Journal of Emerging Trends in Economics and Management Sciences (JETEMS) 2 (2): 124-130 Scholarlink Research Institute Journals, 2011

1 (ISSN: 2141-7024) jetems.scholarlinkresearch.org Journal of Emerging Trends in Economics and Management Sciences (JETEMS) 2(2):124-130 (ISSN:2141-7024)

Determinants of Share Prices in India

1 1

P. S. irmala, 1P. S. Sanju and 2M. Ramachandran

Department of Management Studies, School of Management, Pondicherry University, Kalapet, Puducherry 605 014, India. 2 Department of Economics, School of Management, Pondicherry University, Kalapet, Puducherry 605 014, India Corresponding Author: P. S. irmala
__________________________________________________________________________________________ Abstract The focus of this study is to identify the determinants of share prices in the Indian market. The study uses panel data pertaining to three sectors viz., auto, healthcare and public sector undertakings over the period 2000-2009 and employs the fully modified ordinary least squares method. The results indicate that the variables dividend, price-earnings ratio and leverage are significant determinants of share prices for all the sectors under consideration. Further, profitability is found to influence share prices only in the case of auto sector __________________________________________________________________________________________ Keywords: share prices, determinants, panel unit root, panel cointegration, fully modified ordinary least squares __________________________________________________________________________________________ I TRODUCTIO One of the major avenues of investment that has the book value, etc. or external factors such as interest potential of yielding considerable returns to investors rate, government regulations, foreign exchange rate, is the investment in equity shares. It is also a source etc. Several such factors have been identified by of finance for the capital requirements of firms. previous empirical research. The pioneering work on Returns from such equity investments are however share price determinants by Collins (1957) for US subject to vary, depending upon various factors such identified dividend, net profit, operating earnings and as the performance of the particular stock, the market book value as the factors influencing share prices. conditions, etc. Knowledge of such factors and their Following Collins (1957), there have been various possible impact on share prices is highly appreciable attempts to identify the determinants of share prices as it would help investors make wise investment for different markets. Such studies and the factors decisions and enable firms to enhance their market identified as share price determinants are summarized value. The factors that influence share prices could in table 1. either be internal factors, such as earnings, dividend, Table 1: Summary of Studies Focusing on Share Price Determinants S. o. Study Factors affecting share prices 1 Karathanassis and Dividend, retained earnings, size Philippas (1988) 2 Midani (1991) Earnings per share, financial leverage 3 Irfan and Nishat (2002) Dividend yield, leverage, payout ratio, size 4 Pradhan (2003) Dividend 5 AL-Omar and Book value per share, earning per share AL-Mutairi (2008) 6 Khan (2009) Dividend 7 Somoye et al. (2009) Earnings per share, foreign exchange rate, gross domestic product, lending interest rate 8 Sunde and Sanderson Analyst reports, availability of substitutes, earnings, (2009) Government policy, investor sentiments, Lawsuits, macroeconomic fundamentals, management, market liquidity and stability, mergers and takeovers, technical influences 9 Uddin (2009) Dividend, earning per share, net asset value per share It is evident from table 1 that various factors have emerged as determinants of share prices for different markets, viz., dividend, retained earnings, size,

