The Relationship Between The Operational Profit, Operational Cash Flow And Abnormal Returns In Initial Public Offering In Tehran Stock Exchange

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1 Technical Journal of Engineering and Applied Sciences Available online at TJEAS Journal /53-59 ISSN TJEAS The Relationship Between The Operational Profit, Operational Cash Flow And Abnormal Returns In Initial Public Offering In Tehran Stock Exchange Oktay Yamrali 1,Ali Aliyani Nezhad 2,Es,hagh Hivehchi 3 1.Department of Management, Economics and Accounting, Payame Noor University,I.R.of Iran 2.Department of Management, Economics and Accounting, Payame Noor University,I.R.of Iran 3.Employee of mellat bank of iran,ir Corresponding author: Oktay Yamrali ABSTRACT: The main purpose of the study was to survey the relationship between the operational profit and operational cash flow, and abnormal returns of the accepted companies' stock in Tehran stock exchange. To do so, it was analyzed a sample consisted of 36 companies among newly entered ones in Tehran stock exchange during 2006 to The results indicated that there is a positive and significant relationship between the operational profit and abnormal returns of stock in IPO; and, there is a weak relationship between the operational cash flow and abnormal returns of stock in IPO. Key Words: operational profit, operational cash flow, abnormal returns of stock, initial stock offering INTRODUCTION The relationship between the stock market return and accounting profit, and the subject of the manner of time the capital market reacts to the profit information are of critical importance to study capital markets efficiency as well as evaluate current information efficacy in basic financial statements. Investors, creditors and other users of financial statements utilize the reflected information in accounting profit to assess profitability, net cash inflows, and expected future profits. The usefulness of the reflected information in accounting profit would be confirmed when the accounting profit is able to help the investors and creditors to predict cash flows in terms of amount, access time and the level of uncertainty. In other way, the performance of initial public stock offering has been, for long years, focused by financial researchers and scientists. According to the definition of efficient capital markets hypothesis, stock price at any moment, reflects stock inherent value based on the existed and relevant information in the market. Yet, financial literature indicates that there are three distinctive phenomena in initial public stock offering contrary to the efficient capital markets hypothesis. The first phenomenon is pricing less than the real or so-called initial public stock offering less than the stock price. Less than real pricing means that stock offering companies offer their stocks less than their inherent value and cause pretty higher (almost 10 to 30%) returns to buyers at the first day. The abundant experimental evidences show that less than real pricing in initial public stock offering is a universal comprehensive phenomenon which is almost common in all countries stock exchange. The second phenomenon in initial public stock offering is that this stock as compared to market portfolio or the stock of its similar and comparable companies in industry would have negative returns for its investors in long term. The negative performance of initial public stock offerings in long term has not been confirmed on the contrary to the comprehensive nature of less than real pricing in all capital markets, and its measurement methods have caused conflictions among financial researchers. The third phenomenon relevant to initial public stock offerings included the existence of special periods in terms of number and volume of public offerings in markets (or whatever called hot initial public stock

2 offerings periods in financial literature) and variation size in less than real pricing in accordance with markets circumstance. The three aforementioned phenomena have attracted the financial scholars and researchers, because of its conflict with the basics of efficient capital market hypothesis. In this regard, various theories and hypotheses have been provided by financial economists to describe and explain each phenomenon. As a whole, these theories or hypotheses are reasoned based on information asymmetry among three benefited groups in the process of initial public stock offerings (offering stock company, inves tment bank and potential investors in the market) and relate each phenomenon to particular factors and variables. With regard to all theories arguments, many studies have surveyed the relationship between these phenomena and factors like 1. market conditions at the time of stock offering, 2. composition and numbers of shareholders of offering company before and after stock offering, 3. Information related to offered stock, and 4. stock offering company s accounting information. Despite numerous researches studying the relationship between these phenomena with the first three factors, yet it has been less focused by researchers the studying the relationship of two phenomena of less than real pricing and negative long term performance of initial public stock offerings with accounting variables and information and the efficacy of accounting information in determining offering price and its relation to initial abnormal return as well as negative return of this stock in long