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Share Price Earnings Ratio And Foreign Exchange Rate Finance Essay

The stock market has become an important market which plays a vital role in the economy that develops capital formation and sustaining economic growth. Stock market is a listing stock and a statistic reflecting the composite value of its components. It is used to represent of its characteristics of its component of stocks, in which it have the same commonality such as trading in the same stock market, belong in same industry or having similar market capitalization.

In the securities market, either primary or secondary market, the price of equity is influenced by a number of factors such as the dividend per share and earnings per share (Gompers, Ishii and Metrick 2003). With the movement of the equity’s prices, it will subsequently affect the stock market index performance in a country.

Stock market indices are used as indicators for the performance of the stock market as a whole. A stock market index can be based on a stock exchange or on only a sample of stocks. Stock index is the general behaviour of stock prices by measuring the current price behaviour of representative group of stocks in relation to a base value set at an earlier point time.

The indices can simply computed on the simple average closing price basis while others are derived using a weighted average method. In Bursa Malaysia, all the indices were calculated electronically on minute by minute basis which are made it available immediately to stock broking companies and other real time market information subscribers.

BACKGROUND OF STUDY

In this study, it will determine the correlation of earnings per share (EPS), price-earnings ratio (P/E Ratio) as well the foreign exchange rate (USD/MYR) with the Kuala Lumpur Composite Index (KLCI) performance. It is subsequently important for this research to be conducted in order to give some thoughts and idea, perhaps to the manager and investor in making decision. On the other hand, there are many investors sometimes make speculation on the stock market which regard bearing huge losses.

1.2 PROBLEM STATEMENT

This study is to determine the relationship between the macroeconomic variable which is foreign exchange rate (USD/MYR) and fundamental variables (EPS and P/E Ratio) with the stock market index in Malaysia market, which is the KLCI.

OBJECTIVE OF STUDY

This study will attempt to identify the most influencing factors or determinants towards the changes on Kuala Lumpur Composite Index (KLCI). The main objectives of this study are:

To determine the significance correlation between the macroeconomics variables and the sector market index performance that will be measured through Bursa Malaysia sector index which are KLCI with the selected macroeconomic variable which are the Foreign Exchange Rate (USD/MYR) and the fundamental variables which are Earning Per Share (EPS) and Price-Earnings Ratio (P/E Ratio)

To provide evidence regarding the relationships of macroeconomic variables and the stock market index in Malaysia market so that all of the information can give new knowledge about this matter.

LIMITATION OF STUDY

This study is based on the data collected from the secondary sources. This has produced a difficulty in finding the appropriate data, journals and articles. The information needed is not easy to access due to unavailability of the data especially during the using of Internet services. Some of the information is unpublished through the online network. Besides, the data gained is also not updated.

SIGNIFICANT OF STUDY

To complement the past literature in this area to provide knowledge about this matter.

To help the investors to predict the future stock market movement from the past data gathered.

To help better understanding about the importance of the correlation between the macroeconomic and fundamental variables with the stock market index, KLCI.

SCOPE OF STUDY

The scope of this study would cover the Bursa Malaysia stock market index that include Kuala Lumpur Composite Index (KLCI) of the company listed in the Bursa Malaysia and also the selected fundamental variables (EPS and P/E Ratio) and the macroeconomic variable, foreign exchange rate (USD/MYR).

Time horizon of this study is cross-sectional studies, which the data will be gathered just once over a period. This study will use the monthly basis data from the year 1997 until 2007 as a time frame for this study. The selection on the 10-year duration of time frame as there is different market sentiment happened during the period for instance the financial crisis. It would be a good comparison to see the absolute correlation between the variables with different market condition.

DEFINITION OF TERMS

KLCI – Kuala Lumpur Composite Index

The Kuala Lumpur Composite Index (KLCI) is a capitalization-weighted stock market index introduced in 1986. Previously, it is known as the Kuala Lumpur Stock Exchange (KLSE) that consists of approximately the top 100 companies which listed on the Malaysia bourse. Currently, it is now known as the FTSE Bursa Malaysia KLCI which was implemented on the 6th of July 2009 that comprises the largest 30 companies listed on the Malaysian Main Market by full market capitalization that meet the eligibility requirements of the FTSE Bursa Malaysia Index Ground Rules. Basically, the KLCI is used to provide a performance indicator for the share prices in the Malaysian market.

Earnings Per Share (EPS)

Earnings Per Share (EPS) generally is considered the single most important variable in determining a share’s price. Besides, it is also a major component of the price-to-earning valuation ratio. The EPS shows the amount of money to which a shareholder would be entitled in the event of the company’s liquidation and it is only applies to common shares. EPS serves as an indicator of a company’s profitability, which a portion of company’s profit allocated to each outstanding share of common share. Basically, EPS can be calculated by dividing a company’s total earnings by the number of outstanding shares.

