An Assessment of the Influence of Fundamental Factors on Share Prices in Sri Lanka

Master's Thesis, 2003

86 Pages


Table of contents


Chapter 1: Introduction
1.1 Introduction
1.1.1 The role of a share market
1.1.2 History of the stock exchanges
1.1.3 The development of the Sri Lankan share market
1.1.4 The Colombo Stock Exchange (CSE)
1.2 The significance of the study
1.3 Problem of the study
1.4 Objectives of the study
1.5 The limitations of the study
1.6 Organisation of the study

Chapter 2: Literature Review
2.1 Introduction
2.2. Models of Equity Valuation
2.2.1 The early models
2.2.2 The Durand model
2.2.3 Cost of Capital Model
2.2.4 Gordon Model
2.3 A some other important empirical studies
2.4 Some methodological observations
2.5 Substantive findings
2.5.1 Dividend, dividend payout ratio and retained earnings
2.5.2 Growth
2.5.3 Risk
2.5.4 Leverage
2.5.5 Size

Chapter 3: Research Design
3.1 Introduction
3.2 Scope of the study
3.2.1 Sample selection
3.2.2 Criteria for selection of companies
3.2.3 Sample of cross sections
3.3 Conceptualisation
3.3.1 Return
3.3.2 Growth
3.3.3 Risk
3.3.4 Leverage
3.3.5 Size
3.4 Formulating hypotheses
3.4.1 The data
3.4.2 Method of investigation
3.4.3 Measures of variables
3.4.4 The model

Chapter 4: Data Analysis and Presentation
4.1. Introduction
4.2 Result Of Estimations
4.2.1 Choice of the return measure
4.2.2 Choice of the growth measure
4.2.3 Choice of the risk measure
4.2.4 Choice of the size measure
4.2.5 Choice of the leverage measure
4.3 Discussion of results
4.3.1 Over-all performance
4.3.2 Performance of an independent variables

Chapter 5: Main Findings and Recommendations
5.1 Introduction
5.2 Main findings
5.3 Recommendations





This is a study on equity share valuation. In this work, I have tried to study the behaviour of certain fundamental factors determining share price in Sri Lanka. It attempts to answer the following question:

What is the empirical relationship between equity share price and factors like earning, growth, leverage, and risk and company size?

To assess the relative influence of the above mentioned fundamental factors on share price I used regression analysis with standard OLS assumption and continuous cross-section analysis was carried out with log linear regression model for the period 1993 through 2001. The sample consisted of 30 shares from a group of 239 shares of firms in all industries except the bank and insurance industry. On the basis of this study, I found;

i. Dividend appears a powerful influence on share than growth and retained earnings.
ii. Business risk and financial risk cannot to be assessed which are redundant variables. This means there are relatively free from major risk in Sri Lanka Stock Market.
iii. Company size is considerable influence on share prices in which large companies enjoy high value of share.

On the basis of these findings I may make the following observation about the Stock Market in Sri Lanka.

“The market for equity shares is not very sophisticated in its valuation. It goes mainly by dividend and company size factors which are readily measurable. Factor like growth which is difficult to measure (Fernando, 2008)”

Chapter 1: Introduction

1.1 Introduction

Financial assets defer from other economic assets in that every financial asset has a corresponding liability whereas an economic assets does not (Sundharam.K.P.M, 1995).The financial market is a place where financial assets and obligations are exchanged. There are two major components of any financial market, i.e. Money market and Capital market. The capital market is the market where long and medium term financial instruments are traded, as distinct from the money market, which is the market for short term funds. The money market is mainly for adjusting short-term liquidity of the Financial System while the Capital market is used to finance fixed investments for businesses and government.

The economic growth is fuelled by a flow of funds of varying terms. “The term capital market is also used in a broader sense to denote the institutions which channel the supply of and demand for long-term capital, comprising the stock exchange, the banking system, insurance companies and other financial intermediaries.”(PCFB, 1993). And it is intended to mobilise savings and enable large sums of money to be raised through instrument such as shares, bonds Government Securities. The price prevailing in the capital market and the rates of return on these financial instruments have the important economic function of allocating resources and achieving a balance between saving and investment at a satisfactory level of economic activity. “ Within the capital market, the share market was the most backward component, and since a share market is a vital element in a capital market and is associated closely with business enterprise, its modernisation was accorded high priority ” (PCFB, 1993)

1.1.1 The role of a share market

One of the most important components of the capital market is the share market, which provides an organised forum for the trading of shares and bonds, and thereby harnesses both domestic and foreign saving to finance enterprises. “ It is an ‘ essential concomitant of the capitalistic system of economy, indispensable for the proper functioning of corporate enterprise’. ” (Sessional Paper No. VI – 1993, Presidential Commission On Finance And Banking On The Capital Market).