term. Since, the potential and actual investors are the most important active group in capital market, so their suitable decision making affects their optimal dedication and capital direction. Hence, accounting informational systems must present relevant and reliable information to its financial information users to be applied in their decision making models and to meet their requirements. Previous studies: The logic of profit and stock returns relationship was established by Ball and Brown in The reflected profit in companies financial statements is generally composed of two operational and nonoperational entities that the presented profit continuity is different in each. For instance, it can be claimed that the most important part of net profit is operational profit with a high repeatability than other categories. Market efficacy, in aforementioned study and after that, has been considered as an evident assumption. The results indicated that there is a correlation between stock prices variations in a particular period of time (for example a one year or three month period) and abnormal profit extent and direction (orientation). Given that market efficacy is accepted, these findings are correspondent, assuming that accounting profit reflects effective variables on stock prices. Moreover, the results showed the fact that annual or quarterly profit is also included an informational element in stock market. In spite of mentioned results, above studies were not in line with testing two contrary hypotheses i.e. the hypothesis of non effective accounting variations on stock prices due to capital market efficiency and the impact of accounting changes hypothesis on stock pricing. Indeed, as it was earlier stated, the market efficiency may be accepted as an obvious assumption in such studies and the results have been interpreted based on that. The definition of accounting profit usefulness based on stock profit and returns relationship was correspondent with theoretical framework statement in U.S (1967) and Accounting principles and regulations titled Accounting Guidelines in Iran (1999). According to the mentioned statement, the main goal of accounting and accounting profit is as follows. Providing information to investors and creditors to assess risks and investment potential returns regarded as the main duty of financial reporting. The three established theories in financial literature applied in Ball and Brown study are in order: Marquitz portfolio Theory (in early of 50 th ), the theory formed based on Marquitez theory (in the early of 60 th ), capital market (CAPM model) and the efficient capital market theory (in 60 th ). In 1990, Barlev studied the correlation among these ratios and abnormal returns of companies stock to compare the informational content of financial ratios extracted from cash flow statements with income ratios of profit and loss statement and balance sheet. The result indicated that the financial ratios extracted from cash flows statement are more related to stock returns than financial ratios of balance sheet, and profit and loss statement. Easton, P. D and Harrisstudied the informational content of accrual profit in a research through testing its relation to securities returns and found out the direct relationship between these two variables. Ashiq Ali (1994) studied the increasing informational content of three factors including profit, cash flows earned from operation and working capital of operation. He analyzed 8820 samples firm-year during , and tested his hypothesis through two linear and non linear models. The results of linear model test confirmed the evidences of increasing informational content of stock to operation working capital, and the results of nonlinear model test the increasing informational content of working capital to profit and operational cash flows. The incremental information content about cash flows of operations with little changes was also seen in relation to others. Charito (1997) studied the relationship between profit and cash flow, and securities ret urn by a data set consisting of British companies. The results determined that cash flow would play more important role in market when it has been considered the accruals operation circle and large measuring distance. Moreover, the findings showed the more informational content of cash flows than profit in clarifying securities returns. Plenborg T (1998) studied whether profit, based on Danish data, is superior to simultaneous cash flow in explanation of 54

3 stock abnormal returns during operation circle. He presented that profit has more stable explanatory power, but the length of increasing operation circle may cause the reduction cash flow explanatory power. Charitou, Club and Andrew (2000) analyzed the relationship between profit and cash flow, and securities return by Japanese Data set and similar results reports, and the results presented that profit and cash flows are useful in prospective profit predictions. The study sample consisted of 529 year-firm was during periods using multiple regressions. Kin (2000) studied informational content and the relatedness of profit to stock price. The study results indicated that the informational content of accounting variables has been fixed and unchangeable during research period, while the relatedness of accounting variables to company s value has been descending. Hodgson, A. and Clarke (2000) have reassessed the increasing informational content based on Australian data. They