Literature Review On Features Of Stock Pricing
This literature review is initially done on stock price, earnings, earnings per share, dividend, dividend per share and dividend yield in terms of their features and relationships.
The focus will be given on how stock price being related to the other four variable. Then, the definition of the variables, their connections and topic related information.
2.1 Review of the Literature
2.1.1 Stock price
Stock is ownership in a company, with each share of stock representing a tiny piece of ownership. (Lawrence J. G., 2005). The more shares you own, the more of the company you own, and the more dividends you earn when the company makes a profit. In the financial world, ownership is called equity. Stocks are in two primary classes. The one you choose depends on what you want from a stock. Preferred stock typically pays regular dividends, and investors who want income foremost from their stocks favor it. Common stock represents ownership of a company and may offer more rights and privileges than preferred stock.
Despite some evidence of share price inefficiencies, the speculative component of real share prices is insignificant in the same investment equations implying that the short-term departures from share-market efficiency do not significantly influence investment spending. (Micheal A. & Robert S., 1996)
It is also expected that abnormal profit earn can be earn by chances in future because there are a lot of researchers two decades ago already prove the Efficiency Market hypothesis (EMH) again and again. (Elroy D. & Massoud M., 2000)
Even in Malaysia stock market, there are researchers found that the stock market is in weak efficiency form. (Annuar N., Ariff' M. & Shamser M., 1991)
As the researchers always found similar conclusion; it is not always the stock price react or sensitive to the information or news and the variation of stock price may be reflected by the other factors. (David M. C., James M. P. & Lawrence H. S., 1989)
According to researchers Akintoye, et al. (2009), there are some other factors that could influence the stock price. This means that the stock price is notably influenced by a number of factors such as book value of the firm, dividend per share, earnings per share, price earnings ratio and dividend cover. The authors also stated that the conditions could appear whether it is primary or secondary market.
There are Factors behind increases or decreases in the demand and/or supply of a particular stock could include company fundamentals, external factors, and market behavior. (Al – Tamimi, H., 2007),
2.1.2 Earning per share
Earnings per share represent one of the most widely used indicators measuring the performance of a company. It is calculated by dividing net income by total number of outstanding shares. (Lawrence J. G., 2005)
There are researchers, suggest that the Earning per share (EPS) is part of share price, and the increasing or decreasing of EPS will result the same situation to the share price. (Edward A. & William B., 2006)
The rationale behind the EPS and shareprice are related is when an investor hold a share, he will hold part of company’s income as well because of the ownership. Therefore, the price of share will follow the movement of the company’s earning. (M. J. Gordon, 1959)
However, there are some researchers back 70s, doubt the relationship of EPS and share price, they conclude that there are other factors should be taken into account. (Burton G. Malkiel and John G. Cragg, 1970)
Molodovsky (1995) discussed dividends as the hard core of stock value. The importance of dividends was originally emphasized in the work of Williams (1938). The current study will attempt to investigate identify the most influencing factors of UAE stock markets. Some studies have concluded that company fundamentals such as earning and valuation multiple are major factors that affect stock prices. Other indicated that inflation, economic conditions, investor behavior, the behavior of the market and liquidity, are the most influencing factors of stock prices. The results of this study are consistent with most of the findings provided in the literature review and support the existence of a long-run relationship between stock prices and both internal and external factors. The most important influencing factor is EPS. This means that an increase in the demand for stocks with higher earnings increases stock prices and, consequently, the trading volume. The findings indicate a strong positive impact of EPS on the UAE stock prices. (Al – Tamimi, H., 2007),
According to Oscar Harkavy (1953), the two proposals have been made regarding the retained earnings and common stock price for large, listed corporations. High proportion of earnings retained (EPS) are associated with greater price appreciation. The crucial factor is the profitable utilization of investors' funds. The studies of the individual companies demonstrate that the mere fact of low dividend-payout does not guarantee outstanding price appreciation. Increases in earning power must accompany the increases in book value arising from undistributed profits if price appreciation is to be enjoyed.
Contras with the common findings, some researchers did found other results. In a research, the researchers examine whether the magnitude of this relation is (positively) correlated with the revisions in expected future earnings derived from a univariate time-series model. They found that the earnings does not support the excess volatility of stock prices found in stock market indices by some previous researchers; Leroy Porter (1981) and Shiller (1981). In the context of their system model, which relates differenced earnings to returns, they found no evidence that stock returns are excessively sensitive to the earnings innovations.
This is consistent with the reasoning and evidence presented by another researchers; Marsh and Merton (1986), who find no evidence of excess volatility after dispensing with the assumption that aggregate dividends and stock prices are stationary and assessing volatility with respect to a relatively unsmoothed series such as earnings instead of with respect to a smoothed series such as dividends.