“A Share market, or stock exchange has to perform dual function in an economy” (Wijewardane, 1994) First, by operating a primary market, it provides an opportunity for governments and corporate sector to raise debt and equity capital without going through financial intermediates. Thus, it helps the economy to allocate resources to the most productive uses and build up the capital stock, a prime requirement for economic growth. Second, by operating a secondary market, it helps investors to acquire liquidity and make portfolio re-adjustment so as to raise returns or avoid losses on the basis of new information available.

“The comparative system adopted in stock exchanges are an efficient allocation of funds between competing sector of the economy; the allocation of capital through the price mechanism reflects investors’ valuation of a share.” (Sundharam.K.P.M, 1995). The share price index of a stock exchange is internationally regarded as a barometer of public confidence in the economy. Other instruments such as corporate and government bonds are also normally dealt with on stock exchanges.

1.1.2 History of the stock exchanges

The stock exchange is the market where stocks, shares and other securities are bought and sold. Bourses or stock exchange arose in Europe in the 16th century. Trading was carried on in those exchanges in terms of “securities” which represented goods. Antwerp, Lyons, Amsterdam and London become celebrated all over Europe for their stock exchanges. In course of time, these exchanges, particularly London Exchange, tended to deal only in company shares. The London Stock Exchange may be considered as the earliest of the modern type of stock market. It had more than 500 members in 1802. In course of time, the list of securities traded expanded greatly, the vast majority being international as contrasted with home issue. In New York, the stock exchange came into existence immediately after the 13 colonies become independent to from the United State of America. In 1817, the brokers organised themselves as New York Stock Exchange Board with a definite constitution. There were many changers and reorganizations and amalgamations, till in 1869 the New York Stock Exchange was founded with a maximum membership limited to 1,100.

1.1.3 The development of the Sri Lankan share market

When Sri Lanka was a colony under the foreign powers the plantation industry was given high priority. At the beginning coffee was introduced to Sri Lanka as a main commercial crop. However, after the decline of coffee in the decade of 1870 due to blight, the British plantar decided to introduce tea as a substitute for coffee. As the excess income and profits earned during the boom period of the coffee industry had been remitted in total, the British companies found it difficult to internally finance the necessary investment required to convert to tea plantations. Hence, they commenced the issuing shares both in London and Colombo in order to raise the capital that was required to initiate the tea plantations. The companies registered in London and Colombo were known as sterling companies and rupee companies respectively. In 1896, the Colombo Share Brokers Association was established to be the body responsible for the administration of the Colombo Share Market and marked the inception of the organized share market in Sri Lanka. Subsequently, the name of the association was changed to the Colombo Brokers Association in 1904.

With the commencement of the plantation industry, other commercial organizations were established for the purpose of servicing the requirement of the plantation sector. In addition to the shares of sterling and the rupee companies the shares of Indian and Malaysian companies also were transacted during this period. With the introduction of Exchange Control Regulations in June 1948, the transactions on Colombo Share Market were confined to local companies only.

As noted earlier, owing to inconsistent and anti-private business policies followed by different governments which were in power during 1948 to 1977, the growth of the share market was adversely affected. However, since 1977 the liberal economic policies adopted by the government have shown a tendency toward placing more responsibility on the private sector in economic activities instead of the Government playing a dominant role. The private sector has responded with a rapid expansion since 1977.

The Colombo Brokers Association was active in the share market for a period of about 80 years and was originally established as a replica of London Share Market. However, in contrast to London the share transaction of the Colombo Brokers Association were conducted behind closed doors thus preventing the public from observing the trading process. This resulted in some negative reaction toward its activities. As the Colombo Brokers’ Association realised the importance of mobilizing savings to meet the capital requirements in line with the growth of the private sector, it established a share market open to public on 2nd July 1984.