found out that a non linear relationship of power performance may provide more explanation to both profit and cash flow, in addition, cash flows, on the contrary to reception theory gradually add the explanation power of large companies. Haw, Kie and View (2001) studied the profit s relative and gradual informational content, operational cash flows and accruals in Chinese emerging capital markets during They have used 1516 year-firm as sample. Their results showed that domestic investors in the emerging capital markets in China are concerned with more profit in the information of cash flow in evaluation process. Martinez (2003) analyzed the profit and /or cash flows related to stock returns explanation in French framework. The obtained results showed that cash flows are not able to reveal additional information more than profit. Callen, J., D. Segal in a research studied the effect of accruals on stock returns concluded that accruals, cash flows and the future expected discount rate are relevant in determining company s stock returns. Also, accruals and cash profit as the components of net profit owns the same power in determining company s returns while superior to expected returns. Kim, M., & Kross (2005) studied the ability of current profit in predicting the future operational cash flows during the years of 1973 to They have used the time series regression model. The findings demonstrated that the relationship between the current period profit and the future operational cash flows is increasing over time. They also found that increasing the conservatism in accounting play a vital role in enhancing the relationship between the profit of current period and cash flows. Subramanyam, K. R., & Venkatachalam (2007) carried out a research about the relative importance of profit and cash flows in evaluating the rights of shareholders. They studied the relative power of profit and cash flows in describing the realized inherent value of the firms stocks, and presented that using the realized inherent value simultaneously overcome the inherent problems of the application of future operational cash flows and/or stock returns as the predictive criteria of the value of shareholders rights; hence, this strategy is preferred both theoretically and operationally. The results of their study indicated that profit can better explain the realized inherent value than cash flows. Hirshleifer and et al (2009) concluded that accruals (cash flows) as strong and positive (negative) predictors of market returns and changes in accruals (cash flows) are negatively (positively) correlated with simultaneous returns. Finally they concluded that the level of accruals and cash flows as well as their changes are correlated with discount extent; i.e. the higher the level of accruals and positive change, the more risks and then the severe discounts of future cash flows. Guo and Jiang (2011) believed that the profit accrual constituent is correlated to determinant factors of risks. Their study presented that part of risk related to company s accruals, which is not omissible through diversification, explains the relationship between market accruals and the future stock returns. The other part of accruals, stating variation in accruals particular to each company explains the negative relationship between accruals and prospective stock returns in companies. Moreover, the negative relationship among market set profit changes and simultaneous return, are due to the correlation between profit changes and risk. Zarowin and Cohen (2012) tested this hypothesis whether maximization of reactive profit to pricing is less than the market level, but they have not found any evidences supporting this hypothesis. They perceived that in the situation of being the market s total return as negative, only companies with negative returns included positive optional accruals, while all companies could have had positive optional accruals, if companies maximized the profit with the purpose of handling pricing less than market level. Rahimi (1995) studied the relation of stock returns and price coefficient to profit of accepted firms in Tehran stock exchange. At this study, it was analyzed the hypothesis that stock with low coefficient of price to profit ratio during had higher returns than stock with a high coefficient price to profit. The obtained results proved the research hypothesis that stocks with price coefficient to low profit have higher returns than stocks with high coefficient of price to profit. Kordestani and Roodneshin studied the relativity of cash and accrual elements of accounting profit to company s market value and understood that operational cash flows (profit cash part) have the ability to predict and explain the market value. A large significant volume of researches in accounting literature study the content and information to profit and cash flows for stock returns. Previous studies about relative and gradual content of information related to profit and cash flow in the U.S.A and some other countries like Britain and New Zealand support this issue, however, there would raise an experimental question in Iran. The question related to differences between Iran and these countries. The purpose of the present study is to expand the texts with review of profit s informational content and cash flow in Iran. Study hypotheses 55