Market Greece Kuwait Pakistan Nepal Kuwait Bangladesh Nigeria Zimbabwe

Bangladesh

earnings per share, dividend yield, leverage, payout ratio, book value per share, foreign exchange rate, gross domestic product, lending interest rate, analyst reports, availability of substitutes, Government
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Journal of Emerging Trends in Economics and Management Sciences (JETEMS) 2(2):124-130 (ISSN:2141-7024) policy, investor sentiments, lawsuits, macroeconomic fundamentals, management, market liquidity and stability, mergers and takeovers, and technical influences. In the Indian context, quite a number of studies have attempted to identify the share price determinants. The empirical evidences, however, differ from study to study depending upon the choice of the firms, sample period and econometric methodology chosen for empirical investigation. For instance, dividend is found to be a major determinant of share prices by Zahir and Khanna (1982), Krishan (1984), Chawla and Srinivasan (1987), Zahir (1992), Malakar and Gupta (1999, 2002), Sen and Ray (2003), Sharma and Singh (2006) and Azhagaiah and Priya (2008). Similarly, earnings is also found to influence share prices by Bhole (1980), Zahir (1992), Sen and Ray (2003), Sharma and Singh (2006) and Bapat and Raithatha (2009). Further, Srivastava (1968) report that retained earnings does not influence share prices, while Chawla and Srinivasan (1987) present evidence of retained earnings influencing share prices. Apart from dividend and earnings, the other variables that have been identified as share price determinants in India are: dividend yield [Zahir and Khanna (1982), Krishan (1984), Zahir (1992)], book value per share [Krishan (1984), Sharma and Singh (2006)], price-earning ratio [Mehta and Turan (2005), Sharma and Singh (2006)], security price index [Zahir (1992)], market capitalisation and market price to book value ratio [Mehta and Turan (2005)], return on capital employed [Sharma and Singh (2006)], firm size [Sharma and Singh (2006), Bapat and Raithatha (2009)] and stock volatility [Bapat and Raithatha (2009)]. From the review of literature on share price determinants, we observe that most of the studies have used either time-series or cross-section data. There have also been attempts to identify the share price determinants using panel data. However, such studies have applied the conventional regression analysis and examined whether the data fits into fixed effect or random effect model. These exercises ignore the time series properties of the data and hence, it is likely that the results generated might be suffering from spurious relationship. The present study differs from the earlier empirical works in the sense that it employs the panel unit root tests to understand the time series properties of the data and applies the panel cointegration test to examine the long run equilibrium relationship between share price and the chosen explanatory variables. Subsequently, fully modified ordinary least squares (FMOLS) method is employed to estimate the impact of the chosen variables on share prices, if cointegration is established among the variables. We also attempt to identify the share price determinants across different sectors, as they are likely to vary from one sector to the other. The rest of the paper is
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organized as follows: section 2 deals with the econometric methodology; discussion of empirical results is presented in section 3 and section 4 presents the concluding remarks. THE ECO OMETRIC METHODOLOGY Panel Cointegration Test In this study, we use the econometric methodology proposed by Pedroni (1999) which is meant for testing cointegration among a set of variables. This test is an extension of the Engle and Granger (1987) two step residual based procedure for testing the null hypothesis of no cointegration in the case of heterogeneous panels. The major advantage of this test is that it allows for individual member specific fixed effects, deterministic trends and slope coefficients. The methodology involved in testing for cointegration among a set of variables is discussed below with respect to the model used in this study. To identify the factors that influence share prices, panel regression of share prices (SP) on dividend (DPS), profitability (ROA), price earning ratio (PE) and leverage (DE) as in equation (1) is estimated. SP = + DPS+ ROA+ PE + DE +e (1)
i,t i 1i i,t 2i i,t 3i i,t 4i i,t i,t

where i = 1,. . ., ; is number of cross-sectional units; t = 1, . . ., T; T is the time period; s are the slope coefficients; i is the member specific intercept. The variables in equation (1) are integrated of the same order and said to be cointegrated if ei ,t is a stationary process; hence, testing for cointegration between SP, DPS, ROA, PE and DE involves testing for stationarity of ei ,t . The stationarity of the residuals from equation (1) can be tested by estimating the following auxiliary regression: (2) e =e +u
i ,t i i ,t 1 i ,t

The null hypothesis

i = 1 implies that ei ,t

has unit

root. In order to test the null hypothesis, Pedroni (1999) proposes two different sets of statistics, namely, the within-dimension statistics and the between-dimension statistics. Within-dimension statistics are also known as panel cointegration statistics and between-dimension statistics as group mean panel cointegration statistics. There are seven test statistics of which, Panel Variance, Panel Rho, Panel PP and Panel ADF statistic are withindimension statistics, while Group Rho, Group PP and Group ADF statistics are between dimension statistics. Although the null hypothesis is the same, the alternative hypothesis is different for the two sets of statistics. The null hypothesis relating to within dimension statistics is defined as i = 1 for all i against the alternative of i = < 1 for all i. The alternative hypothesis implies that there is

Journal of Emerging Trends in Economics and Management Sciences (JETEMS) 2(2):124-130 (ISSN:2141-7024) cointegration among the variables of all the members of the panel. The null hypothesis pertaining to between dimension statistics is defined as i = 1 for all i against the alternative of i < 1 for all i. In this case, unlike within dimension statistics, a common value for i is not assumed. Thus, the alternative hypothesis implies that cointegration exists for atleast one individual member of the panel. The between dimension statistics, therefore, allows to model an additional source of potential heterogeneity across individual members of the panel. Fully Modified Ordinary Least Squares method The application of OLS method to obtain the cointegrating vector from a panel leads to biased estimates due to endogeneity problem. However, the fully modified ordinary least squares (FMOLS) method of Pedroni (2000) accounts for heterogeneity across individual members of the panel, corrects for serially correlated errors and resolves the endogeneity problem; hence, the estimates are unbiased. The FMOLS produces two types of estimators, viz., pooled panel estimator and group mean panel estimator. The former is based on within dimension of the panel whereas the latter is based on between dimension of the panel. In the case of pooled panel estimator, the null hypothesis is defined as H0: i = 0 for all i against the alternative of H1:

Table 2: Details of final sample S. o. Sectors o. of Firms 1 Auto 09 2 Healthcare 09 3 PSU 19 Note: PSU Public Sector Undertaking As a measure of share price (dependent variable), average of yearly high and low share prices is used. It is deflated by the wholesale price index. Earlier studies have identified various factors as share price determinants. In this study, four factors viz., dividend, profitability, price-earning ratio and leverage, are considered as possible determinants of share prices. Dividend, the return that shareholders receive on their shareholdings, is a source of regular income to them. Dividend seeking investors wish to earn current income in the form of dividend rather than capital appreciation, and prefer firms that pay higher dividends. This preference creates greater demand for higher dividend paying stocks, which triggers the market price of such stocks. This way, dividend is expected to be positively related to share prices. As a surrogate for dividend, dividend per share i.e. the total dividend amount paid to equity shareholders upon the number of equity shares outstanding is used. Dividend per share is deflated by the wholesale price index. Profit after tax and preference dividend is the earnings available to the equity shareholders. Firms utilize these earnings to distribute dividends to shareholders. Thus, higher the profits, higher are the dividend payments, which in turn enhances the market price of the stocks. A positive relationship is thereby expected between share prices and profitability. As a measure of profitability, the ratio of profit after tax to total assets i.e. return on assets (ROA) is used. Price-earning (PE) ratio indicates the price that investors are willing to pay for the net profit per share earned by the firm. It is computed as the market price per equity share upon earnings per share of the firm. Since price-earning ratio reflects the market expectations about the firms future performance, a high PE ratio denotes the investors expectations that the firm will have higher earnings in the future. Investors would therefore be willing to pay more for the shares of firms with higher PE ratio. A positive relationship is therefore expected between share prices and price-earning ratio. Leverage measured as debt-equity ratio, indicates the proportion of a firms assets that is financed by debt as against equity. Raising capital via debt involves periodic interest payments on part of firms; increased use of debt by a firm would therefore result in higher interest payments and this lowers the earnings available to equity shareholders. Investors therefore generally prefer firms with lower debt. This way a
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i = a 0

for

all i, where

is the

under the null and a is some alternative value for which is

hypothesized common value for also common to all members of the panel. In the case of group mean panel estimator, the null hypothesis is defined as H0: i = 0 for all i against the alternative of H1: i 0 for all i, where i are not necessarily constrained to be homogeneous across different members of the panel. Thus the group mean panel FMOLS estimator provides greater flexibility by allowing heterogeneity of the cointegrating parameters. EMPIRICAL RESULTS The study uses panel data consisting of annual time series data over the period 2000-2009 and crosssection data pertaining to three sectors. The initial sample consisted of the various BSE sectoral indices. The final data sample has been constructed such that there are a minimum of 9 firms in each sector with continuous data on the selected variables over the sample period. The details of the final sample1 are given in Table 2. Data on all the selected variables is obtained from Centre for monitoring Indian economy database Prowess.
1

Complete list of the selected firms under various sectors can be availed from the authors upon request.