Meanwhile, another group styled the “Stock Brokers’ Association’ commenced their share market on 2nd December 1984 at another place. As a results hares of the same companies were transacted at different level in mornings and the afternoons without any change in the circumstances. This created confusion in the minds of the investment public which promoted the government appoint a commission to conduct a survey on the Sri Lanka Capital Market. It was recommended that to amalgamate both share markets under the name of Colombo Securities Exchange Limited (renamed the Colombo Stock Exchange in 1990).

1.1.4 The Colombo Stock Exchange (CSE)

The Colombo stock Exchange (CSE) is the only organised market in Sri Lanka for the listing and trading companies’ shares. It provided for both a primary market and a secondary market in which existing shares are traded. The statutory body responsible for regulating the securities market is the Securities and Exchange Commission. The objective of the share market policy should be to establish a fair, efficient and stable share market. Fairness entails provisions for investor protection and information disclosure. Efficiency arises from competition in the provision of securities market service. Stability is an achievement through prudential regulation and supervision of trading, clearance and settlement procedures.

There are 239 companies listed on the Exchange. as at 31st December 2002. The market capitalization of the CSE as at 31st December 2002 was 160 Billion (US$ 1.7Bilion). This amounts to 12% of GDP. There are 20 business sectors represented on the Exchange. “The Stock Exchange is structured as a Self-Regulatory Organization. It is responsible for regulating member firms (stockbrokers) and listed companies. The Central Depository System (CDS) is a 100% owned subsidiary of CSE which provides facilities for the clearing and settlement of securities. The Exchange operates an order driven market using an automated screen based trading system and an automated post trading clearing and settlement system.” (Hand book of listed companies 1998)

There are two major market indices namely the CSE All Share Price Index (ASPI) and the Sensitive Price Index (SPI) to measure the market movements. All Share Index of the Colombo share market has been prepared on the basis of market capitalization which is the internationally accepted measure. The weighting is done in proportion to the ordinary capital issued of the listed companies valued at the current market price. Apart from the All Share Price Index, a Sensitive Price Index is prepared on the basis of selected “Blue Chip” companies which as of year-end 1990 comprise 24 companies. The main purpose of the Sensitive Price Index is to identify the general direction of price movements in the larger capitalization shares. The Sensitive Price Index is calculated in the same manner as the All Share Price Index and 1985 was used as the base year. (The Colombo Stock exchange introduced a new index which is known as the “Milanka Price Index” (MPI) with effect from 4th January 1999. The MPI replaced the Sensitive Price Index. The base index is set at 1000 point. The MPI is conductive to the introduction of index based instruments. It mirrors the changes in the ASPI and the issue of liquidity has also been addressed in its construction. Criteria taken into account in its construction are size and liquidity. Size has been measured by market capitalization as at 30th June 1998 and liquidity has been determined by the number of trading value as a percentage of the average market capitalization as at 1st January, 31st march and 30th June 1998).

The performance of any share market should be assessed from the point of view of both the primary and secondary market operations. The primary market helps to build up capital stock, while the secondary market provides liquidity, profit opportunities, means of risk diversification and facilities for portfolio re-adjustment. On both counts, the key indicators shown by the Colombo Stock Exchange is shown in the table 1.1.

Table 1.1: Colombo Stock Exchange Trading Statistics, 1993-2002

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Source: The Colombo Stock Exchange, (1993-2002).Hand book of listed companies, Colombo, Sri Lanka

1.2 The significance of the study

The prices of the quoted companies’ shares are determined by supply and demand which themselves are influenced by a number of factors. These are divided into two categories as fundamental factors and external factors. Fundamental factors that are derived by each company financial statistics, could be changed by adjusting company performance itself. External factors, such as economic policy, political environment could not be changed like that. Knowledge of the relative influence of fundamental factors on equity share prices is helpful to corporate management, government and investors, Corporate management is generally interested in enhancing the market value of its equity capital for the following two inter-related reasons:

One of the most important indices by which the performance of a company and competence of its management is judged is the price performance of its equity shares. If the equity share of a company enjoys good price performance then it is easier for the company to raise additional funds. In this context, knowledge of the relative influence of various fundamental factors on share prices provides some guidelines for financial decision-making aimed at, among other things, enhancement of market equity value.

As the firm is interested in the buoyancy of its equity, the government is interested in the buoyancy of stock market as whole because it facilitates the flow of capital. The understanding of the determination of share price is useful in the formulating of government polices relating to dividend payment, bonus declaration and personal and corporate taxation which have important bearing on the stock market.