4 First hypothesis: There is a significant relationship between operational profit and stock abnormal returns. Second Hypothesis: There is a significant relationship between operational cash flow and stock abnormal returns. RESEARCH TYPE AND PARTICIPANTS The participants of this study are the newly entered companies to Tehran stock exchange. After checking done in choosing the best sample, 36 firms were chosen at the best condition for a 7 year period as samples and for gathering data. The intended sample was selected according to the following criteria: 1. They must have no operational interruption during research phase. 2. They must not be one of investing, financing or leasing firms. 3. No change in financial period is allowed. 4. The required data are available. Models, Variables and measuring procedures DEPENDENT VARIABLE Firms stock abnormal return in the first supply is a dependent variable of the present study which is defined as follows: = = stock abnormal returns of firm i in month t. = price index returns and cash returns in Tehran stock exchange 4 in month t. = abnormal returns (adjusted to exchange returns) shares i in month t. Stock return is measured as follows: [( % % ) ] ( % ) Market returns is computed as follows: = ( ) (3) = price index and cash yield at the end of month t. = Price index and cash yield at the beginning of month t. After computing monthly abnormal return, to compute the mean abnormal return of sample share n in month t, the following relation is used: = We have: = the mean abnormal return rate of n shares in month t. = the number of shares in month t. After calculating the abnormal retur n mean rate N shares in month t, the cumulative abnormal return rate is measured as follows: = DEPENDENT VARIABLE Operational profit To compute the operational net profit (loss) in various firms, in this study, we applied operational net profit ratio to market value of shareholders rights, since the firm s size factor would not disturb the research and the data spread are limited: = (6) = Net operational value = Operational profit of firm i at the end of period t = the market value of shareholders rights in firm i at the beginning of period t Operational cash flow: To compute operational cash flows in various firms, in preset study, it has been used the ratio of operational cash flows to market value of shareholders rights: = = Net operational cash flow = Operational cash flow of firm i at the end of t time period = Shareholders market value firm i at the beginning of t period (5) 4 TEDPIX (Tehran Stock Exchange Dividend And Price Index) 56

5 The methods of data analysis and hypotheses test Data analysis and hypothesis testing are done through linear regression descriptive statistics and Pearson correlation, which means that the required data are initially computed, and the regression tests performed to study the relationship between stock returns, and operational profit and operational cash flows of companies. Excel and SPSS 18 software has been applied to process the information and statistical tests. Descriptive statistics Test Descriptive statistics is initially presented in chart 1. Chart 1 shows descriptive statistics like mean, median, standard deviation, minimum and maximum for all variables including the operational profit, operational cash flows and stock abnormal returns (used in regression model). The mean of stock abnormal returns variable is 29.87%, i.e. the studied companies in the intended time period had almost 30% abnormal returns. Stock Abnormal Rreturns Operational Profit Operational Cash Flow Chart 1. Study Descriptive Statistics / Correlation Coefficient test The existence and orientation of linear correlation among the study variables were studied through Pearson correlation coefficient and the results are shown in chart 2. As it can be seen there is a positive, significant correlation between operational profit and stock abnormal returns variables at error level of less than 1%. But, there is no significant correlation between operational cash flows and stock abnormal returns. In addition, the correlation between operational cash flow and operational profit is computed about zero which shows the non existence of any relationship among study independent variables, all variables determination coefficient is near to zero. All the aforementioned present the validity of the test. Variables Stock Returns Operational Profit Operational Cash Flow Chart 2. Pearson Correlation test Stock Abnormal Returns Operational Flow Profit (0.0) (0.0027) (0.0) OperationalCash Flow 1 Multi variable regression test The data were tested through SPSS software in a multivariable regression test and the following results were obtained Chart 3. Multivariable Regression Test Variables Coefficient t-student Statistics Significance Level Intercept Operational profit Operational cash flow Adjusted R F-statistic Prob(F-statistic) 0.00 Durbin-Watson , RESEARCH FINDINGE As the results in chart 3 show, the operational profit has a coefficient of about Yet, the significance level of above mentioned variable is 0.0, and has error less than 1%, hence, it can be stated that there is a significant and positive relationship between the ability of operational profit and stock abnormal returns. Therefore, the first hypothesis is affirmed. On the other hand, as it can be seen in chart 3, there is no significant relationship between operational cash flows and stock abnormal returns (coefficient of 0.013). So, the second hypothesis is rejected which was about the relation of operational cash flow and stock abnormal returns. As it is presented in the chart, the amount of statistics significance level is F with a zero probable error indicating the significance of the whole model. The adjusted determination coefficient equals which states the model s great explanatory power to present that 56.5% of stock abnormal returns changes are explained through independent variables. Errors independency is one of regression assumption. If errors independency assumption is rejected and the errors are correlated, it would not be allowed the use of regression. Durbin- Watson statistics is used to study the errors independency from each other, and if it was in 1.5 to 2.5, the 57

