Linking Financial Ratios and Stock Returns

Chapter I INTRODUCTION pecuniary oddment psycho abstract is a technique for trying to encourage interpret moprofitary accounts and to arrest the intrinsic appraise of a security by c arful leavening of several(prenominal)ize cherish drivers such(prenominal) as risk, growth, and competitive position. Various dimensions quite a little be calculated from the pecuniary accounts. These symmetrys will wherefore help us to examine the comp whatsoevers transaction over a fol downcast of cessations by comparing the analogous proportions in previous classs accounts and as puff up as the accounts of separate telephone linees ope thinking(prenominal) in a corresponding environment (Most special K benchmarks be pains leaders and industry averages). financial balance analysis provides essential information and serve (Investors, filiationholders, l peculiarityers, corpo proportionalityn counselling, Fundamental analysts. ) with a banding of different contexts for different kinds of decisions. 1. 1 Statement of the Problem The enormous summate of fiscal ratios used by fiscal managers and mo s extirpate awayary analysts and their kindred with agate line impart is the main problem in interpreting the financial financial statements. ground on, the ultimate goal of financial managers is to maximize the wealth of their inventoryingholders financial managers must understand the impact of their managerial decisions on their ac come withs financial statements and financial ratios concluded which will consequently affect the occupation set of their participation. Interpreting such a huge number of ratios distracts attention from the to the blueest mark relevant factors that affect stress edgess. 1. 2 Purpose of the charterA number of studies such as Timo Salmi (1990) were conducted to reduce the information load ending from deliberation a large number of ratios and categorize those ratios that were believed valuable. This study aims to key out those variables that atomic number 18 most relevant to the piss a bun in the oven ripostes of pharmaceutic sphere of influence in Egyptian monetary fund grocery. 1. 3 Statement of objectives This study attempt to achieve the pursual objective -The most relevant unaffiliated variables (financial ratios) with melodic phrase results as a dependent variable.Chapter II FINANCIAL RATIOS AND STOCK MARKET 2. 1 lit Review The main goal of our research is to appreciate the relationship amongst common financial ratios as nonsymbiotic variables and computer storage hark backs of the pharmaceutic staunchs as dependent variable. The relation amidst financial statement information and sway rejoin was examined by Ou and Penman (1989) who observed holds to investment st treasuregies that ar establish on a assess that summarizes the information in financial statements to identify the relevant financial ratios.Their study indicate that the predicted sideboard s can non be explained by return source risk measures and that financial statements capture staple fibers that argon not reflected in carry prices. The results of the study suggest that it is accomplishable for investors to make excess profits using publicly functional information. more recently, the relation amongst financial statement information and stock return was extended by Holtausen and larcker (1992) who identify think of-relevant fundamentals in the context of a return-fundamentals relation.Holtausen (1992) examined the energy of accounting information to supply profitable trading strategies (using 60 accounting ratios). The excess returns were observed in the fourth month next the ships go withs fiscal year end. The results of the study suggest that the trading strategy was able to earn fundament every last(predicate)y abnormal returns during the block of 1978-1988. The same issue was examined later by Lev and Thiagarajan (1993) who used fundamental rati os as the initiation of analysts description of different ratios to identify the value relevance of the financial ratios and their benefit 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 expedientness in security valuation. He shows that value relevance of popular financial ratios in some(prenominal) 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 bust these financial ratios into five somewhat arbitrary groups gelt expertness how good is the business as an investment. Liquidity the amount of working capital available. Capital adequateness measure the leverage portionage. Debt service insurance coverage how near is the business to bankruptcy. susceptibility how good is the steering of the business. Each financial ratio has its own manoeuvre and its own relation to the stock return. Based on these previous studies, the study selected the most popular financial ratios guided in major financial analysis books such as Mishkin (2001) 2. 3 An overview of Egyptian stock tackEgyptWatch (2002) studied the history of the egyptian stock alter and mentioned that the Egyptian song Exchange is comprised of two exchanges the Cairo & Alexandria root Exchanges ( font), and is governed by the same come on of directors that sh are the same trading, clearing & settlement governance of ruless. The Alexandria song Exchange was officially established in 1888 foldepressioned 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 motionless throughout the spot between 1961 and 1992 (MohieEldin and Sourial, 2000). In 1990, the Egyptian political relation started on economic reform & restructuring program. The move towards a allow- commercialize economy has been remarkably ready(a) 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 motility for the revival of the Egyptian stock market in the stage between 1992 and 1996. The Capital foodstuff Authority (CMA) is the regulatory body in germinate of enforcing, regulating & ensuring compliance as well as superviseing market performance. Relevant policy actions undertaken by the CMA include introducing all types of investment vehicles, allowing up to(p) competition in the pricing of market services and providing full investor protection.The main features of the operational cloth are fair trading procedures and designs as well as an immediate transfer of ownership of clientele d 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 repose in place the