatization in Egypt and the methods that have been followed in this regard. Also Dr. Mokhtar Khatab has mentioned to the Government of Egypt (GOE) his efforts in undertaking an extensive privatization program whereby state-owned companies are transferred to the private sector through several methods McKinney (1996). †¢The transfer of ownership & control of state-owned enterprise to the private sector through a partial or a full public share flotation on both the domestic or foreign stock exchanges. †¢Direct sale of a controlling interest to domestic or foreign investors. Direct sale of a controlling interest to employees. †¢The law also allows the sale or lease of company assets, unlimited sale of government-owned shares, or liquidation. Primary objectives of the plan are to generate higher productivity and faster (but sustainable) growth, and as a consequence an increase in returns on assets and equity while at t he same time raising internal efficiency, improving capital structure and increasing capital expenditure. Since the early 1990s a number of key programs have been put into place to greatly liberalize commerce and trade; and to re-frame the country’s legal, regulatory, judicial, and tax structures. An equally important focus of the plan is the creation of new jobs that an expanding economy will provide for the workforce. Over the past five years, the GOE has achieved very gratifying results in macroeconomic terms. This is due to the creation of policies to remove trade barriers, the reform of trade and financial markets, and the reform of the legal taxation and regulatory frameworks, Field (1995) 2. 3. 3 Updates on the Situation of the Privatized Companies The Government of Egypt (GOE) has designed a balanced privatization program, which includes the following share sales strategies. The Egyptian Ministry of Public Enterprise Sector (2001) revealed that: †¢Public Offerings on the Cairo and Alexandria Stock Exchange 37 companies have so far been approved by the GOE for privatization and have been sold through Initial Public Offering (IPO) or second offerings. The sales of these companies netted 5. 6 billion pounds which represents 36% of privatization proceeds to date. 16 companies have achieved partial privatization netting the government nearly 1. 76 billion LE. †¢Sale to Anchor and Strategic Investors 3 companies have been privatized by this method, accounting for 6. 4 billion pounds LE in proceeds to the government. Sales to anchor investors have amounted to 42% of the total privatization proceeds thus far. †¢Employee Stock Ownership Programs (ESOPs) The GOE has approved the allocation through the sale of 10 percent of the public enterprises’ share offerings to the employees as part of the â€Å"Employee Stock Ownership Program†. I n other cases, and according to the particular circumstances of each company, the majority of shares have been sold to its management and employees. To date, mainly medium-sized companies in the public works sector have implemented this scheme. So far, 30 Employee Shareholder Association (ESA) sales transactions have taken place bringing in 870 million pounds LE. †¢Lease Management Contracts In this method, Companies were offered for management by the government to the private sector with an option to buy at a future date. This alternative is not very different to the anchor investor approach if and when the managing company exercises its option to buy. Five contracts of this type are currently active. Chapter III PHARMACEUTICAL SECTOR OVERVIEW The government has set a 40% ceiling (maximum that could be privatized), 10% of which is reserved for Employee Shareholder Associations (ESA), on the privatization of any public pharmaceutical company. The restriction relates to the government’s desire to maintain control of the industry for its significant role in society, The Egyptian Ministry of Public Enterprise Sector (2001). The first five companies that have been privatized: Alexandria, Cairo, Memphis, Arab and Nile pharmaceuticals. These companies have already been 40% privatized. The privatization plan then expanded to cover 11 companies at the end of June 2002. . 1 Pharmaceutical Industry Highlights Drug policy and planning center (2002) has published the following statistics: 199920002001 Market Size (LE bn)4. 655. 42 No. of Products (thousand)3. 63. 84 Per capita spending (LE)72. 6677. 1882. 14 3. 2 Pharmaceutical Products Total exports made by Egypt to the whole world includes a lot of commodities which are classi fied to (Fuels Products, Cotton, Raw Materials, Semi finished commodities and finished commodities). Central Bank of Egypt (2002) revealed that Pharmaceutical products are considered as part of finished commodities, they represent 3% of finished commodities and 1. % of the total export. Also, Pharmaceutical products play a significant role in Egypt’s import. They represent 4% of the total import and 21% of their classification division (consumer goods). Figure (1) shows Pharmaceutical Export and Import situation. Figure (1) Local production of medicine satisfies 92% of the market demand, whereas the remainder is balanced by imports. Kompass Egypt (2002-2003) classified the local market players as: 1) Public-sector companies. 