A Review of the Factors Influencing the Stock Return (Liquidity, Size, P/E Ratio) of the Listed Companies in Tehran Stock Exchange from 2007 to 2011

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1 A Review of the Factors Influencing the Stock Return (Liquidity, Size, P/E Ratio) of the Listed Companies in Tehran Stock Exchange from 2007 to 2 98 Ruhollah Bayat, Assistant professor of Economics at Imam Khomeini International University (IKIU) Arash Hajikarimi, Industrial management group. Raja Nonprofit university, Ghazvin branch, Ghazvin city,iran Ali Elyasi Bohluli, Industrial management group, Raja Nonprofit university,ghazvin branch, Ghazvin city,iran Corresponding author: im.elyasi@gmail.com Amir Houshiar Industrial management group. Raja Nonprofit university_ Ghazvin branch_ Ghazvin city_ Iran Abstract If the accounting data are to be useful in decision making, they should be relevant and reliable. On the other hand, the usefulness of the data collected from the financial statements depends on the ability of the company to describe and forecast the value of the company, and the value of the company is under direct influence of its current and future returns. Thus, we aim to study the prediction of the stock return using the accounting variables. After studying the literature of the field, we decided to conduct our study on P/E ratio, the company size and liquidity. Our statistical population consists of the listed companies in Tehran Stock Exchange. Our sample consists of active companies during the years 2007 till 2. The results show that there are meaningful relationships between liquidity and stock return, and the company size and stock return. There was found no meaningful correlation between P/E ratio and stock return. Finally we have conducted a regression analysis. Keywords: Return on equity, P/E ratio, liquidity, company size Introduction The expansion of the financial markets, an offshoot of the development of different industries, has caused the investors and trade enthusiasts to have an increasing tendency towards learning about the active companies in the market. Regarding this fact, the investors are looking for ways to expand their knowledge. In Iran Stock Exchange, thousands of investors invest their money hoping to earn more. Some of these investors achieve their goal and some lose their capital. Knowing the mechanism of Tehran Stock Exchange from different perspectives, we can predict its course and its changes. Moreover, we can reduce the risks involved in the market, if we have information about it. In other words, investing in a stock with lower intrinsic value than the market price means not allocating resources optimally and not gaining the desired return and even undergoing losses. Thus, the consistency of earnings is questioned; and the importance of the factors determining the real value of the stock is highlighted. On the other hand, seeing from an individualistic perspective, we can tell that in a normal society, all the people are striving to increase their welfare.so, it is natural that the investors are looking for investing opportunities through which they can maximize the return. Therefore, they need some tools to predict the return. This need has also necessitated devising some models for predicting the stock return.today, analyzing the accounting and financial variables is an efficient technique and a suitable device to assess the performance in the past and predict the future of the company.one of the significant variables is the stock return. It is one of the important factors in choosing the best investment. Moreover, studies have shown that the financial ratios are appropriate tools for predicting and estimating the stock return, therefore, our study is to review the relationship between the stock return and P/E ratio, company size and liquidity.