Bursa Malaysia

Bursa Malaysia is a stock exchanged located in Kuala Lumpur, Malaysia where equities, derivatives, and other financial securities are trade on a daily basis. It operates a fully-integrated exchange, offering the complete range of exchange-related service including trading, clearing, settlement and depository services. Today, Bursa Malaysia is one of the largest bourses in Asia with just under 1,000 listed companies offering a wide range of investment opportunities to the investors. Companies are listed on Bursa Malaysia Securities Berhad Main Market and ACE Market. Bursa Malaysia is committed to maintain an efficient, secure and active trading market in assisting the development and enhancement of the Malaysian capital market.

Price-Earnings Ratio

Price-Earnings Ratio (P/E Ratio) is short for the ratio of a company’s share price to its per-share earnings. For the calculation of the P/E, it may be calculated simply by taking the current stock price of a company and divide by its earnings per share (EPS). Most of the time, the P/E is calculated using the EPS from the last four quarters. Companies that are not profitable may probably have a negative EPS, pose a challenge when it comes to calculating their P/E. Theoretically, a stock’s P/E will tells how much investors are willing to pay per dollar of earnings. Historically, the average P/E ratio in the market has been around 15-25. This fluctuates significantly depending on the economic conditions. If the P/E is on the higher side when compared to the industry averages, it means the market is expecting some positive events from the company as far as earnings are concern

Foreign Exchange Rate (USD/MYR)

The foreign exchange rate specifies between two currencies on how much one currency is worth in terms of the other. In this study, the measurement used is RM per unit of US$. The US$ rates used are the average of buying and selling on inter-bank rates.

ORGANIZATION OF PROJECT PAPER

This project paper consists of few chapters that come with various parts under each of the chapters. The following are the contents of each chapters covered in this project paper:

Chapter 1: Introduction, Background of Study, Problem Statement, Objective of Study, Limitation of Study, Scope of Study, Significant of Study and Definition of Terms.

Chapter 2: Literature Review and Theoretical Framework.

Chapter 3: Research Methodology and Data Analysis, Data Sampling and Data Collection.

CHAPTER 2

2.0 LITERATURE REVIEW

An efficient capital market suggest that the security prices will adjust rapidly to the arrival of new information, and therefore the current security prices fully reflect all available information. The semi-strong efficient market hypotheses asserts that security prices adjust rapidly to the release of all public information that includes all non-market information such as earnings and dividends announcement, price to earnings (P/E) ratios, dividend yield ratios, price book value ratios, stock splits, news about the economy and political news ( Reilly and Brown, 2006).

According to Gompers, Ishii and Metrick, 2003, in the securities market which comprise of the primary and secondary market, the movement of the stock’s price is influenced by the factors that include dividend per share, earnings per share and also the price earnings ratio. It shows that these variables subsequently have correlation to the stock market index performance.

Basu (1977) found that there is a relationship exists between historical PE ratios and the subsequent risk adjusted stock market performance. Such relationship runs against the semi strong form EMH as it suggests that investors could employ publicly available PE ratios to

predict future rates of return.

Maghyereh (2002) investigated the long-run relationship between the Jordanian stock prices and selected macroeconomic variables, again by using Johansen’s (1988) cointegration analysis and monthly time series data for the period from January 1987 to December 2000. The study showed that macroeconomic variables were reflected in stock prices in the Jordanian capital market.

The impact from both factors for instance the micro and macro-economics have significant relationship on equity pricing in the stock market which subsequently affect the performance of the stock market index. Corwin, 2003 said that declining dividends and earnings in the market may have negative impact on equity pricing and vice-versa.

According to Maysami, Lee and Mohamad (2004), the stock prices should reflect expectations about future profit and corporate profit generally reflect the level of economic activities. If the stock prices accurately reflect this underlying fundamental, then the stock prices should be employed as leading indicators for future economic activities and not the way around. Therefore the study on the causal relations among the macroeconomic variables and stock prices are important in the formulation of the nation’s macroeconomic variables.

Islam (2003) conducted the studies in examining the short run dynamic adjustment and long term equilibrium relationships between the Kuala Lumpur Composite Index and the selected macroeconomic variables (interest rates, exchange rates, inflation rates and industrial productivity). He found that the existence of the short runs (dynamic) and the stable long run (equilibrium) relationships between stock returns of Kuala Lumpur stock market and that selected macroeconomic variables by using the monthly data from January 1990 to June 2002.

Kasman (2003) investigated the relationship between stock prices and exchange rates by using high-frequency data of exchange rates and aggregate stock indices of Turkey. His result indicate that the existence of long run stable relationship between stock indices and exchange rates.

Through the employment of Hendry’s (1986) approach which allows making inferences to the short-run relationship between macroeconomic variables as well as the long-run adjustment to equilibrium, they analysed the influence of interest rate, inflation, money supply, exchange rate and real activity, along with a dummy variable to capture the impact of the 1997 Asian financial crisis.