2) Private-sector companies. 3) Multinationals Figure (2) Note: The term Private sector encompasses Multinationals and other Private companies. The government has set a relatively low tariff on imported drugs, which averages around 5%. The main reason for this comparatively low duty is the state’s policy of making medicine available to the bulk of the population at the cheapest possible price. 3. 3 Pricing Policy Prior to the reform program in 1991, the government’s major consideration when setting prices for drugs was to make medicine affordable to the bulk of the population regardless of a company’s cost structure. The focus on the social role of medicine, rather than the profitability of pharmaceutical companies, is the main reason behind this policy. The Drug Policy & Planning Center (DPPC) is the main regulatory authority controlling the pharmaceutical industry. The center is in charge of drug registration and pricing. The DPPC (2002) uses a â€Å"Cost Plus Formula† to price drugs. The formula stipulates a price equivalent to the products cost plus a certain profit margin. The profit margin is 25% for nonessential products, and 15% for essential products. It is noteworthy that once a product has been priced, it is seldom eligible for re-pricing to account for increasing costs. The heavy drop in the value of the Egyptian pound was mirrored in an increasing raw material costs burdening the Egyptian Pharmaceutical companies, which import around 80% of their raw material requirements. In order to save the profit margins from the aftermath of the devaluation, the Ministry of Health finally agreed to raise the prices of five products for each pharmaceutical company starting February 2002. 3. 4 GATT and TRIPS Egypt is a signatory to the General Agreement on Tariffs and Trade (GATT) which will come into effect for the pharmaceutical sector in Egypt in 2005. The agreement is likely to have serious repercussions for the pharmaceutical industries of developing countries including Egypt. The agreement calls for the abolition of both quantitative and qualitative barriers to entry for pharmaceutical products, thus eliminating any governmental protection of the industry. Under GATT, Egyptian companies have to abide by the restrictions imposed by patents and property rights for a period of 20 years. Based on the Egyptian commitment with the agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS), which is part of the GATT, President of Egypt published The Law No. 2 for year (2002), calling for the Protection of any invention whether industrial or intellectual. The agreement will result in the extension of a patent to 20 years and will grant protection to the product and the production process. Chapter IV METHODOLOGY AND EMPERICAL MODELS 4. 1 Data Set In our study, we select all the pharmaceutical companies quoted in the Egypt ian stock exchange which consists of 11 pharmaceutical companies representing the pharmaceutical sector. We covered the period from 1996 to 2001. Analyzing six continuous years of data, strengthen and support results and give our conclusion stability and reasonability. Kompass Egypt Financial Year Book and the Egyptian Capital Market Authority were the prime sources for our data set. Additionally, for the purpose of this analysis, we calculate the returns using annually prices of securities for years starting from 1996 to 2001. 4. 2 Selection of Financial Ratios (Independent variables) According to the literature, we determine the most useful financial ratios that could be functional in security valuation by analyzing and comparing several papers and texts were analyzed and compared. The reasons behind the selection of these financial ratios: †¢Their talent in theoretical explanation of fundamental relationships and signals experienced by the firms. [Foster 1986] †¢The importance of their existence in published annual reports. [Gibson 1982] †¢Surveys proved that chief executive officers and other senior executives are concerning popular financial ratios for various types of decision making. [Walsh 1984] The following table provides the most common financial ratios that might affect stock returns. For each financial ratio, we provide the way of calculation, the hypothesized positive or negative relationship with stock returns. Table (1) The common financial ratios and their prediction with stock returns GroupFinancial ratiosVariablesEquationsPrediction of relationship ProfitabilityEarning per ShareEPSNet income / Number of shares outstandingPositive Return on EquityROENet income / owners’ equity Return on AssetsROANet income / total assets Profit MarginPMNet income / total sales LiquidityCurrent RatioCTRCurrent assets / Current liabilitiesNegative Quick RatioQR(Current assets – Inventory) / Current liabilities Operating Cash flow RatioOCFCash flow from operations / Current liabilitiesPositive LeverageDebt to Equity RatioDERLong term liabilities / owners’ equityNegative CoverageInterest CoverageICEBIT / interest expensePositive EfficiencyAssets TurnoverATOSales revenue / Total assetsPositive Receivables TurnoverRTOSales / Account Receivables EBIT: Earnings before Interest and Taxes We refer to the explanantion of these financial ratios (independent variables) in the Appendix section. . 3 Buy-and-Hold Returns (BHR) As far as the dependent variable is concerned, stock returns, there is no consensus on the appropriate methodology for calculating the long-run stock returns (see among other, Barber and Lyon, 1997; Kothari and Warner, 1997; Brav and Gompers, 1997; and Barber, Lyon and Tsai, 1999). Researchers use several methods to calculate long run returns, in particular Buy-and-Hold returns (BHRs) method. The first s tep in calculating Buy-and Hold return method is to calculate rate of return on stocks. We consider that the appropriate rate of return on a given stock is the difference between the stock prices in time t plus dividends in time t-1 and the stock prices in time t-1 , as follows: (1) Where is the return for security I for period t, refers to the closing price of security I at time t , and is the price of security I at time t-1 , is the dividend received for period t-1 for the firm I As far as we consider time t as a year, rate of return on stocks ( ) that we calculated from the previous equation is the Buy-and-Hold return method for a financial year. (2) Where is Buy-and-Hold Return for security i in period t. we consider it a year. 4. 4 Regression Model To determine the relationship between the independent variables (financial ratios) and the dependent variable (stock return), we follow a similar methodology to that of Belkaoui (1997) and estimate the following regression: (3) Where is the annual stock return of firm I at time t, is the earning per share for firm I at t ime t, is the return on equity for firm I at time t, is the return on assets for firm I at time t, is the profit margin for firm I at time t, is the current ratio for firm I at time t, is the quick ratio for firm I at time t, s the operating cash flow for firm I at time t, is the debt to equity ratio for firm I at time t, is the interest coverage ratio for firm I at time t, is the asset turnover for firm I at time t, is the receivable turnover for firm I at time t. Since the return of a given stock is based on a period extending from 9 months prior to the fiscal year-end and 3 months after the fiscal year-end, corresponding roughly with the period between announcing the financial statement, the starting month would be December for firms whose fiscal years end at Jun, the 30th and June for firms whose fiscal years end at December the 31st. CHAPTER V RESEARCH FINDINGS 5. 1 Results We present results of a regression model where independent variables in the regression equation are chosen in two ways (both general and step wise regression). Multicollinearity tests the correlation among two or more of the independent variables (financial ratios) used in the regression equation. Multicollinearity is a problem because it increases the likelihood of rounding errors in the calculation of the beta estimates and standard error, and also it may produces confusing and misleading (signs of beta parameters are different from those signs expected) results (Mendenhall, 1996). Table (2) shows that the existing problem in this Multicollinearity is especially evident for the correlation between the Current Ratio and the Quick Ratio reaching 0. 92 and significant at 99% level. Current Ratio and Quick Ratio are two faces for the same coin. They are categorized under liquidity ratios group, they have the same explanation about the result and there is a little bit difference in their equations (In Quick Ratio, Inventory is excluded from the Current Assets). So we eliminate Quick ratio from the independent variables (financial ratios) and retain on Current Ratio because it is more popular. Table (2) Correlation Matrix to explain the relationships among the financial ratios as independent variables VariablesQRATODERCTRICEPSOCFPMRTOROAROE QR1. 000 ATO-0. 4204*1. 000 DER0. 03920. 3860*1. 000 CTR0. 9239*-03478*0. 08801. 000 IC0. 3752*-0. 3246**-0. 15040. 3610*1. 000 EPS0. 1884-0. 2604**-0. 12480. 0724-0. 03061. 000 OCF0. 0641-0. 3243-0. 29300. 15720. 19970. 32021. 000 PM0. 1659-0. 4338*-0. 2835**0. 23450. 04750. 6245*0. 34311. 000 RTO-0. 2999**0. 1663-0. 0413-0. 0230-0. 0298-0. 19220. 6846*0. 16561. 000 ROA0. 0535-0. 1600-0. 4080*0. 16850. 17500. 6342*0. 6703*0. 6392*0. 3761*1. 000 ROE0. 1264-0. 1178-0. 01580. 21150. 10610. 11030. 8970. 2610**0. 18200. 3693*1. 000 * Significant at the 1% level ** Significant at the 5% level Table (3) & (4) show the multiple and step-wise regressions of the relationship between explanatory variables (financial ratios) and stock returns utilizing buy-and-hold return (BHR) method. The relationship between stock returns and common financial ratios is es timated using the following equation: Where is the annual stock return of firm i at time t. BHR is calculated as follows: Where is buy- and- hold return for security i, in period T, T is the trading month number 12, and indicates the first event month of calculating the return. s the dependent variable in the regression equation. Table (3) Multiple Regressions of the Relationship between Financial Ratios and Stock Returns Independent variables BetaT testSig. T 1- Current ratio (CTR)0. 7821993. 0940. 0055* 2- Interest coverage ratio (IC)0. 6895873. 0850. 0056* 3 Profit margin ratio (PM)0. 6434102. 5740. 0177** 4- Earnings per share (EPS)0. 3790681. 1190. 2757 5- Operating cash flow ratio (OCF)0. 2002970. 5430. 5931 6- Assets turnover (ATO)0. 1150700. 4550. 6537 7- Return on Equity (ROE)0. 0966730. 5010. 6215 8- Debt to equity ratio (DER)0. 0622020. 3040. 7640 – Receivables turnover (RTO)-0. 165573-0. 4660. 6457 10- Return on Assets (ROA)-0. 121268-0. 3320. 7433 Multiple R = 0. 68529F = 6. 76472 R square = 0. 46962Significant F = 0. 0031 * Significant at the 1% level ** Significant at the 5% level The results from table (3) show that the F test used to test the overall utility of the model indicates that the model is significant at the 99% level. However, the R square is 46. 96% indicating that the ten independent variables together explained approximately half of the variance in the yearly return of pharmaceutical sector as a dependent variable. Also, T test of the individual Betas (financial ratios) indicates that the most active ratios in determining stock returns are Current Ratio (CTR), Interest Coverage Ratio (IC) and Profit Margin Ratio (PM) with a significant level of 99%, 99% and 95% respectively. To check on the signs of the beta coefficient, the dependent variable (stock return) was regressed on each of the independent variables (financial ratios) and the signs of the resulting betas were checked against that of the original equation. There are three ratios which are Current Ratio, Receivable Turnover and Return on Assets that had different signs from the original regression equation The positive coefficient estimated for Current Ratio with stock returns is not expected because conservative policies that tend to keep current asset higher than current liability have lower risk and also have lower expected return than the aggressive policies. So we conclude that rational investors put more confidence in low risky stocks and look forward for stable stocks more than the temporary profitable stocks. On the other hand, Receivable Turnover ratio and Return on Assets ratio are completely insignificant as show in table (3), so there is nothing important to explain their different signs from the original prediction. Table (4) Step-wise Regression of the Relationship between Financial Ratios and Stock Returns Independent variables R? BetaT testSig. T ChangeAccumulation 1- Current ratio 0. 194050. 194050. 7302745. 2990. 0000* 2- Interest coverage ratio 0. 121330. 315380. 7161115. 2420. 0000* 3 Profit margin ratio 0. 072850. 388230. 4597934. 1170. 0001* Multiple R = 0. 62308F= 12. 69213 R square = 0. 38823 * Significant at the 1% level ** Significant at the 5% level In the next step, we utilize the step-wise regression to reach the final model that contains the significant explanatory variables and give better explanation for the relationship. Consistent with the general regression models, the step-wise results confirm the above mentioned findings as Current Ratio (CRT) is the most significant variable at the 99% and explained about 19% of the variance in the yearly return of pharmaceutical sector with R square about 19%, while R square for the model is about 39%. Interest coverage ratio has also explained about 12% of the variance in the yearly return of pharmaceutical sector. Interest coverage ratio is regarded as a measure of a company’s creditworthiness because it shows how much income there is to cover interest payments on outstanding debt. Profit margin ratio explained about 7% of the variance in the yearly return of pharmaceutical sector with R square 7%. From results we conclude that rational investors and stockholders are looking for strength and stability first then profitability when evaluating a pharmaceutical stock company. Table (5) Stepwise Multiple regression analysis for the good predictors Company R? BetaT testSig. T ChangeAccumulation 1- Memphis0. 466240. 466240. 73001412. 4530. 0000* 2- Cairo0. 213940. 680180. 6092937. 6880. 0000* 3- Alexandria0. 094360. 77454-0. 521862-4. 6470. 0001* Multiple R = 0. 88006F= 23. 73573 R square = 0. 77454 * Significant at the 1% level ** Significant at the 5% level Stepwise multiple regression model yielded a reduced equation containing only three companies (independent variables) explaining about 77% of the variance in the yearly return of pharmaceutical sector as a dependent variable: the analysis yielded three good predictors as demonstrated at table (5), the results proved that Beta value of Memphis Pharmaceutical and Chemical Industries was 0. 73 and it is significant at 99% level. Additionally, Memphis Company alone explained about 47% of the variance in the yearly return of the pharmaceutical sector. The second good predictor is Cairo Pharmaceutical and Chemical Industries while its Beta value was 0. 60 and it is significant at 99% level. Cairo Company alone explained about 21% and together with Memphis Company explained about 68% of the variance in the yearly return of the pharmaceutical sector. The third and last predictor is Alexandria Pharmaceutical and Chemical Industries with a Beta value of -0. 52 and significant at 99% level. Alexandria Company explained alone about 9% of the variance in the yearly return. 5. 2 Summary and Conclusion The relationship between financial ratios and stock returns has been a popular issue in the area of accounting and finance for a long time, so we found that it is a good issue to discuss on the Egyptian stock market. Here, an analysis is undertaken to show the value relevance of the financial ratios and their usefulness in security valuation in the Egyptian pharmaceutical sector. In our research, we use step-wise multiple regressions between financial ratios and stock returns, also between pharmaceutical companies’ returns and pharmaceutical sector returns. The results from using step-wise and multi regression indicate that Current Ratio (CTR), Interest Coverage Ratio (IC) and Profit Margin Ratio (PM) respectively, are the most relevant ratios in determining stock returns. Additionally, Memphis Pharmaceutical and Chemical Industries is the most relevant company in explaining the variance of the pharmaceutical sector return as a whole. Finally, it seems that Current Ratio (CTR), Interest Coverage Ratio (IC) and Profit Margin Ratio (PM) play a significant role in formulating investment decisions in the Egyptian stock market (specifically, Pharmaceutical sector). Egyptian rational investors put more confidence in low risky stocks and look forward for stable stocks more than the temporary profitable stocks. 5. 3 Further Research The study was conducted on Egyptian pharmaceutical sector and taken all pharmaceutical companies (11 companies) that have been quoted in Egyptian stock exchange, covered the period from 1996 to 2001. Replicating the study on other sectors in Egypt such as (Agriculture, Food & Beverages, Construction, Banks†¦) at different times could be very useful. The study could be also replicated on the valuable Egyptian market indices such as (Case 30, IFCG, MSCI, EFG Hermes). These studies could help in determining more clearly the relationship between financial ratios as independent variables and stock returns as dependent variable. CHAPTER VI REFRENCES Barber, B. , Lyon, J. , and Tsai, C. , (1999), â€Å"Improved Methods for Tests of Long-Run Abnormal Stock Returnsâ€Å", Journal of Finance, 54 (1), 165-201. Baraber, B. , and Lyon, J. , (1997), â€Å"Detecting Long-Run Abnormal Stock Returns: The Empirical Power and Specification of Test Statisticsâ€Å", Journal of Financial Economics, 43 (3), 41-72. Brav, A. , and Gompers, P. , (1997), â€Å"Myth or Reality? 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(1986), â€Å"The Relative Information Content of Accruals and Cash Flows: Combined Evidence at the Earnings Announcement and Annual Report Release Date† Journal of Accounting Research, p. 165-200 CHAPTER VII APPENDIX (A) Financial Ratios Financial ratios are very important for new investors who would like to invest in the firm and also for stockholders who are the investors of the firm because financial ratios give them several indicators which they can evaluate the firm with. 1) Profitability Ratios The main goal of these ratios is to help us to judge how good the firm's profit performance. Profitability ratios refer to the ability of a firm to generate revenues in excess of expenses. 1. 1 Earnings per Share The portion of a company’s profit allocated to each outstanding share of a company’s common stock. E arnings per share is simply a fundamental measure of profitability that shows how much profit was generated on a per-share-of-stock basis. EPS doesn’t reveal a great deal. Its true value lies in comparing EPS figures across several quarters, or years, to judge the growth of a company’s earnings on a per-share basis. David Irwin (2001) Therefore, studying refers to a positive relationship between EPS and stock market return. To calculate EPS, start with net income (earnings) for the period in question, subtract the total value of any preferred stock dividends and then divide the resulting figure by the number of shares outstanding during that period. Or: Net income / Number of shares outstanding 1. 2 Return on Equity ROE is a fundamental indication of a company’s ability to increase its earnings per share and thus the quality of its stock, because it reveals how well a company is using its money to generate additional earnings. ROE allows investors to compare a company’s use of their equity with other investments, and to compare the performance of companies in the same industry. ROE can also help to evaluate trends in a business. Businesses that generate high returns on equity are businesses that pay off their shareholders handsomely and create substantial assets for each dollar invested as mentioned by Peter S. 1999). To calculate ROE, divide the net income shown on the income statement by shareholders’ equity, which appears on the balance sheet: Net income / owners’ equity 1. 3 Return on Assets A Company’s profitability expressed as a percentage of its total assets. Return on assets measures how effectively a company has used the total assets at its disposal t o generate earnings. Because the ROA formula reflects total revenue, total cost, and assets deployed, the ratio itself reflects a management’s ability to generate income during the course of a given period, usually a year. Ross (2002) Naturally, the higher the return the better the profit performance. ROA is a convenient way of comparing a company’s performance with that of its competitors. ROA should have a positive relationship with the stock market return. To calculate ROA, divide a company’s net income by its total assets, then multiply by 100 to express the figure as a percentage: Net income / total assets 1. 4 Profit Margin Profit Margin is a company’s net profit or loss as a percentage of total sales for a given period, typically a year. This ratio shows how efficiently management uses the sales revenue, thus reflecting its ability to manage costs and overhead and operate efficiently. It also indicates a firm’s ability to withstand adverse conditions such as falling prices, rising costs, or declining sales. Ross (2002) The higher the figure, the better a company is able to endure price wars and falling prices. Investors tend to prefer a higher percentage of profit margins, which considered being an indication of a positive relationship between profit margin and stock market return. The calculation is very basic: Net profit / total sales (2) Liquidity Ratios These are ratios that measure the liquidity of the firm. Firms have to ensure that they have the liquidity required to meet all their commitments. To the extent a firm has sufficient cash flow; it will be able to avoid defaulting on its financial obligations and, thus avoid experiencing financial distress. 2. 1 Current Ratio Current ratio is the company’s liquidity and its ability to meet its short-term debt obligations. By comparing a company’s current assets with its current liabilities, the current ratio reflects its ability to pay its upcoming bills in the unlikely event of all creditors demanding payment at once. Current liabilities are debts that are due within one year from the date of the balance sheet as mentioned by Charles P. (2002). The basic source from which to pay these debts is a current asset. As long as firms are searching for no risks by increasing current assets, profitability will be getting shrunk. So that current ratio should have a negative relationship with stock market return. Working capital is also called net current assets or current capital, and is expressed as: Current assets / Current liabilities 2. 2 Quick Ratio How quickly a company’s assets can be turned into cash, which is why assessment of a company’s liquidity also is known as the quick ratio, or simply the acid ratio. Regardless of how this ratio is labeled, it is considered a highly reliable indicator of a company’s financial strength and its ability to meet its short-term obligations. Because inventory can sometimes be difficult to liquidate, the quick-test ratio deducts inventory from current assets before they are compared with current liabilities-which is what distinguishes it from the current ratio. Potential creditors like to use the quick-test ratio because it reveals how a company would fare if it had to pay off its bills under the worst possible conditions. Indeed, the assumption behind the quick-test ratio is that creditors are howling at the door demanding immediate payment, and that an enterprise has no time to sell off its inventory, or any of its stock. This ratio should have also negative relationship like the current ratio with stock market return. The quick-test is computed by subtracting inventories from current assets and dividing the difference by current liabilities: (Current assets – Inventory) / Current liabilities . 