Journal of Emerging Trends in Economics and Management Sciences (JETEMS) 2(2):124-130 (ISSN:2141-7024) negative relation between share prices and leverage is expected. Prior to testing for cointegration, the data needs to be tested for stationarity. We employ two panel unit root tests, viz., Fisher type Augmented Dickey-Fuller (Fisher-ADF) and Phillips-Perron (Fisher-PP) tests to test the unit root properties of the data. These tests accommodate individual member specific unit root process. The results of the panel unit root tests for the chosen variables, both in level and first difference are reported in table 3. Table 3: Panel Unit Root Test Results Null Hypothesis H0: Series has Unit Root Fisher ADF test Fisher PP test Test Level First Level First Sectors Difference Difference Share Price Auto 19.81 41.87 11.01 46.96 (0.34) (0.00) (0.89) (0.00) Health 20.14 76.93 19.72 79.19 Care (0.33) (0.00) (0.35) (0.00) PSU 18.19 109.94 20.31 163.06 (1.00) (0.00) (0.99) (0.00) Dividend per share Auto 29.24 60.19 21.99 59.99 (0.05) (0.00) (0.23) (0.00) Health 9.95 72.57 8.85 91.54 Care (0.93) (0.00) (0.96) (0.00) PSU 30.37 186.16 28.55 210.17 (0.81) (0.00) (0.87) (0.00) Return on Assets Auto 19.52 61.94 14.83 73.21 (0.36) (0.00) (0.67) (0.00) Health 27.53 115.96 28.17 127.50 Care (0.07) (0.00) (0.06) (0.00) PSU 37.00 192.82 36.81 201.79 (0.52) (0.00) (0.52) (0.00) Price-Earning ratio Auto 12.56 106.98 22.08 119.24 (0.82) (0.00) (0.23) (0.00) Health 25.80 82.90 25.35 93.06 Care (0.10) (0.00) (0.12) (0.00) PSU 33.18 227.83 43.57 245.75 (0.69) (0.00) (0.25) (0.00) Debt-Equity ratio Auto 23.66 77.96 28.80 77.26 (0.17) (0.00) (0.05) (0.00) Health 18.58 73.72 16.81 73.46 Care (0.29) (0.00) (0.40) (0.00) PSU 48.33 160.21 49.57 155.38 (0.12) (0.00) (0.10) (0.00) Note: Numbers in (#) are p-values; PSU Public Sector Undertaking As shown in table 3, the Fisher ADF test result for share price in level fails to reject the null hypothesis that share price in level is nonstationary. Similarly,
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the result of Fisher PP test indicates that share price in level is nonstationary. Hence, we test for stationarity of share price in first difference. Both the Fisher ADF test and Fisher PP test results indicate that share price in first difference is stationary. This implies that, for all the sectors under consideration, the variable share price follows an I(1) process. Next, we examine whether the variable dividend per share is stationary. The results of both Fisher ADF and Fisher PP tests indicate that dividend per share in level is nonstationary. When tested for stationarity in first difference, the results of Fisher ADF and Fisher PP tests reject the null hypothesis that dividend per share in first difference is nonstationary. Therefore, for all the sectors, dividend per share becomes stationary upon first differencing and it follows an I(1) process. For the variable return on assets, both the Fisher ADF and Fisher PP test reveal that return on asset in level is nonstationary. In first difference form, return on assets is found to be stationary as indicated by the test results. Thus, the data pertaining to the variable return on assets, for all the sectors, follow an I(1) process. Similarly for the variables price earning ratio and debt equity ratio, the results of both Fisher ADF and Fisher PP tests fail to reject the null hypothesis that the variable in level is nonstationary. Upon first differencing, both these variables turn out to be stationary. The results thus indicate that the variables price earning ratio and debt equity ratio for all the sectors under consideration follow an I(1) process. Overall, for the chosen sectors, the variables share price, dividend per share, return on assets, price earning ratio and debt equity ratio are nonstationary in level and stationary in first difference. Since all these variables follow I(1) process, we next proceed to test whether there exists cointegration between these variables. To test for cointegration, we employ panel cointegration test proposed by Pedroni (1999), the results of which are reported in table 42. Table 4: Panel cointegration test results Null hypothesis H0: no cointegration Sectors Group ADF test statistics Auto -4.15 (0.00) Health Care -2.08 (0.02) PSU -7.10 (0.00)

2 Joyeux and Ripple (2004) state that the group-ADF test as well as the panel-ADF test performs better in cases where the time dimension of panel is less than 100. In similar direction, Lee and Chang (2008) also point out that the panel-ADF and group-ADF statistics have better small sample properties as compared to other statistics. Of these two statistics, the group-ADF statistic allows potential heterogeneity across individual members of the panel. Hence, we consider the group-ADF test statistics to test for cointegration between the variables.