Often investors make wrong decision due to their ignorance or incorrect understanding of the functioning of the stock market. Knowledge of valuation process obtaining on the stock market is likely to dispel wrong notions and forming better judgement, and investment decision. Although its so important to the economy, since there is no empirical research done in respect of all factors affecting in share prices with data relating Sri Lanka stock market, this study provides some guidance to the understanding of share price determination in Sri Lanka.

1.3 Problem of the study

The share prices are determined in accordance with supply and demand. When supply exceeds demand, the price decline and when demand exceeds supply the price rises.

Accordingly, fluctuations in share prices of companies are frequently observed in the market. People who buy and sell shares in the share market with speculative intention very keenly study price fluctuations in order to attempt to maximise their gains (profit). The two major market indices namely the CSE All Share Price Index (ASPI) and the Sensitive Price Index (SPI) are to measure the market movements. The behaviour of these two indices since their inception is indicated Figure 1.

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Figure 1: The behaviour of two indices

The Colombo Stock Exchange, (1993-2002).Hand book of listed companies, Colombo, Sri Lanka

The company share prices in the past seventeen years have fluctuated on several occasions. These fluctuations are clearly reflected by price indices. But, under such fluctuation, each company share price enjoys different price level. “These price of companies shares is determined by supply and demand which themselves are influenced by a number of factors.” (Wijewardane, 1994) “Fundamental factors like earnings, dividend and risk explain the variations in share prices in each individual company” (Chandra, 1975).

Thus, there are two main features in the Sri Lanka Share Market which are similar to other countries. One thing is that as shown by the stock market indices there is fluctuation in share price periodically. Next thing is that company’s share price enjoys significant price level under such fluctuation. Of these statistic is provided that there may be some reason affected to fluctuate share prices and in addition any other reason effect to enjoy different price level each company. That means, although fluctuation of the share prices in time to time each company’s share price level is determined by its fundamental factors. Consequently, such individual company share price level is determined by each company financial statistics. If Company can change this statistical performance the price level could be changed. In this context, “Knowledge of the relative influence of fundamental factors on equity share prices is helpful to corporate management, government and investors.” (Chandra, 1975) So, this is a study on equity share valuation. It attempts to answer the following question.

What is the empirical relationship between equity share price and corporate financial economic factors?

1.4 Objectives of the study

This study aims to achieve the following objectives:

(i) To identify the most significant corporate financial economic factors which have influenced share prices in Sri Lanka
(ii) To analyse the relationship between share price and corporate financial economic factors.
(iii) To identify the influence of corporate financial economic factors in share valuation.

1.5 The limitations of the study

There are 240, listed companies in Sri Lanka. This study covers all these industries, but some limitations are considered. (Describe in Chapter 03). This study is based on secondary data, depend mainly the Hand Books of listed companies in 1989-2002 published by Stock Exchange, and annual reports of companies are considered as a supplementary level. So, validity of those data is depending on that source. This study is limited to a seven-year period 1993-2002.

1.6 Organisation of the study

The study is composed of five chapters. The first chapter deals with the introduction, including the background, significance, problem, objectives and limitations of the study. The second chapter reviews several empirical works in the field of share valuation, the nature of relationship used, methodology employed, and learn about substantive empirical findings. The third chapter discusses the research design relevant to the study. It deals with Scope of the study, Conceptualisation that has been discussed certain stands of theoretical analyses. The purpose is to expound the relevance and nature of influence of the explanatory variables considered in this study, Formulating Hypotheses, Research Methodology adopted to analyse the information devoted to the analyses of certain financial economic factors. Fourth chapter reports the empirical results obtained from estimating the model for selected companies. The model was estimated for different measures of independent variables in accordance with alternative procedure outlined in research methodology (model). The quantitative contribution of variables that emerged generally significant in the best specification was evaluated. Fifth chapter presents the main findings and conclusion.

Chapter 2: Literature Review

2.1 Introduction

Share valuation is an advanced and significant topic in financial literature. “Share prices and its influences of determinants are not certain understand clearly which difference type of markets behaviour determines the difference type of result”. (Fama, 1970) As a result, in the past few decades there has been an explosive increase in research on share price models and its empirical works. Thus, before making an assessment of influence of factors affecting share price in Sri Lanaka Stock Market, It is worth trying to understand what models have been employed so far and the empirical results derived from such studies. So then, this chapter discusses the respective models of equity valuation and the earlier empirical studies and their significance.