In a study of the impact of dividend and earnings on stock prices, Hartone (2004) argues that a significantly positive impact is made on equity prices if positive earnings information occurs after negative dividend information. Also, a significantly negative impact occurs in equity pricing if positive dividend information is followed by negative earning information. Docking and Koch (2005) discovers that there is a direct relationship between dividend announcement and equity price behavior. Al-Qenae, Li & Wearing (2002) in their study of the effects of earning (micro-economic factor), and interest rate (macro-economic factors) on the stock prices on the Kuwait Stock Exchange, discovered that the macro-economic factors significantly impact stock prices negatively.

2.1 THEORETICAL FRAMEWORK

There is a classical theory that explained the correlation between the macroeconomic and fundamental variables with the stock market index, KLCI. This study tries to look at the possibility of the relationship between the dependent and the independent variables in Malaysia market.

Dependent variable: Bursa Malaysia Stock Index: FTSE Bursa Malaysia KLCI.

Independent variables: EPS, P/E Ratio and Exchange Rates (USD/MYR).

To be clearly seen, below is the schematic diagram to show the relationship between the dependent and independent variables:

Figure 1: Relationship Diagram

Independent Variables Dependent Variable

Earnings Per Share

FTSE Bursa Malaysia KLCI

P/E Ratio

Foreign Exchange Rate

Base on the schematic diagram above, it can be elaborated that the performance of FTSE Bursa Malaysia KLCI are determined by the earnings per share (EPS), price-earnings ratio (P/E Ratio) and the foreign exchange rate (USD/MYR). The dependent variable (FTSE Bursa Malaysia KLCI) will reflect in any changes in independent variables (EPS, P/E Ratio and foreign exchange rate (USD/MYR).

CHAPTER 3

3.0 RESEARCH METHODOLOGY

Introduction

After gathering all the information from introduction and literature review, it may now proceed with the methodology and data that need to be discovered deeply. Perhaps, it is to get the accurate information from the real sources. To achieve this, it needs to know and understand the study very well and explore the appropriate method for the research.

Data Analysis

The statistical tool that will be used in this study is the Multiple Linear Regression Model as well as the t-test analysis from the SPSS software to identify the correlation and relationship between the independent variables with the dependent variable. Multiple Linear Regression Model aids in understanding how much of the variance in the dependent variable is explained by a set of predictors. This type of analysis is also to trace the sequential previous that cause the dependent variable through path analysis. With that, this model is more appropriate to be used since it can explain the correlation between the dependent and independent variables much better. Besides that, the t-test analysis will be use as a test of the hypothesis generated that the difference between the two responses measured on the same statistical unit.

In this research, there will be three hypotheses to be tested using the regression to see whether it is applicable in FTSE Bursa Malaysia KLCI, which are:

Hypothesis 1

H0: There is no significant correlation between EPS and FTSE Bursa Malaysia KLCI.

H1: There is a significant correlation between EPS and FTSE Bursa Malaysia KLCI.

Hypothesis 2

H0: There is no significant correlation between P/E Ratio and FTSE Bursa Malaysia KLCI.

H1: There is a significant correlation between P/E Ratio and FTSE Bursa Malaysia KLCI.

Hypothesis 3

H0: There is no significant correlation between foreign exchange rate and FTSE Bursa Malaysia KLCI.

H1: There is a significant correlation between foreign exchange rate and FTSE Bursa Malaysia KLCI.

3.1 DATA SAMPLING

This study will focus on the performance of the Malaysian stock market index, which currently known as the Kuala Lumpur Composite Index (KLCI) between the year 1997 to 2007 in monthly basis. Prior to the year 2009, the KLCI is basically consists of approximately the top 100 companies which listed on the Malaysia bourse.

On 6th of July 2009, the KLCI was transformed into the FTSE Bursa Malaysia KLCI. It consists of the 30 largest companies by market capitalization instead of the previous 100 stocks in the KLCI. Despite the change, KLCI will still continue to be the index for the Malaysian stock market. The sample of this study would be the fundamental variables, which are the average EPS and P/E ratio to the KLCI as well as the macroeconomic variable, foreign exchange rate from the duration selected.

3.2 DATA COLLECTION

Data concerning on the macroeconomic and fundamental variables and the Bursa Malaysia stock index will be gathered to see whether there are any correlation between these variables with the performance of KLCI as being the main objective of this study. The secondary data regarding the index will be collected from the Bank Negara Malaysia includes the stock market index, KLCI. For the independent variables that include foreign exchange rates, earnings per share and price-earnings ratio, the data will be collected from Monthly Statistical Bulletin published by Bank Negara Malaysia, OSK Investment Bank Database and also from the DataStream Tool.

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