Retained Earnings and Share Price Relationship in Pakistan

The objective of this research paper is to study the relationship between retained earnings and share price in the Pakistan stock market. For analysis, a sample of 40 listed companies was taken from Karachi stock market. In this research, variables data was taken from the period of 2005-2008. Simple Linear Regression technique was used to analyze the relationship between share price and retained earnings. A positive relation was found between retained earning and stock price.

This paper supports the fact that retained earning is relevant in determining share price for a sample of firms listed in the Karachi Stock Exchange.

As far as my knowledge is concerned, this paper is first to show that corporate earnings is a key driver of stock price change in the Pakistan.

CHAPTER 1:

INTRODUCTION

Overview:

Earnings and dividends occupied an important role in financial accounting research and finance. It is the most extensively accepted measure of firm performance. Attention was also given to earnings because it is commonly used in evaluating management performance. Perhaps the biggest reason for the attraction to earnings, though, lies with the notion that retained earnings serves as a predictor of future cash flows. Many theories have represented that the accrual earnings represents the best predictor and of future cash flows than the historical cash flows. A company’s existence depends on its ability to make positive cash flows, and research confirmed that share price directly related to an entity’s cash flow prediction. Thus, because earnings of the company are viewed as a key determinant of share price. Mary, Cram and Nelson (2001) found that the systematic ability of earnings can be improved when disaggregated into its major accrual components. One of the components was sales revenue, which unpredictably ignored in the literature as a predictor of share price. The degree of relationship of earnings and cash flow, sales with share price was a aim of this study. Empirical studies indicate that when share prices are related to the current dividends and retained earnings, higher dividend’s are associated with higher price earning ratio. Graham and Dood assert that the impact of dividend on price is four times that of retained earnings; moreover, the studies of Myron Gorden, David Durand and others indicate that dividend multiplier is several times the retained earning multiplier. A very recent study on this topic has been done by Friend and Puckett for USA they concluded that in general, there is little basis for the view that dividends have an impact on price which is several times that of retained earnings. A firm’s ability to generate cash flow affects the value of its securities, so the ability to assess future cash flow was important for the investment community, both shareholders and creditors. While shareholders may be concerned with the stream of cash flows to perpetuity, many creditors were concerned solely the short term cash generating ability of a company.

Problem statement:

To investigate the Impact of Retained Earnings, Dividends on Share Price.

Hypothesis

H1: There is a positive relationship between Retained Earnings and Share Prices.

Outline of the Study:

Next section 2 is Literature review, section 3, methodology and data collection, section 4 results and summary, section 5 conclusion remarks

Definition

Retained earnings refers to the portion of net income which is kept by the companies rather than distributed to its owners as dividends.

CHAPTER: 2

LITERATURE REVIEW

The study relates to examine the relationship of earning with share price.

When conservative accounting practices are observed by firms, the quality of its earnings can be affected by the changes in the amount of its investments. Increase in investment decreases reported earnings and creates reserves. Dropping investment releases those reserves and earnings increase. If there is temporary change in investment then earnings are depressed or inflate temporarily, it means that investment is not a fine indicator of future earnings.

This paper contributes to the research on how the quality of earnings is affected by accounting methods. We define the term to mean that reported earnings, before unusual items that are recognized on the income statement, is of good quality if it is a good sign of future earnings. Thus we consider good earnings to be “sustainable earnings,” as referred to in financial analysis (Mulford and Comiskey,1996). When an accounting treatment produces weak earnings, we consider those unsustainable earnings to be of poor quality.

Changes in dividends informs the investors about the determination of past earnings changes. The determination of earnings is the extent to which an unpredicted change in earnings revises hope of future earnings for the periods in the same way as the unexpected change. This uncertainty about the of earnings is determined as later earnings announcements for following quarters provide additional information. Investors assessments of the persistence of past earnings can be revised by the change in dividends because the managers are unwilling to increase (decrease) dividends unless earnings increase (decrease) are determined.

We examine whether investors recognize a change in dividends as a sign about the determination of past earnings changes by examining the statistical relation between the market reaction changes in dividends and recent past earnings changes.

Healy and Palepu’s (1988) stated that dividend changes manager’s private information about future earnings changes. They found a positive relation between abnormal returns and following changes in earnings. Financial statement analysis advocates examining the accrual and cash basis components of current earnings for the purpose of predicting future earnings.

The nature of the information contained in the cash basis and accrual and components of earnings and the degree to which this information is reflected in share prices. The results specify that earnings show attributable to the accrual component of earnings exhibits lower persistence than earnings show attributable to the cash basis component of earnings. The firms with comparatively high (low) levels of accruals experience negative (positive) future stock returns that are determined around future earnings announcements. Although there is unreliable evidence that stock prices respond positively to firms meeting expectations. We observe whether there is a market return to meeting current period earnings expectations, and whether any such return reflects the implications for following earnings of meeting expectations in the current period or shows a distinct market premium. It seems reasonable to say that there is a wide agreement that either favorable earnings or dividend announcements can persuade positive abnormal stock returns. The effect of earnings announcements on share price changes has been recognized by Ball and Brown, Foster, Watts and Rendleman et al. The effect of dividend announcement was first highlighted by Pettit. Miller and Scholes , in a study focused primarily on dividends and taxes as a result they found significant evidence of a dividend declaration effect. Figures of earnings can be manipulated by accounting practices, and so may be interpreted with uncertainty by the investment community (Kaplan and Roll ). Similarly, dividend declarations are only a crude way to communicate information to capital markets. While both dividend and earnings data have been shown to influence share performance that the capital market would be interested in the consistency by earnings and dividend announcements. This might show the way to a validation effect on share prices.