2 The Theoretical Basis of the Study One of the factors influencing decision making in the stock market is the stock return. The return includes data that the potential investors can use in their financial analysis and predictions. If a meaningful relationship between the stock return and our intended independent variables (size, liquidity and P/E ratio) is found, we can consider the aforementioned factors as the measures for assessing and estimating the return. Return The goal of the investors is maximizing the return, though they are also attempting to reduce the risks. The return in the investing process is considered an incentive and a reward for the investors. The return is important for the investors because the investment is done for earning it. An assessment of the return is the only logical way (before assessing the risks) for comparing the different and alternative investments. In order to better understand the performance of the investment, it is needed to measure the real value of the past, especially because assessing the return of the past has a major role in estimating and predicting the future return (Charles P. Jones, 1943). Return Components: Return has normally two parts: Earning: the most important part of return is the earning that is in the form of periodic cash flow of the investment and can be interest or dividend. The distinctive feature of earning is that the issuer makes some payments to the owner in form of cash. The cash flows are related to the price of the securities. Gain (Loss) of the investment: the second important part of return is gain (loss) of the investment, which is attributed to common stock but is also used in long-term bonds and other securities with fix income. This part which is caused by an increase (decrease) in asset price is called gain (loss) of the investment. The gain (loss) of the investment is caused by the variance between the buying price and the price when the owner of the securities intends to sell them. This variance can be gain (loss). These two parts together make securities. Each security is described as follows: Price increasing+ the total return of the securities= earning Price decreasing (1-2) The equation (1-2) is the descriptive statement of the total return for securities. The statement can be rephrased as the total return rate consists of the earning and price variance. Note that each of these two parts can be zero, or the price variance can be negative, but the profit can never be negative. Risk Risk and return are two inseparable parts of investments and financing because the investment decisions are always made based on the relationship between risk and return. Risk is defined as the variance between the real return and the expected return of the investment. Most investors believe that the real return is less than the expected return. The more the distribution of the return the more the risk will be. (Charles P. Jones, 1943). Different Types of Risk Modern investment analysts identify two sources that cause difference and distribution in return: The type that exists naturally including the interest rate volatility risk; and the type that is attributed to some kinds of securities including financial risk and trade risk. We discuss both of them as follows. One logical way for identifying the parts of the total risk is differentiating between the general parts (market) and particular parts (especial securities). Modern analysts call these two types of risks systematic and unsystematic respectively. We can show them this way: unsystematic risk + systematic risk= total risk.. (2-2) Unsystematic risk: the part of the total return variability that is not dependent on the total market variability is called unsystematic risk. This type of risk is attributed to some especial securities and depends on the factors such as trade risk, financial risk and liquidity risk. Although nearly all the securities contain unsystematic risk, it is mostly attributed to common stocks. We can reduce this type of risk by creating portfolio. Systematic risk: the investors can reduce the part of the total risk that is not related to the market by creating portfolios. The remaining part is related to the market and is thus irreducible. If the stock market plunges, it affects most of the stocks and vice versa. These changes happen regardless of one particular investor s behavior; they are, therefore, critical for all the investors. Variability in the total return of the 99

3 A Review of the Factors Influencing the Stock Return securities has a direct relationship with the changes in the market or the financial situation, and is called systematic risk or market risk. Typically, all types of securities have systematic risk to a degree (including bonds and stocks) because the systematic risk covers inflation risks, market risks and interest rate risks (Charles P. Jones, 1943). CAMP Model Capital asset pricing model is a pattern for determining the relationship between risks and the return of an asset. It is a model for pricing the assets due to their risks. CAMP is based on the assumption that the investors use it to create an efficient portfolio based on their knowledge about portfolio theory and reducing unsystematic risks by diversification, and that each investor creates different portfolios according to their risk-taking degree. CAMP model offers a way to measure the risk of an asset and the relationship between the risk and the expected return by suggesting three assumptions, apart from considering the assumptions of an efficient market: first, risk-free assets exist and the investors can lend and borrow unlimited amounts under the risk free rate of interest, and this rate is the same for all the investors; second, taxes, transaction costs, limited short-selling and other limitations of the market, do not exist; third, asset quality is fixed, and all the assets are tradable and divisible. Having considered the assumptions mentioned above, this model answers the questions this way: first, the risk of an asset is determined by the degree of dependability of its return with the market return; second, the relationship between the risk and the expected return is linear and direct. In other words, CAMP is a static model of portfolio allocation in case of uncertainty and risk-taking. As shown by Bradley and Myers (1981), Fama (1976) and other researchers, this model relates the return (R i ) of the asset (i) with the risk free return (R f )and the market return (R M ). We can show it in the following equation: (1) ER i= R F +(ER M -R F )β Mi Here, E is the expected value, and the market beta of each share equals: (2) β Mi β Mi is the measure of the systematic risk of the asset (i) In order to examine the model, we can state the Eq 1 as: R i =a 0 +a 1 β Mi + a 0 = risk free rate of the return (R F ) a 1 = the surplus of the stock return (ER M -R F ) R i = the observed return on the stock (i) Vi = the expected error (ER M -R i ) So, this model relates the return of the asset (i) with its systematic risk What is P/E? P/E ratio stands for the ratio of price to the earning per share (EPS). As it is implied in the name, to calculate P/E, the current stock price of a company is divided by EPS: Normally, P/E ratio is calculated when the company reveals P/E information (typically every 6 and 9 months). Theoretically, P/E of each share tells us how much the investors are willing to pay for each amount of earning; therefore, it is also called the stock coefficient. In other words, if the P/E ratio of a share is 20, it means that the investors are willing to pay 20 rials for each rial of its earning. Review of Literature Identifying the factors influencing the stock return has always been the goal of the numerous researches in financial and accounting studies. Sharpe (1964), Lintner (1965) and Mossin (1966) have proposed a model based on Markowitz framework. This model assumes that the investors use CAMP for creating portfolio. It also assumes that there is a risk free asset which has a particular return. This assumption is really important because it helps us in the valuation of the assets with the appropriate decreasing rate which is used in every valuation model. In other words, if we can estimate the rate of return, we will then be able to compare the estimated rate with the expected rate, which is calculated by CAMP model, and determine whether our pricing is done correctly. The periodic researches about the stock return, like Nicholson (1960), were not

4 used because of their small samples in empirical experiments, until the databases were made and the researches could use them to find big enough and high-quality samples to achieve reliable results. Bortolotti (2006) showed that issuing of the stocks is the main source of liquidity in the stock market for privatization of 19 companies; and as a result of privatization, liquidity increases.deuskar (2006) proposed a model for liquidity behavior and volatility of the stock price. In this model, the investors predict the recent changes in price for the changes in a risky asset. When the changes of the asset are high, its risk premium is also high, and the current rate of return decreases. The return rate of the risk free assets is also low and the market faces illiquidity.piqueira (2005) believes that the transactional activities can explain the expected changes in a cross-sectional manner. The results show that there is a relationship between the illiquidity cost and the company size. Moreover, the study shows that the influence of the stocks of large companies with high liquidity on the trade volume is meaningful. He introduced the transactional activities as the only index of liquidity. Marshall, B. & Martin, Young (2006) investigated the relationship between the excess stock return of common stocks in the Australian stock market and the factors such as Beta risk, company size, offer prices, circulation rate and ratio of illiquidity. The results showed that among the various liquidity measures, the ratio suggested by Amihud justifies the excess stock return in the best way. Amihud (2002) demonstrated that the expected illiquidity of the market has a direct relationship with the expected excess stock return. He claimed that we can explain a part of expected excess stock return through illiquidity premium. He considered the ratio of the absolute value of the stock return to the trade volume in dollar as an illiquidity measure, and thought that it played a major role in determining the stock premium of the small companies. Studies in Iran Ghasemi (2008) in a study titled A Review of the Factors Influencing the Excess Stock Return of the Listed Companies in Tehran Stock Exchange showed that only the systematic risk index (Beta) influences the expected return, and the company size, the ratio of the book value to the market value, trade circulation, and the ratio of the earning to the price have no influence on the expected return. Another study was done by a PhD student at Tehran University, Saeed Bagherzade, titled A Review of the Factors Influencing the Expected Return of the Listed Companies in Tehran Stock Exchange. The study shows a part of the empirical evidence in Tehran Stock Exchange of the years 1995 to His study shows that:there is a meaningful linear relationship between the market risk (measured by Beta), the company size, and the trade volume; and also between the ratio of the book value to the market value and return. Moreover, there was no significant relationship between the ratio of earning to the price and the mean of the return, in his results. Sharif (2003) in a study titled Designing Capital Asset Pricing Model (CAMP) in Tehran Stock Exchange showed that CAMP cannot determine the return behavior and its relationship with Beta in a situation when the market takes a negative course (negative risk premium); and when the market takes a positive course, there is a positive relationship between risk and return. Methodology Regarding the topic and the hypotheses, our research is practical, descriptive and correlational. Our data are collected through library-based and field-based methods of data collection. Hypotheses Regarding the importance of the stock return in financial decision making, the hypotheses are listed as follows: There is a meaningful relationship between the company size and the stock return There is a relationship between liquidity and stock return. There is a meaningful relationship between P/E ratio and stock return. Statistical Population and Sampling The data used in the research are provided from the financial statements of the listed companies in Tehran Stock Exchange for their credit and ease of access. The statistical population of the study includes all the companies listed in Tehran Stock Exchange. We have used simple random sampling. Our sample includes 95 companies that were later reduced to 78 due to the simple sampling method used. After eliminating the errors and outliers, companies were selected. Finally our research was conducted on companies. The independent variables: P/E, size and liquidity 010

5 A Review of the Factors Influencing the Stock Return The dependent variable: stock return Statistical Methods To analyze the data, we have used descriptive and inferential statistical methods. In the descriptive part, we have used frequency distribution tables, measures of central tendency (mean) and variability (standard deviation). In the inferential part, considering the hypotheses derived from the Kolmogorov Smirnov test, we have used Spearman's correlational test with the help of SPSS. Testing the Hypotheses The first hypothesis: there is a meaningful relationship between the company size and return H 0 = there is no positive and meaningful relationship between the company size and the stock return. H 1 = there is a positive and meaningful relationship between the company size and the stock return. Spearman s correlational table for analyzing the relationship between the company size and the stock return of the listed companies in Tehran Stock Exchange. The Stock Return of the Listed Companies in Tehran Stock Exchange Level of Spearman's number Significance correlation coefficient 031/0 305/0 764/0 044/0 788/0 039/0 52/0 093/0 136/0 214/0 062/0 266/0 variable 5-year Mean The Size Company The Second Hypothesis: there is a meaningful relationship between the liquidity index and the stock return. H 0 = there is no positive and meaningful relationship between the company size and the stock return. H 1 = there is a positive and meaningful relationship between the company size and the stock return. The results of Spearman s correlational table for analyzing the relationship between the liquidity index and the stock return of the listed companies in Tehran Stock Exchange Stock return of the listed companies in Tehran Stock Exchange Level of Spearman's Number significance correlation coefficient 01/0 36/0 122/0 221/0 82/ 033/0-014/0 345/0 245/0 168/0 001/0 496/0 variable 5-year mean The size company The third hypothesis: there is a meaningful relationship between P/E ratio and the stock return. H 0 = there is no positive and meaningful relationship between P/E ratio and the stock return. H 1 = there is a positive and meaningful relationship between P/E ratio and the stock return. The results of Spearman's correlational test for analyzing the relationship between P/E ratio and the stock return of the listed companies in Tehran Stock Exchange

6 The stock return of the listed companies in Tehran Stock Exchange Level of Spearman's Number significance correlation coefficient 588/0 079/0 367/0 13/0 905/0 017/0 681/0 06/0 405/0 12/0 91/0 016/0 variable 5-year mean The size company Summary and Conclusion In this study, we analyzed the relationship between return on equity variables and the investment volume, and the stock return. Thus, the hypotheses are stated as follows: The Results of the Hypothesis Testing: Hypothesis 1: there is a meaningful relationship between the company size and the stock return. Conclusion: the correlation coefficient between these two variables is This means that there is a positive and meaningful relationship between them. Hypothesis 2: there is a relationship between liquidity and the stock return. Conclusion: the correlation coefficient between these two variables is This means that there is a positive and meaningful relationship between them. Hypothesis 3: there is a meaningful relationship between P/E ratio and the stock return. Conclusion: the correlation coefficient between these two variables is This means that there is no positive and meaningful relationship between them. Limitations Among the possible limitations for generalizing the results are the following: 1- Limitation in the range of the price percent (+%04 and -%04) and also the restriction on the basic volume (the restrictions in the trading system of the market). 2- We should be cautious in generalizing the results to the trading environments because the study is done in a developing country with its own specific economic and social structures. Because of the limited researches conducted on the relationship between some variables including investment volume and the stock return in Iran, we were restricted in our access to the resources. Suggestions for Future Researches The influence of the stock markets is undeniable in the economic development of a country. The major role of this market is to incentivize the resources efficiently, and allocate them optimally. If our market is to be an efficient one, all the reliable and relevant data including accounting data should be accessed freely and easily by all the traders, and they should also have the same interpretation of the data. Because the results show meaningful relationships between accounting variables and stock return, the suggestions for further studies are listed below.

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