6 correlation assumption would be rejected and the regression may be used. As in chart, the amount of Durbin- Watson statistic equals which show the independency of the errors, and that there is no correlation among the errors so the correlation assumption is rejected and the regression can be used. Therefore, we demonstrated that the test carried out was significant and the obtained results from the chart were provable. Therefore, the following equation can be totally attained: CAR q-s = 67% + 0/76 E it + 0/013 CFO it + e it CONCLUSIONS In this section, it is attempted to conclude properly by data and data analysis. The purpose of this study was to interpret the results appropriately by applying information and techniques, tests suited to obtained data natures and the hypothesis type as well as analyzing the results of statistical computations. The researcher should be able to theorize by the obtained results, analyzing them and expanding them to total. Conclusion is the final product of a scientific research which researcher state findings and probable recommendations, relying on testing hypothesis. The main purpose of this study was to survey the relationship between operational profit and operational cash flow, and newly entered companies stock abnormal returns in Tehran exchange stock. The totally result was that this study provided Iranian experimental evidences about the relationship between profit and cash flows, and stock returns. The first hypothesis studied the relationship between the operational profit and stock abnormal returns; the results confirmed the existence of that relationship. This conclusion coincided with Barlev, Easton, P. D and Harris, Charitou, Plenborg, Club and Andrew, Kin, Martinez, Kallen and Segaul, Sabraniam and et al. In the second hypothesis, it was studied the relationship between operational cash flow and stock abnormal returns, and the hypothesis was rejected. This conclusion coincided with the studies of some scientist including Plenborg, Martinez, and did not coincide with Barlev, Charitou, Club and Andrew, Hudsen and et al, Kallen and Segaul, Hershfiler and et al, Kordestani and Roodneshin. Limitations and Delimitations Limitations and delimitations are the integral part of any research, since new and further researches are based on them. This study is not exceptional. 1. Research time period was assumed in 2006 to 2013 which was a heterogeneous period as Tehran stock exchange was faced a downturn in 2006, while the present study assumed a homogenous period. 2. Limited population, the results of the study were limited to accepted companies in Stock exchange. Therefore, these results were not expanded to companies outside Exchange. 3. In this study we assumed the efficacy of Tehran stock exchange, but the point was not approved by most researches, mentioned earlier, which were carried out to demonstrate exchange efficacy. Further research recommendations 1. The relationship between operational profit and cash flows, and stock abnormal returns can be separately studied and the results may be compared. 2. There are few researches about stock abnormal returns and the behavior of other variables in Iran. Therefore, it is recommended to do more researches about this variable and its relationship with other accounting variables. Finally, this study also requires more research which may improve our understanding from the operational profit role and operational cash flow in explaining stock abnormal return. We concluded that future researches would be useful in explaining stock abnormal return in this capital market by the comparison of profit common role and cash flow, and by the method permitted to evaluate more accurately the effect of accounting performance on profit and cash flow. REFERENCES -Ashiq Ali (1994). The Incremental Information Content of Earning, Working Capital from Operating and Cash Flow, Journal o f Accounting Research,Vol32, No1. -Ball, R., & Brown, P., (1968), "An Empirical Evaluation of Accounting Income Numbers", Journal of Accounting Research, _Autumn,PP Barlev, B and Clivant,J (1990), The Information content of founds statement Ratios, Journal of Accounting, Auditing and finance. -Callen, J., D. Segal. (2004). "Do Accruals Drive Firm Level Stock Returns?A Variance Decomposition Analysis ". Journal of Accounting Research. 42(3). pp Charitou, A "The role of cash flows and accruals in explaining security returns: evidence for the UK ", European Accounting Review, Vol. 6, no. 4, pp Charitou, A., Clubb, C. and Andreou, A "The value relevance of earnings and cash flows: -Empirical evidence for Japan", Journal of International Financial Management & Accounting, Vol. 11, no. 1, pp Chasteen G. Lanny, Flaherty E. Richard, O Connor C. Melvin, Intermediate Accounting, 6. Edition, Irwin McGraw-Hill, New York,

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