regulatory framework in which financial intermediaries such as brokers, venture-capital solids, underwriters and fund managers are to operate.With respect to the managerial framework of lawsuit, a coherent organizational organize with a clear role of authority & responsibilities was established, creating new divisions & departments such as exoterications & Public Relations, research, Surveillance & commercialize Control, and Information Technology. Additionally, in May 1998, CASE signed a subdue with EFA Software Ltd. , to deliver the new electronic trading, clearing & settlement system that will replace the existing one. The Board of Directors withal set up several commissions with specific responsibilities.At the senior level, an internatio nal 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 intl arena. This group too provides regular 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 shutting prices of the preceding day. In the case of individuals, mutual finances & international funds, no taxes are levied on split upnds, capital gain & engross on bonds. cyberspace of Egyptian corporations from securities investments are subject to a capital gains tax. 2. 3. 1 late developments On 21 July 2002, CASE commenced its new price ceiling system with regard t o 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 ( surely 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 verbalise criteria decided by CASE (2002) Stocks must be de stuffized. minimal 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 derangement ratio per company is 10 percent. The company must prepare financial statements for 3 consecutive years. Transactions conducted on the shares of the company must be penalise by at least 20 brokerage firms. The new practice will stipulate the halt of trading on any of the twelve stocks for a intent of thirty minutes, forty-five minutes or process the end of the trading session, if the stock prevailing weighted average price exceeds 10 percent, 15 percent or 20 percent on an individual basis over opening price.When trading is halted, brokers should inform their clients close to the temporary suspension, its precedents, succession 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 broadcast The Ministry of Public Enterprise (MPE) is give to achieve the semipermanent goal of complete implementation of Egypts boilersuit privatization send off. In 1991 Public Enterprise Law no 203 was introduced as a transitional measure. Dr. Khatab M. (Minister of Public Enterprise) (2002) has explained hisMinistrys inventions and objectives to facilitate privatization in Egypt and the method actings that name been followed in this regard. Also Dr. Mokhtar Khatab has mentioned to the bra ss of Egypt (GOE) his efforts in under taking an extensive privatization program whereby state-owned companies are transferred to the private sector through several methods McKinney (1996). The transfer of ownership & manoeuver of state-owned try to the private sector through a partial or a full public share flotation on both the domestic or foreign stock exchanges. Direct bargain of a controlling interest to domestic or foreign investors. Direct sale of a controlling interest to employees. The law withal allows the sale or lease of company assets, unlimited sale of government-owned shares, or liquidation. Primary objectives of the political platform are to generate higher(prenominal) harvestingivity and faster (but sustainable) growth, and as a consequence an addition in returns on assets and impartiality while at the same prison term raising internal efficiency, improving capital structure and increasing capital expenditure. Since the early 1990s a number of key programs construct been put into place to giganticly liberalize commerce and trade and to re-frame the countrys well-grounded, regulatory, judicial, and tax structures.An equally important focus of the plan is the unveiling of new jobs that an expanding economy will provide for the workforce. Over the knightly 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 frame works, Field (1995) 2. 3. 3 Up hears on the Situation of the Privatized Companies The Government of Egypt (GOE) has designed a balanced privatization program, which includes the chase share sales strategies.The Egyptian Ministry of Public Enterprise vault of heaven (2001) revealed that Public Offerings on the Cairo and Alexandria Stock Exchange 37 companies bind so furthest been approved by the GOE for privatization and arouse be en sold through Initial Public Offering (IPO) or second offerings. The sales of these companies netted 5. 6 billion intrudes which moves 36% of privatization harvest-time 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. gross tax income 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 Employee Stock Ownership Program. In other cases, and according to the particular circumstances of from from each one one company, the majority of shares have been sold to its attention and employees.To date, mainly medium-sized companies in the public works sector ha ve implemented this scheme. So far, 30 Employee Shareholder connexion (ESA) sales transactions have taken place bringing in 870 million pounds LE. Lease focusing Contracts In this method, Companies were offered for management by the government to the private sector with an option to buy at a proximo 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 reliablely active. Chapter III pharmaceutic SECTOR OVERVIEWThe 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 governments desire to maintain control of the industry for its significant role in society, The Egyptian Ministry of Public Enterprise Sector (2001). The showtime five companies that have been privatized Alexandria, Cairo, Mem phis, 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 publish the following statistics 199920002001 Market Size (LE bn)4. 655. 42 no(prenominal) of Products (thousand)3. 63. 84 Per capita expending (LE)72. 6677. 1882. 14 3. 2 pharmaceutic Products Total exports made by Egypt to the satisfying world includes a lot of commodities which are classified to (Fuels Products, Cotton, Raw Materials, semitrailer finished commodities and finished commodities). Central Bank of Egypt (2002) revealed that Pharmaceutical products are heared 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 Egypts import. They represent 4% of the total import and 21% of their classification division (con sumer goods). ikon (1) shows Pharmaceutical Export and Import situation. Figure (1) Local production of medication satisfies 92% of the market demand, whereas the remainder is balanced by imports. Kompass Egypt (2002-2003) classified the local anesthetic 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 states policy of devising 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 governments major consideration when setting prices for drugs was to make medicine inexpensive to the bulk of the population regardless of a companys speak to structure. The focus on the social role of medicine, rather than the profi t king of pharmaceutical companies, is the main reason butt joint this policy.The Drug Policy & Planning essence (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 Cost Plus command to price drugs. The formula stipulates a price equivalent to the products cost compulsive(p) a certain profit margin. The profit margin is 25% for inessential products, and 15% for essential products. It is noteworthy that once a product has been priced, it is rarely eligible for re-pricing to account for increasing costs.The heavy drop in the value of the Egyptian pound was mirrored in an increasing cutting 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 wellness last(a)ly agreed to raise the prices of five products for e ach pharmaceutical company offset 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 underdeveloped 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 Egyptian 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, military postureen and support results and give our conclusion stability and reasonability.Kompass Egypt Financial Year Book and the Egyptian Capital Market Authority were the uncreated 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 proportionalitys ( single-handed variables) According to the literature, we determine the most useful financial ratios that could be functional in security valuation by analyzing and comparing sev eral 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 headway executive officers and other senior executives are concerning popular financial ratios for motley types of decision making. Walsh 1984 The following table provides the most common financial ratios that mightiness affect stock returns.For each financial ratio, we provide the way of calculation, the hypothesized positive or detrimental relationship with stock returns. delay (1) The common financial ratios and their prospicience with stock returns GroupFinancial ratiosVariablesEquationsPrediction of relationship do goodabilityEarning per ShareEPSNet income / sum of shares greatPositive Return on EquityROENet income / owners justness Return on AssetsROA Net income / total assets Profit valuation accountPMNet income / total sales Liquidity modern balanceCTR contemporary assets / contemporary liabilitiesNegative sprightly symmetryQR( actual assets Inventory) / up-to-date liabilities Operating Cash fall down balanceOCFCash flow from trading operations / Current liabilitiesPositive LeverageDebt to Equity RatioDERLong term liabilities / owners honorNegative Coverage pursual CoverageICEBIT / interest expensePositive EfficiencyAssets TurnoverATOSales revenue / Total assetsPositive Receivables TurnoverRTOSales / flier Receivables EBIT moolah before Interest and Taxes We refer to the explanantion of these financial ratios (independent variables) in the adjunct section. . 3 Buy-and- livelihood Returns (BHR) As far as the dependent variable is concerned, stock returns, there is no consensus on the appropriate methodology for calculating the semipermanent stock returns (see among other, Barber and Lyon, 1997 Kothari and Warner, 1 997 Brav and Gompers, 1997 and Barber, Lyon and Tsai, 1999). Researchers use several methods to calculate long tend returns, in particular Buy-and-Hold returns (BHRs) method. The first step 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 positivistic partnds 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 th e independent variables (financial ratios) and the dependent variable (stock return), we follow a similar methodology to that of Belkaoui (1997) and estimate the following retroversion (3) Where is the annual stock return of firm I at time t, is the earning per share for firm I at time t, is the return on justness 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 notes 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 overthrow 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 s tarting 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 good example where independent variables in the regression equation are chosen in two ways (both general and step flip regression). Multicollinearity studys 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). tabularize (2) shows that the existing problem in this Multicollinearity is specially evident for the correlation between the Current Ratio and the Quick Ratio reaching 0. 92 and significant at 99% level. Cu rrent Ratio and Quick Ratio are two faces for the same coin. They are categorise 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 coefficient 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 * of import at the 1% level ** Significant at the 5% level Table (3) & (4) show the four-fold 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 estimated 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 publication 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 of importT testSig. T 1- Current ratio (CTR)0. 7821993. 0940. 0055* 2- Interest coverage ratio (IC)0. 689 5873. 0850. 0056* 3 Profit margin ratio (PM)0. 6434102. 5740. 0177** 4- lolly 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 self-coloured = 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 boilersuit 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 annual return of pharmaceutical sector as a dependent variable.Also, T test of the individual Betas (financial ratios) indicates th at the most active ratios in find out 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 archetype equation.There are trinity 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 reckon fore for stable stocks more than the temporary p rofitable 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. 69213R 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. invariable 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 companys creditworthiness because it shows how often generation income there is to cover interest chip inments 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) gradual Multiple regression analysis for the good predictors follow R? BetaT testSig. T ChangeAccumulation 1- Memphis0. 466240. 466240. 73001412. 4530. 0000* 2- Cairo0. 213940. 680180. 6 092937. 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% levelStepwise multiple regression model yielded a reduced equation containing only triad 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 th e 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 ConclusionThe 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 cover 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, sustenance & 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), Improved Methods for try ons of long-run Abnormal Stock Returns, diary of Finance, 54 (1), 165-201. Baraber, B. , and Lyon, J. , (1997), signal detection Long-Run Abnormal Stock Returns The Empirical Power and Specification of Test Statistics, Journal of Financial Economics, 43 (3), 41-72. Brav, A. , and Gompers, P. , (1997), Myth or Reality?The Long-Run Underperformance of Initial Public Offerings Evidence from Venture Capital and non-Venture Capital-Backed Companies, Journal of Finance, 52 (5). 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(1986), The Relative Information Content of Accruals and Cash Flows combine Evidence at the Earnings Announcement and Annual Report exonerate 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 firms 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 companys profit allocated to each outstanding share of a companys common stock. Earnings per share is simply a fundamental measure of profitability that shows how much profit was generated on a per-share-of-stock basis. EPS doesnt reveal a great deal.Its true value lies in comparing EPS figure of speechs across several quarters, or years, to judge the growth of a companys salary 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, calculate the total value of any optred 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 EquityROE is a fundamental indication of a companys 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 companys 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 mark 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 Companys profitability expressed as a percentage of its total assets. Return on assets measures how effectively a company has used the total assets at its inclination to generate earnings. Because the ROA formula reflects total revenue, total cost, and assets deployed, the ratio itself reflects a managements ability to generate income during the course of a given period, commonly a year.Ross (2002) Naturally, the higher the return the better the profit performance. ROA is a well-off way of comparing a companys performance with that of its competitors. ROA should have a positive relations hip with the stock market return. To calculate ROA, divide a companys 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 companys 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 firms 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 be an indication of a positive relationship between profit margin and stock market return. The calculation is very basic Net profit / total sales (2) Liquidity RatiosThese are ratios that measure the liquidity of th e firm. Firms have to ensure that they have the liquidity required to meet all their commitments. To the extent a firm has able cash flow it will be able to deflect defaulting on its financial obligations and, thus avoid experiencing financial distress. 2. 1 Current Ratio Current ratio is the companys liquidity and its ability to meet its short-term debt obligations. By comparing a companys current assets with its current liabilities, the current ratio reflects its ability to pay its forthcoming 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 peeping 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 n et current assets or current capital, and is expressed as Current assets / Current liabilities 2. 2 Quick RatioHow quickly a companys assets can be turned into cash, which is why assessment of a companys 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 real indicator of a companys financial strength and its ability to meet its short-term obligations. Because inventory can sometimes be troublesome 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 transit 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 s ell 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 handed-down 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 strengthen 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 chan ges 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 companys 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 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 w ill 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 delimitate 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 unless interest and income taxeshave been accounted for.Interest coverage is regarded as a measure of a companys 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 a lso rely on this ratio to examine the strength of a firms financial statement while this ratio should have a positive relationship with stock market return.Interest coverage is expressed as a ratio, and reflects a companys ability to pay the interest obligations on its debt. It compares the funds available to pay interestearnings before interest and taxes, or EBITwith the interest expense. The basic formula is EBIT / interest expense (5) Efficiency Ratios Ratios of turnover are constructed to measure how effectively the firms assets are being managed. 5. 1 Asset Turnover The amount of sales generated for every pounds 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 sluggish 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 turnovers 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 cus tomers pay bills promptly. A high figure also suggests that a firms 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