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Literature Review On Book Factors And Earnings


The aim of the research is to find the effect of size and book factors on the earnings and returns. For the purpose of this research textile industry is chosen along with its sectors weaving spinning and composite. Different companies from these sectors along with their closing value taken from the business recorder are taken into consideration.

The research is based on the findings of Fama and Fench who stated that the ratio of Book equity to the market equity is the main player in determining the major essence of the average stock returns. Further more if this ratio is considered along with the size than they also play a major role in minimizing the risks in the construction of portfolios. Higher ratio of book equity to market equity yields poor earnings and its lower ratio generates higher earnings.(Fama and Fench,1990)

When conducting research it is necessary that when stocks grouped to size and book equity to market equity ratio should indicate the clear differences in profitability .On summarizing the above point it can be concluded that those firms which have high return on growth usually have low book equity to market equity ratio and vice versa.

Besides this there is also a relation between size and profitability. Stocks are directly proportional to the earnings, smaller the size of the stocks smaller the earnings generated by the firms. Size usually effect earnings due to the low profits on stocks and these points were proved in 1981.

Before 1980 there was a very little or no relation between the size and profitability. But the recession which occurs in the early eighties generates the depression of small stocks prohibiting its participation in the boom period of mid eighties. In this regard different theorists have given different point of views.

According to Penman when portfolios of book equity to market equity are generated for the tenure of five years firms which have low ratio become healthier in terms of profits and vice versa.

According to the theory presented by Lakonishok Shleifer and Vishny

growth rates don’t have any effect on the size of firms and they become same in the coming years after the portfolio formation regardless of high and low book equity to market equity of stocks.

The explanation behind their statement lies in the fact that those firms which have low book equity to market equity ratio generates low returns on the stocks and thus the weakness lies in the generation of future earnings growth ability of the firm which becomes weaker than the market. Same is the case with the firms with high book equity to market equity ratio because their ability of future generation of earnings become stronger than the market. In summarizing their theory that firms with higher book equity to market equity ratio have higher returns on earnings and thus they verify the irrational pricing..

Main point that should be kept into consideration is that this analysis does not cater asset pricing issue. The earnings by the firms in different ratios of the size of book equity to market equity groups occupy the place in the market in the same manner as their stock returns. The routes occupy by the factors like market and size can be distinguished clearly by their position in returns. Besides this detail analysis there is a weakness that can be seen in asset pricing model and it lies in the fact that book equity to market equity in earnings is responsible for driving this ratio in returns.,

Basically asset pricing Model was developed in relation with the Capital Market Theory in order to show the balance between risk, return on assets and uncertain future payments. It was in early nineties when Fama and Fench discovered that Beta does not describe clearly the differences in stock returns. and thus in order to conduct a meaningful study they considered three variables size, Book equity to market equity in explaining the clear variations and ups and downs in stock returns. In the three factor models Fama and Fench were able to minimize the anomalies that were creating disruptions in the capital asset pricing Model.

The anomalies that were arising in the Capital Asset Pricing Model was because of its lack of ability in taking into account the systematic risk, neglecting some important attributes of the firm ,biased interpretation of information and the statistical and other errors involve in feeding the computer data. In the late nineties Daniel and Titman argued that firm’s traits are responsible for showing the ups and downs and differences in the stocks average returns. DT also argues that even under the controlled circumstances the average return does not necessarily have the positive relation with the three factors. (Daniel and Titman, 1999)

In 2000 Pastor and Stambaugh elaborate this view through their research on a mean variance efficiency portfolio by doing a comparison between the risk based model developed by Fama and Fench and the firm trait based model developed by Daniel and Titman .After conducting research they came to the conclusion that both models are similar and give rise to same portfolios when considered for investment purposes. The crux of this research lies in the point that many factors are responsible for capturing the detail analysis of stock returns. (Stambaugh, Daniel and Titman,2000)

In the late nineties Miller also collaborate in this view. He said though since many decades single beta was used to explain the depth of the stock returns but base on recent study more than one factor is required to get the deep insight about the stock returns. In 1999 Malkiel found that risk management requires more empirical tests. (Miller and Malkei, 1999)

To check the multifactor model Chui and Wei in 1998 perform the empirical tests to check the validity on Asian region data. After conducting research they came to the conclusion that there is a weak bond between the average stock return and the market. Beside this they also concluded that Fama and Fench three factor characters are associated with each other.(Chui and Wei,1998).

Drew and Veeraraghavan also confirmed that multifactor approach developed by Fama and Fench provides a deep insight in examining the cross sectioning of returns and explaining the strong relationship between size, book equity to market equity ratio and stock returns. However in Chinese market is still lacking in finding the relationship between the three factors defined by the Fama and Fench. . (Drew and Veeraraghavan, 2000)

In order to gain insight about all the tests proving the relationship between the size, book equity to market equity ratio and stock returns developed by the Fama and Fench it is necessary that they should pass through bias hypothesis proposed by kothari,Shanken and Sloan and the other hypothesis given by Black in 1995. This challenge can be respond in a better way through the statement given by Halliwell, Heaney and Sawicki. According to them repetition of the same result in any stock market suggests that there is a strong persuasive asset pricing effect. (Halliwell, Heaneyand Sawicki, 1995)

The point of the debate in conducting the research is that asset pricing model explains the ups and downs in a better way than the CAPM. To prove this, markets of different countries are taken in to account. Firstly china is taken into consideration because its analysis is difficult as compare to the other markets .Secondly multifactor effect can be explained in a better way through seasonal effect. On conducting the research following conclusions were obtained.

Very low cost portfolio for size will generate a positive result of 0.9273% per month.

Book to market equity effect is not as prominent as it should be in United States market.

Basic findings of this research were that value firms which are defined as the firms who have high book equity to market equity ratio give prominent results. Besides this research does not apply on the changes that occur because of seasonal effects like New Year and Christmas particularly in the data of January. Other major point that can be taken into account is that investors in China are quasirationals and non beta risk is also attached with the factors found in three factor model. Furthermore beta is not efficient enough to explain in detail about the average stock returns. This research is applicable on both the type of investors’ i-e. risk aversive and risk taker.(Drew and Veeraghavan,2000).

The research done on Shangai Stock market provides an incentive to those investors who are interested in taking advantage of extra benefit in the form of extra returns. These investors should shape their portfolios in accordance with the book equity to market equity ratio and thus by doing so they can expose their portfolios to the risks. According to Cochrane

Anomalies are applicable in the small and valuable ratio only when the investors are knowledgeable about distressed and ill liquid stocks. If the strategies are not working than it is essential for the investor to work in the opposite direction.(Cochrane,1999)

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