2.2. Models of Equity Valuation

Michael Keenan (1970) evaluated that the economic scientists are also doing empirical research on models of equity valuation. To Keenan engaged in major five models can be employed on equity valuation in financial literature. According, a systematic discussion is made here under each of those five models and the outcomes of different studies done based on those models.

2.2.1 The early models

There have probably been attempts to find explanatory predictors for equity share prices so long as equity securities have existed. Formal attempts to develop models of equity valuation closely parallel the development of analytic economics. Such models seem to have evolved as applications of interest rate theory and relate to similar attempts to develop models for interest bearing instruments. There are few academic articles before 1945 in the area of equity valuation models. Tinbergen (1939) is one of the early attempts to develop an econometric model of share price formation. He begins with discussion of what he calls that simple static law “share prices vary proportionally with dividends and, inversely, proportionally with the rate of interest, for which the long-term rate may be taken”. According his hypothesis expected dividends may differ from current constant dividends so price may vary less than proportionally with change in dividend. Tinbergen’s dynamic theory of share price formation can thus be summarized as

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The model was tested in a simple linear form on time series indexed data for different countries. By today’s standards the model is clearly deficient in the statistical procedures employed: but judged in its historical perspective – or even by today’s standards in term of the insight of the theory formulation the study remains an important contribution to the received literature on theory and research methodology in the area of equity valuation.

2.2.2 The Durand model

Durand (1957) published a paper titled “Bank stock prices and the bank capital problem in 1952” as part of the National Bureau of Economic Research’ Financial research program in New York. The purpose of the study was to measure the relative importance of some basic variables that might affect the market price of bank stock.

Durand was concerned that some stocks were selling for less than book value, for he believed that in the long run the ability of a bank to raise capital through a stock flotation depends on whether or not a stock is selling for more than its book value. While a bank could certainly sell stock even if present book value were greater than present market price, it appeared at the time of the study that such equity financing could only be done at rather prohibitive cost.

The question that concerned Durand was “Give a ratio of market price to book net worth, what level of the bank’s rate of return would be necessary to maintain a ratio of at least 100%?” At least one additional factor was thought to influence this relationship, and that was the dividend payout ratio. For this purpose, prepared an estimate as follows;

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From above, Eqns, (1), (2) and (3) were estimated for several bank stock samples and Eqns. (4) and (5) were estimated for four groups of public utility stocks.

The main findings of this study were,

(i) The reduction in the residual sum of squares due to addition of D /E in Eqns. (3) is too large to be attributed to chance.
(ii) The reduction in the residual sum of squares due to addition of D /E in Eqns. (5) is highly significant for two utility samples.

So, Durand’s general conclusion is that the effect of dividend payout on stock price is significant.

In this work Durand explicitly sounded a warning on the theoretical and statistical problems that would arise from this type of research strategy in the area of equity valuation (Keenan, 1970).

2.2.3 Cost of Capital Model

Instead of working directly on an equity valuation model some researchers have preferred to work on solving the relative valuation problem. In such work, the theory and testing related to cost of equity capital or stockholder required rate of return to variables that attempt to specify risk-return expectation in terms of operational measures. The obvious gain of such a structure is the relativistic nature of most of the variables.

In financial literature, the most famous cost of capital model is undoubtedly the Modigliani Miller Model. Modigliani and Miller (1958) Published a paper titled “The Cost of Capital, Corporation Finance, and Theory of Investment” and constructed equation for an electric utilities sample for two years 1947 and 1948 and an oil company’s sample for 1953.

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In this attempt Miller and Modigliani found leverage has positive influence on stock yield. However, mention that caution is indicated with regard to the above test partly because of possible statistical pitfalls and because not all factors that may have a systematic bearing on stock yields have been included.

In 1966 Miller and Modigliani presented their own elaboration of their original model (Miller and Modigliani, 1967)(Keenan, 1970). In this version, there is a shift of focus to;

(i) The development of explicit firm valuation theory - and hence shareholder value model.
(ii) The development of more sophisticated statistical testing procedures.

The two stages least squares regression procedure is used to develop a model incorporating the following variables.

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Abbildung in dieser Leseprobe nicht enthalten = Risk class index

There is an important shift in the type of output demanded from the new research.

Weston (1963) tested the cost of capital and stock yield propositions of Miller and Modigliani (1967) and Modigliani and Miller (1958) by presenting paper titled “A testing Cost of Capital Propositions”. The sample of electric utilities for 1959 was used and Equation estimated;

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Weston found;

(i) In Eqns. (1) debt/equity ratio has a significant influence on the earnings yield of common stocks.
(ii) In Eqns. (2) the coefficients of debt/equity ratio and total assets variables are insignificant and the coefficient of earnings growth rate is highly significant.

Thus, he concluded;

(1) The growth variable has a highly significant and negative influence on stock yield.
(2) When leverage is used as the only explanatory variable, it has a significant positive but insignificant influence on stock yield but when it is used in conjunction with size and growth variables its influence become insignificant.
(3) Size has an insignificant influence on stock yield.

Typical of such approaches is the model formulated by Benishay (1961). Model attempts to examine empirically the determinants of the differences in rates of return on corporate equities. The following equation and variables are included in the Benishay Model (Benishay, 1961).

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In this study Benishay (1961) examined the influence of trend in earnings (X1), trend in market value of equity price (X2), dividend payout ratio (X3), expected stability of future incoming stream (X5), size of firm and liquidity of its shares (X6), and debt equity ratio (X7), on earnings price ratio (Y). he used log values for Y, X3 , X4, X5 and X6 and actual values for other variables. For this study, he used a sample of 56 companies observed for four year (1954-1957) and main findings were;

(i) X1 has a non- significant negative coefficient in his third equation and its performance in the first equation is poor.
(ii) In his second equation, the coefficients of X2 generally have a significant negative sign.
(iii) X3 has negative and statistically significant coefficients.
(iv) X4 has consistently negative significant coefficients.
(v) X 5 has positive coefficient.
(vi) X6 has negative and significant coefficients. The performance of X 6 is better than any other variable.
(vii) X7 has negative coefficient in all the four cross sections.

According to that result, Benishay (1961) concluded as follows;

(1) The influence of dividend payout ratio on earnings – price ratio is negative and significant.
(2) Trend in earnings has no significant influence on earnings - price ratio.
(3) Trend in market value of equity price has a significant negative influence on earnings - price ratio.
(4) Risk has negative, but sometime significant on share price.
(5) Size has negative and significant influence on earnings – price ratio.

2.2.4 Gordon Model

(Gordon, 1959; Gordon, 1962a; Gordon, 1962b)has made different attempts to find explanatory variable to describe the equity valuation process. In 1959, he published a paper titled “Dividends, Earnings, and Stock Prices” and following Equation is constructed based on four industry samples for two-year period.

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Gordon found for this work;

(i) In eqn. (1) a1 ’s are high and stable; a2 ’s are very low.
(ii) In eqn. (2) a1 ’s are much higher than a2 ’s and a3 ’s are very low.
(iii) In eqn. (3) there is improvement in the dividend coefficient, both in statistical significance and in the range of fluctuation. The growth coefficient however is disappointing.

From the above result Gordon concluded;

(1) Dividend has a much higher influence on share price than retained earnings.
(2) Growth coefficient to be disappointed
(3) Risk has a negative, but sometimes non–significance on share price.

In 1962 (Feb) Gordon made another attempt using five industry samples for five-year period on his study of “The Saving, Investment, and Valuation of a Corporation” (Gordon, 1962b). Through this attempt an equation was constructed as follows;

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Gordon (1962b) found for this work;

(i) The influence of dividend on share price to be highly significant.
(ii) The growth coefficients to be substantially larger than those of his earlier work.
(iii) Risk has a negative, but sometimes non-significant influence on share price
(iv) Size has a positive and significant influence on share price.

Again Gordon (1962a) proposed a model by publishing his famous book “Investment, Financing, and Valuation of a Corporation”. The most elaborate attempt, in this model was to find explanatory variables to describe the equity valuation process. This is the model, which was explicitly designed to answer the question as to what variables might explain the value of common stock equities. The six variables are suggested as possible contributions to an equity valuation.

(i) The dividend of the firm.
(ii) The expected growth rate on dividends.
(iii) A measure of earnings instability.
(iv) A measure of the firm’s leverage.
(v) An index of the operating assets liquidity.
(vi) A measure of firm’s size.

In the empirical specification of this model, the six variables are postulated to have a simple multiplicative relation to the dependent variable price. In this work, containing an elaborate exposition of his theoretical and empirical studies Gordon considered the following equations:

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Sample data of food and machine industry for 1954 – 1958 were used for above equation. The equation results indicate the following;

(i) For eqn. (1) Gordon (1962a) found that:

a. Dividend coefficients are highly significant, fluctuate in a narrow range, and are significantly less than one;
b. Growth variable coefficient are highly significant for the food sample and generally significant for the machine sample;
c. Earnings instability coefficients are all negative but not significant for two of five food samples and three of the five machinery samples;
d. Corporate size performs well;
e. The leverage variable has uneven performance – for the food sample it has negative sign throughout and is significant in 3 cases and for the machine sample it has the wrong sign in 4 cases and is not significant even once; and
f. Asset liquidity and debt maturity variables perform poorly.

(ii) Eqn.(2) is a slight modification of Eqn.(1). In it the leverage measure has been changed to (1+h-ih/k) from (1+h) and U has been dropped. Gordon found one difference between the performances of Eqns. (1) and (2). The estimation of Abbildung in dieser Leseprobe nicht enthaltenthe f in Eqn. (2) for the food sample shows ‘dramatic improvement’. The estimations of Abbildung in dieser Leseprobe nicht enthalten for the machine sample, however, do not respond to the changes in the leverage variable.

(iii) Eqn. (3) is Eqn (2). With vq, the equity accretion rate, added to the growth variable and 1+q, the outside financing rate, a new variable. For the food sample the coefficients of outside financing though right in sign in every year, is not significant. The performance of the other variables, in general, for the food sample, suffered on incorporation of outside equity financing. Tearnings instability and size coefficients are weaker slightly and in some years the leverage coefficient is materially lower. Only the asset liquidity variable remains unaffected. For the machine sample, Abbildung in dieser Leseprobe nicht enthaltendose not perform well and the growth coefficient is lower. For the other coefficients, there is no material change.

As a result, Gordon found for this work:

(1) The influence of dividend on share price to be highly significant.
(2) The growth coefficients to be generally significant.
(3) Risk has a negative, but sometimes-non-significant influence on share price.
(4) The performance of leverage to be uneven for one samples it has negative and often significant influence on share price and for the other sample, it has positive but insignificant influence on share price.
(5) Size has a positive and significant influence on share price.

By several elaborate attempts of his work, Gordon found explanatory variables to describe the equity valuation process. Such explanatory variable can be identified as Return, Growth, Risk, Leverage, and Size.

By using above variables Chandra (1975) has conducted a study to assess the effects of certain economic factors on share prices in India. For examine the determinants of share prices, Chandra’s five independent variables were, viz., return (arithmetic average of earnings per share (EPS) of last three years and arithmetic average of dividend per share(DPS) for last two years), growth (growth in EPS, DPS, and based on retained earnings), risk (variability of EPS), leverage (net worth plus preference plus debenture divided by net worth; total assets plus the difference between total assets and net worth divided by total assets; all measures relate to previous period and use book value) and Size (total book value assets on the previous year and sales in the previous year). Share price was measured as the arithmetic average of the high and low prices over the financial year of the company.

To study the influence of these variables he used the multiplicative relationship: Chandra’s (1962a) methodology included multiple regression analysis with standard OLS assumption. To overcome the problem heterroscedasticity either variables may be deflated or log linear model be used.

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Continuous cross-section analysis was carried out with the above equation using different variable measures for the period 1960 through 1970. The sample consisted of 50 shares drawn at random from a group of 110 shares of firms in all industries except the banking, insurance and textile industries.

The main findings of his estimation are;

(i) Return (dividend) has an overwhelmingly powerful influence on share price.
(ii) Growth of return has very weak and often insignificant influence on share price.
(i) Risk has no influence on share price: it is a redundant variable.
(ii) Leverage has no influence on share price it is a redundant variable.
(iii) Size has a positive and significant influence on share price.

2.3 A some other important empirical studies

Fisher (1961) , “Some Factor Influencing Share Prices”

It was the purpose of this paper to estimate the influence of dividends; undistributed profit and company size on share price obtain from five crosses – sectional samples of equities quoted on the London Stock Exchange. Sample study used five industry samples between 1949 and 1957.

Equation estimated;


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An Assessment of the Influence of Fundamental Factors on Share Prices in Sri Lanka
University of Kelaniya
Master of Commerce
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assessment, influence, fundamental, factors, share, prices, lanka
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Dr. Sriyantha Fernando (Author), 2003, An Assessment of the Influence of Fundamental Factors on Share Prices in Sri Lanka, Munich, GRIN Verlag,


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