3 Operating Cash Flow Ratio Traditional working capital ratios indicate how much cash the company had available on a single date in the past. Cash flow ratio, on the other hand, tests how much cash was generated over a period of time and compare that to near-term obligations as published by John R. and Jeanne H. (1998). This ratio should str engthen the investors’ confidence toward the firm, therefore it should be positively related with stock market return. The numerator of the OCF ratio consists of net cash provided by operating activities. This is the net figure provided by the cash flow statement after taking into consideration adjustments for non-cash items and changes in working capital. The denominator is all current liabilities, taken from the balance sheet: Cash flow from operations / Current liabilities (3) Leverage Ratios 3. 1 Debt-to-Equity Ratio How much money a company owes compared with how much money it has invested in it by principal owners and shareholders. The debt-to-equity ratio reveals the proportion of debt and equity a company using to finance its business. It also measures a company’s borrowing capacity. The higher the ratio, the greater the proportion of debt but also the greater the risk. Mishkin (2001) describes the debt-to-equity ratio as â€Å"a great financial test† of long-term corporate health, because debt establishes a commitment to repay money throughout a period of time, even though there is no assurance that sufficient cash will be generated to meet that commitment. Creditors and lenders, understandably, rely heavily on the ratio to evaluate borrowers. As long as this ratio is considered to be low, investors’ confidence will be increased which negatively related with the stock performance. The debt-to-equity ratio is calculated by dividing debt by owners’ equity, where equity is, typically, the figure stated for the preceding calendar or fiscal year. Debt, however, can be defined either as long-term debt only, or as total liabilities, which includes both long- and short-term debt. The most common formula for the ratio is: Long term liabilities / owners’ equity (4) Coverage Ratios 4. 1 Interest Coverage The amount of earnings available to make interest payments after all operating and non-operating income and expenses—except interest and income taxes—have been accounted for. Interest coverage is regarded as a measure of a company’s creditworthiness because it shows how much income there is to cover interest payments on outstanding debt. Banks and financial analysts also rely on this ratio as a rule of thumb to gauge the fundamental strength of a business as argued Eugene F. & Joel H. (1998). Investors also rely on this ratio to examine the strength of a firm’s financial statement while this ratio should have a positive relationship with stock market return. Interest coverage is expressed as a ratio, and reflects a company’s ability to pay the interest obligations on its debt. It compares the funds available to pay interest—earnings before interest and taxes, or EBIT—with the interest expense. The basic formula is: EBIT / interest expense (5) Efficiency Ratios Ratios of turnover are constructed to measure how effectively the firm’s assets are being managed. 5. 1 Asset Turnover The amount of sales generated for every pound’s worth of assets over a given period. Asset turnover measures how well a company is leveraging its assets to produce revenue. A well-managed manufacturer, for example, will make its plant and equipment work hard for the business by minimizing idle time for machines. The higher the number the better-within reason. As a rule of thumb, companies with low profit margins tend to have high asset turnover; those with high profit margins have low asset turnover. This ratio can also show how capital intensive a business is. Some businesses-software developers, for example-can generate tremendous sales per dollar of assets because their assets are modest. At the other end of the scale, heavy industry manufacturers need a huge asset base to generate sales as refered by Eugene F. & Joel H. (1998). As long as the plant and equipment work hard and sales are increasing that would be an indication of a good sign. Consequently, this ratio should be a positively related with stock market return. Asset turnover’s basic formula is simply sales divided by assets: Sales revenue / Total assets 5. 2 Accounts Receivable Turnover This ratio explains the number of times in each accounting period, typically a year that a firm converts credit sales into cash. A high turnover figure is desirable, because it indicates that a company collects revenues effectively, and that its customers pay bills promptly. A high figure also suggests that a firm’s credit and collection policies are sound. In addition, the measurement is a reasonably good indicator of cash flow, and of overall operating efficiency as hence by Mishkin (2001). This ratio should have a positive relationship with stock return. The formula for accounts receivable turnover is straightforward. Simply divide the average amount of receivables into annual credit sales: Sales / Account Receivables (B) Statistical Results