Journal of Emerging Trends in Economics and Management Sciences (JETEMS) 2(2):124-130 (ISSN:2141-7024) Note: Numbers in (#) are p-values; PSU Public Sector Undertaking From table 4 it is evident that, for all the sectors under consideration, the Group ADF test statistics rejects the null hypothesis that there is no cointegration between the variables. This implies that the variables share price, dividend per share, return on assets, price earning ratio and debt equity ratio are cointegrated and that there exists a long run equilibrium relationship between them. Having identified that the variables are cointegrated, we proceed to estimate the model specified in equation (1) in order to identify the share price determinants. For this purpose, we employ the group mean panel FMOLS method proposed by Pedroni (2000), and the results are reported in table 53. Table 5: Group mean panel FMOLS results
Sectors Auto Health Care PSU 1 12.27 (11.17)*** 64.62 (10.22)*** 25.58 (9.31)*** Slope Coefficients 2 3 2.48 6.36 (-1.71)* (4.37)*** 5.95 6.14 (0.09) (4.84)*** -20.69 9.55 (-0.04) (21.39)*** 4 -3.14 (-3.09)*** -2.74 (-5.86)*** -0.70 (-5.85)***

Zahir (1992) and Somoye et al (2009) have also found evidence of profitability being a significant determinant of share prices. The variable price earning ratio is found to be a significant factor influencing share prices for all the three sectors under consideration. It is found to be positively related to share prices. This indicates that the shares with higher PE ratio will be better valued in the market as it reflects the investors expectations that the firm will have good prospects in the future. The finding of price earning ratio as a significant determinant of share prices is in line with Mehta and Turan (2005). The results further indicate that debt-equity ratio is a significant determinant of share prices for all the three sectors and that it exerts a negative relation with share price. This implies that as the debt content in the capital structure of a firm decreases, its share price rise and vice versa. This finding indicates that investors prefer firms with lower debt content, since increased use of debt by a firm lowers the earnings available for equity shareholders and investors become apprehensive about their returns. In a nutshell, the FMOLS test results reported in table 5 reveal that the variables dividend, price-earning ratio and leverage are significant determinants of share prices for all the sectors under consideration. Further, profitability is found to be a significant factor influencing share price only in the case of auto sector. CO CLUSIO The present study attempted to identify the factors that influence share prices for the selected sectors of Indian market. Panel data pertaining to the sectors auto, healthcare and public sector undertaking over the period 2000-2009 is used. The study has chosen dividend, profitability, price-earning ratio and leverage as possible determinants of share prices and employs the fully modified ordinary least squares method to identify the share price determinants. The results indicate that the variables dividend, priceearning ratio and leverage are significant determinants of share prices for all the sectors under consideration. Further, in the case of auto sector, profitability is also found to be a factor influencing share prices. REFERE CES Al-Omar, H. and Al-Mutairi, A. 2008. The Relationship Between the Kuwaiti Banks Share Prices and Their Attributes. Scientific Journal of King Faisal University (Humanities and Management Sciences), 9(1): 325-338. Azhagaiah, R. and Priya, S. 2008. The Impact of Dividend Policy on Shareholders Wealth.
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Note: Numbers in (#) are t-values; PSU Public Sector Undertaking; *** and * denotes significance at 1% and 10% level respectively; 1, 2, 3 and 4 are the slope coefficients for DPS, ROA, PE and DE respectively. From the results of table 5 it is evident that the variable dividend per share is a significant determinant of share prices for all the sectors under consideration. As expected, dividend per share is positively related to share price. This means that share price would rise with an increase in dividend per share. This finding indicates that investors attach more value to those firms that pay dividends and therefore, a consistent and liberal dividend policy would enable firms enhance their market value. Similar evidence of dividend being a significant determinant of share prices is reported in Zahir and Khanna (1982), Karathanassis & Philippas (1988) and Zahir (1992). Next, we examine the influence of return on assets on share prices. As is evident from table 5, return on assets is found to significantly influence share prices in the case of Auto sector. As expected, return on assets bear a positive relation with share prices. For the remaining two sectors, Healthcare and PSU, return on assets does not influence share prices. This finding implies that investors do not attach much importance to profitability of a firm. Instead, what matters to the investors more is the portion of earnings that is paid to them in the form of dividend.
3

The estimates are obtained using the RATS code provided by Peter Pedroni.

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