Another researcher; Abdulrahman A. Al-Twaijry (2008) study is to review the stock market from its formal initial in 1985 until 2006. Both graphical and statistical analyses are employed to closely investigate the behaviour of the market with more focus on the recent dramatic changes. The link between stock performance (earning and dividends) and stock price (and return) should be strong. The previous studies confirmed, using data from Western stock market, that stock price (and return) is strongly correlated with the stock performance. Saudi market the case may not be the same since people are not educated enough yet about how, when, and where to invest their money in the stock market. People’s decisions on this matter are mostly directed by factors different from the company performance. These factors include friends and family influence, company and government announcements, and stock price past behaviour. To investigate the impact of the crisis on the efficient market hypothesis, they examine the correlation between stock prices (dependent variable) and stock earnings and dividends (explanatory variables), the results is there are positive correlation from the EPS and DPS.
2.1.3 Dividend per share
Dividend is a part of net income distributed in cash to shareholders of the company. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business, or it can be paid to the shareholders as a dividend. Many corporations retain a portion of their earnings and pay the remainder as a dividend. (Lawrence J. G., 2005)
In a study examines whether discounted cash flow models, multiplier methods, and market-value-added approach presented in finance texts are useful tools for predicting stock prices. Among all financial variables that were considered in this study, dividend and highest effect predicting share values of the firm. (Reza Rahgozar, 2006)
In another study, there are researchers focus on whether the relation between stock prices and dividends changed. Rather than focusing on a long-term historical period, they examine the present-value model by pooling individual firms over the past 20 years and use panel cointegration estimation methods to test the long-run relation between stock prices and dividends. They also apply panel cointegration testing and estimation methods to quarterly data for 84 firms over the 1979–1999 periods to determine the long-run relation between stock prices and dividends and to test the present-value model. The results indicate that in the period studied, there is an approximately one-for-one long-run relation between stock prices and dividends for large established firms. Further, stock prices explain more than one-third of dividend movements in the short-run. (Alireza N. & Jack S. 2003)
There are results shows that variance-bound test results are consistent with the efficient markets hypothesis when other cash distributions are included. The researchers use the variance-bound test methodology of West (1988b) to test the hypothesis that stock price is not too volatile. Our data are from the Toronto Stock Exchange (TSE) for the period January 1950 to February 1991. They first analyze monthly and annual series of ordinary cash dividends and find results comparable to those of West (1988b), i.e., stock price appears overly volatile. The same test is then performed on broadly defined series of monthly and annual cash flows, where the series include ordinary dividends and cash generated by share repurchases and cash mergers and acquisitions. The results indicate that stock price volatility is consistent with the discounted value of expected dividends when differencing is required to induce stationary. (Lucy F. Ackert and Brian F. Smith 1993)
Another research that testing the relationship between stock prices and dividends by using US stock market data, and focus upon the time-series properties of aggregate price and dividend indexes. This paper employs the cross-sectionally augmented panel unit root test introduced by Pesaran (2005). The sample for the present study comprises 104 UK non-financial companies, for which complete and continuous share price and dividend series were available over a 34-year observation period from 1970 to 2003 (inclusive). The panel test results largely support the present value model, yielding evidence of cointegration between real prices and dividends. (John G., David G. M. and John O.S.W., 2008)
Hartono (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 behaviour.
Molodovsky (1995) discussed dividends as the hard core of stock value. The importance of dividends was originally emphasized in the work of Williams (1938). The current study will attempt to investigate identify the most influencing factors of UAE stock markets. Some studies have concluded that company fundamentals such as earning and valuation multiple are major factors that affect stock prices. Other indicated that inflation, economic conditions, investor behavior, the behavior of the market and liquidity, are the most influencing factors of stock prices. The results of this study are consistent with most of the findings provided in the literature review and support the existence of a long-run relationship between stock prices and both internal and external factors. The findings indicate a strong positive impact of DPS on the UAE stock prices. (Al – Tamimi, H., 2007),
The study is to review the stock market from its formal initial in 1985 until 2006. Both graphical and statistical analyses are employed to closely investigate the behaviour of the market with more focus on the recent dramatic changes. The link between stock performance (earning and dividends) and stock price (and return) should be strong. The results is there are positive correlation from the EPS and DPS.9 (Abdulrahman A. Al-Twaijry, 2008)
There is a paper uses the technique of extreme bound analysis (EBA) originally suggested by Leamer (1983, 1985) and extended by Granger and Uhlig (1990) and Sala-i-Martin (1997). It attempts to examine the robustness of 11 variables as determinants of stock price variation for companies listed on the Kuwait Stock Exchange .The empirical results presented in this study are based on a sample of cross-sectional data of 61 companies listed on the Kuwait Stock Exchange for the period of 1999-2002. It can be seen that the variables of interest, EPS are all highly correlated with the stock price in Kuwait stock market. (Talla M. Al-Deehani ,2005)
2.1.6 Dividend yield
The studies about the profitability of an investment strategy that were focused on the high dividend yield stock from British Stock Exchange in year 1994 to 2007. Their finding had demonstrate that the portfolios composed of the best 10 highest dividend yield stock are able to beat the market for the entire period from 1994 to 2007, but this are not consistently. It also had present for this studies that had important for the investors regarding to their investment horizon choice. High dividend yield portfolio had proven as the profitable investment for the long term and these can be varying in the short term. (Janusz B., Kathryn A. and Jerzy G., Joanna B. ,2008)
The strong support had provided by the Cross-sectional weighted least squares regression for the dividend signalling hypothesis and restricted supporting for the free cash flow argument in order to explain the stock price reactions to announcements of the dividend policy changes. For the NASDAQ dividend initiations, it had shown the strong positive relationship between stock price reactions and change in dividend yield. Change in the dividend yield is more important for the high Q firms compared with the low Q firms. Firms with the low dividend yield which would exclude the dividend transmit less information, and therefore the stock price reaction become smaller. (Patricia A. Ryan, Scott Besley and Hei W. L., 2000)
Another Authors; Chaudhary Mohammad Irfan and Dr. Mohammed Nishat (2000) had distinguished the joint effect of the several factors such as the dividend yield, payout ratio, size, leverage, asset growth and earnings volatility applied on share price in Karachi Stock Exchange for the long run. But the most important factors that authors had observed were the dividend yield, payout ratio, size and leverage. They also attempt to observe the impact of these factors where to assess for the straighten out impact on the share price changes. As the results they found that the dividend per share could drive the share in terms of long run.