Confirmation from a collection of studies shows that equity value is related to accounting earnings (e.g., Ball and Brown 1968; Barth et al. 1992). However, in more reasonable settings with market imperfections, accounting methods can provide complementary information about book value and earnings. Balance sheet information provides net worth of resources of the firm. These information are based mostly on historical market prices and is therefore mainly independent of the achievement with which the firm currently employs its resources. On the other hand earnings from the financial statement provide a measure of value which reflects that how much of the resources are being employed by the firm from this earnings.

There is a relationship between insider trading and the information captured by annual earnings for a large sample of firms. Insider trading changes the annual unexpected earnings. Insider buying interactively confirms the positive information captured by unexpected positive earnings and this communication reduces the noise in unexpected earnings. The result with regard to the adverse information captured by the group with insider selling and negative unexpected earnings is similar but less prominent. The examination also suggests that insider buying and selling conveys information not fully captured by current earnings.

From the Ball and Brown (1968) several studies have documented that unexpected changes in earnings are related with unexpected changes in firm. Their work recognize that market agents learn about earnings and valuation related events from many information sources throughout the year. The financial reports issued by companies are the output of a fairly complete measurement process which also involves some preventive recognition and valuation rules. Hence, annual accounting earnings, at the time of its declaration, may contain a summary of some of the information already communicated to the market by more timely non financial sources. Graham and Dood attempted to study the role of the factors which influence share prices of joint stock companies. One naturally feels that the price of the shares of a company at a point of time will be governed by its future growth potential and past earnings. The past earnings of the firm is measured by the dividends and the price will be determined by dividend payout. Future growth potential or the forthcoming earning of the firm is indicated by the current years retained earning; so, the price of the share at a point of time will be governed by the dividend and retained earnings of the firm. The studies indicate that when share prices are related to the retained earnings and current dividends, higher price earning ratio are associated with higher dividends. Graham and Dood’ assert that the impact of dividend declaration on share price is four times that of retained earnings.

Several factors influence the fluctuations of share prices. Among them, corporate earnings stand greatest in the minds of speculators and investors. It is a common belief for many people that current earnings and prices of common stocks move in strongly related and that changes in current earnings largely explanation for the fluctuations of share prices.

CHAPTER 3:

RESEARCH METHODS

Retianed earning has significant influence on the determination of share prices. To that degree investment in shares show to be growth oriented.

Graham and DL Dood ;(1934);Scurity Analysis, USA.

The analysis utilized Simple Linear Regression. The most basic test involved regressing the dependent variable Share Prices against the independent variables Retained Earnings. This provided a basic test of the relationship between Share Prices and Retained Earnings. The following regression was adopted:

y=a+bx

where

y

is the value of the dependent scale variable Share Prices

b

is the value of the coefficient,

x

is the value of the predictor Retained Earnings

a

Constant

The expectation was that the Retained Earnings would be positively related to Share Prices. That is, increases in retained earnings the firm will be associated with an increase in the firm’s stock price. By contrast, firms with relatively higher earnings volatility or higher leverage will tend to display higher price volatility.

DATA

All the firms that were listed on the Karachi Stock Exchange from 2005 to 2008 have been taken for the research purpose. The annual data of these firms were taken from the various issues of “Balance Sheet Analysis� published by State Bank of Pakistan. Price data has been taken from the annual reports and other annual publications of Karachi Stock Exchange. Data of daily price were taken from the ZHV Securities Karachi.

All of those firms taken into account which has no missing information of data of variable that was included in research.

Sample size

A sample of 38 companies of Textile Industry listed in Karachi stock exchange from the period of 200-2008.

Research Model developed

Y= a + bx

SP= (constant) + RE

Statistical Technique

Simple Linear Regression was used.

CHAPTER 4:

RESULTS

FINDINGS AND INTERPRETATION OF DATA

ANOVAb

Model

Sum of Squares

df

Mean Square

F

Sig.

1

Regression

13595.856

1

13595.856

21.319

.000a

Residual

95659.112

150

637.727

Total

109254.968

151

a. Predictors: (Constant), Retained Earnings

b. Dependent Variable: Share Prices

The ANOVA Table suggested that Retained Earnings explained significant amount of the variance in the Share Price. In above in model table p<0.05 and therefore can concluded that the regression was statistically significant. F-statistic was a ratio of “sample variances� the larger the F-ratio the more variability in the dependent variable in that case it 21.319 which quite larger F-ratio which shown that variation in share prices are largely by predictors.

Model Summary

Model

R

R Square

Adjusted R Square

Std. Error of the Estimate

1

.353a

.124

.119

25.25327

a. Predictors: (Constant), Retained Earnings

The capital “R� in this table is coefficient of correlation which is .353 which shown that there was positive correlation between dependent and independent variables.

The results of model summary suggested that 12.4% variation in dependent variable (Share Price) was due to the Independent variables (Retained Earnings)

Adjusted R Square was a adjustment of R Square that adjusts for the number of explanatory conditions in a model. Unlike R Square, the adjusted R Square increases only if the new term improves the model more than would be predicted by chance.

Adjusted R Square showed that variation in share price is 11.9% by predictors after adjusting the error terms.

Coefficientsa

Model

Unstandardized Coefficients

Standardized Coefficients

t

Sig.

B

Std. Error

Beta

1

(Constant)

27.108

2.233

12.138

.000

Retained Earnings

.073

.016

.353

4.617

.000

a. Dependent Variable: Share Prices

Share Price=27.108+ 0.073(Retained Earnings).

The constant was also significant since p=0.000 which showed that when all independent variables were zero than the value of the Share Price was 27.108.

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