The decrease in the dividend yield was offset by risen growth in earning per share. The greater grown in earning were permitted the better dividend growth and this had lead the stock price appreciated. Dividend yield as the simply ratio between dividend and stock price. When the dividend yield decline, the stock price had considered as overprice.All of these had also considered as more valuable for current compare with past previously. (John B. Carlson, 2001)
2.1.7 P/E Ratio
Some analysts view the current high price earnings ratio of the stock market as a sign that the stock market may be headed for a downturn. This view receives some support from historical evidence that very high price-earnings ratios have usually been followed by poor stock market performance. When price-earnings ratios have been high, stock prices have usually grown slowly in the following decade. Moreover, at times such as the present when high price-earnings ratios have reduced the earnings yield on stocks relative to interest rates, stock prices have also tended to grow slowly in the short run. Forecasts based on such evidence are subject to much uncertainty, however, because history may not repeat itself. Specifically, the possibility cannot be ruled out that this time will be different due to fundamental changes in the economy that will allow high price-earnings ratios to persist and thus stock prices to continue growing both in the near term and in the coming decade. (Pu Shen, 2000)
In a research to determine that whether the PE ratio is importance of the share price by using the US stock market, researchers found that the price earnings ratio have significant relationship with the stock price as the increase of PE ratio will drive the stock price down in long run. In short run the results might be different. (William B. and Dale M., 1978)
Researcher shows that price-earnings ratios have significant negative relationships with the stock in long run according to the test from 2003 to 2008 in the Saudi Stock. Where the abnormal price-earnings ratios should not be consider due to the results of immense error. (Abdulrahman A. Al-Twaijry, 2007)
When price-earnings ratios have been high, stock prices have usually grown slowly in the following decade. Moreover, at times such as the present when high price-earnings ratios have reduced the earnings yield on stocks relative to interest rates, stock prices have also tended to grow slowly in the short run. (Vorek M., 2009)
2.2 Review of relevant Theoretical Models
In order to test the above mentioned hypotheses, the following model has been
SP = f (EPS,DPS,DY,PE)
SP: Stock price;
EPS: Earnings per share;
DPS: Dividend per share;
DY: Dividend yield;
PE : P/E ratio
2.3 Proposed Theoretical
Earnings per share Independent variable
Dividend per share
2.4 Hypotheses Development
In the light of the literature review, the following hypotheses are formulated:
H₀, ₁: There is no significant relationship between stock price and Earnings per share.
H1, ₁: There is significant relationship between stock price and Earnings per share.
H₀, ₂: There is no significant relationship between stock price and Dividend per share.
H1, ₂: There is significant relationship between stock price and Dividend per share.
H₀, ₃: There is no significant relationship between stock price and Dividend yield.
H1, ₃: There is significant relationship between stock price and Dividend yield.
H₀, ₄: There is no significant relationship between stock price and Price earnings ratio.
H1, ₄: There is significant relationship between stock price and Price earnings.
This chapter review the stock price, earnings, earnings per share, dividend, dividend per share and dividend yield in terms of their features and relationships. In the chapter, all the four independent variable will be shown how they related to the dependent variable. Then, the theoretical model of this paper are presented and hypotheses being developed. On the next chapter, the research methodology which is a preview of the overall approach in research design, sampling design, data collection, and methods of analysis will be shown.
Need help with your literature review?
Our qualified researchers are here to help. Click on the button below to find out more:
In addition to the example literature review above we also have a range of free study materials to help you with your own dissertation: