International Journal of Basic Sciences & Applied Research. Vol.

, 6 (3), 269-280, 2017

Available online at http://www.isicenter.org
ISSN 2147-3749 2017

Stock Return Predictability with Financial Ratios: Evidence from PSX 100
Index Companies

Wasim Ud Din

MS (Management Sciences) from Department of Management Sciences, Comsats Institute of Information

Technology, Islamabad
*
Corresponding Author Email: wasimkust@gmail.com

Abstract
The objective of the current study is to investigate the stock returns
predictability by using financial ratios and control variable of PSX 100
Index companies during period from 2001-2014. The current study mainly
focuses on investigating better predictor of stock returns. The methodology
is based on Ordinary Least Square (OLS) to estimate the multiple linear
regression model. The correlation matrix shows that there is no
multicollinearity found between variables. The result of F-Limer test shows
that the panel data is appropriate while Hausman test shows that random
effect model is appropriate to estimate the model. The results reveal that all
variables are statistically significant but some variables have negative
impact on stock returns such as asset turnover ratio, EPS, inflation, interest
rate and GDP. However, debt ratio, return on sales, firm size, market
return and Tobins-Q have positive and significant impact on stock returns.
In conclusion, potential investors not only focus on huge returns for
investing in smaller market cap firms but also investing in large market cap
firms of PSX 100 Index companies due to reason that large firms benefit
from economies of scale. Furthermore, the stock returns are predictable
through financial ratios and control variables in PSX 100 Index Companies
and investors also set the investment criterion to see the firm size and
Tobins-Q when investing in large or small market cap companies to earn
excess returns.

Keywords: Predicator, Hausman test, Tobins-Q, PSX 100 Index Companies,

Criterion, Excess Returns.

Introduction

Financial ratios are classified into five basic types for convenience: liquidity, activity (efficiency), debt,
profitability and market based ratios. Liquidity, activity and debt ratios mainly measures risk, profitability ratios

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measure only return and market based ratios capture both risk and returns for investors. A single ratio doesnt
usually provide suitable information to evaluate the total performance of companies. On the other hand, if ratio
analysis is concerned only with particular characteristics of a financial position of companies, only one or two ratios
may be enough. The financial ratios are used for comparison and calculated on annually basis by using financial
statements of companies. If they are not calculated on annually basis, then the effects of seasonality may lead to
inaccurate conclusions and investment decisions. It is necessary to use audited financial reports of companies for
ratio analysis. But, the data of unaudited financial reports may not reflect the accurate financial condition of
companies. By using financial ratios, we must be cautious when relating old companies to new companies or a
company to itself over a long-term period (Gitman Lawrence, 2004).
Financial ratio is a fraction that shows the relationship between one or more variables which is taken from
financial statements for comparison. Financial ratios are the most powerful of all tools used for the analysis and
interpretations of financial statements that can enhance informed judgments and investment decisions (Lasher,
1997). To evaluate the stock returns, the vital criterion for evaluating the performance of companies is to measure
the rate of stock returns. This criterion itself contains information for investors used to evaluate the performance of
companies. Analysts use ratios as a common tool to identify the weaknesses and strengths of a company. However,
this ratio is only realized the complications, signs and not the primary problem. If the ratio is high or low, it is
important to realize a situation in company; however, cannot obtain sufficient information (Ghale, 2015). The
investors have less information about the stock exchange markets and many studies suggests that find the criteria
that help them investing. If so, they can decide to investigate very cautiously and in a speedy way. However, to find
relevant accounting variables for investors leads to better investment decisions (Hejazi et al., 2011).
The basic aim of investors from investing in companys stock is to raise profits which are attained by stock
returns of companies. The stock return is the essential element in selecting the sound investments decisions.
Furthermore, any investor in selecting their best investment decision is to achieve stock returns with more
efficiently, competently and a lesser amount of risk. Yet, the investors must need information about those stock
returns of companies that can increase profits. The information which exists about companys stock is based on
internal or external information of that company. Internal information of the company is reflected in its financial
reports such as balance sheet, profit and loss statement and cash flow statement. The outside information of
companies are available in the stock exchange market. Consequently, these internal and factors can affect the stock
returns. Furthermore, external information determines the stock prices in the stock exchange market and has
influence on investment decisions made by investors (Modridi & Mousavi, 2009).
A survey conducted in the Boston College (2007), 62% respondents preferred financial information and 38%
respondents preferred non-financial information which is mainly used in investment decisions (Shehzad & Ismail,
2014). Stocks are the most chosen investments since they offer higher stock returns than other instruments. So, the
elements determining stock returns are one of the most vital subjects in finance. Furthermore, the investors will
prefer to buy the stock of those companies when book value of stock is larger than market value of stock.
Moreover, the financial ratios are vital indicators for valuation of a company and investment decisions
(Emamgholipour et al., 2013). The difficult and interesting phenomena for both financial analysts and investors are
that stock returns have permanently been a source of debate in the financial markets. The valuation of correlation
between financial ratios and their impact on the stock returns which is one of the dilemmas often debated in this
field of study (Karami & Talaeei, 2013).
Stock return is a crucial problem as well as the strategically target to achieve by shareholders who wish to
maximize it. Therefore, this issue has had lots of different results of experimental researches in the world. Many
financial ratios are statistically significant and positively related with stock returns as backed by literature. There is
no agreement among authors that stock returns are unpredictable and some said that stock returns are predictable.
But forty years ago, stock returns are not predictable because overall efficiency of markets (Fama, 1970). Stock
returns are predictable through market based ratios (Kheradyar et al., 2011; Zeytinoglu et al., 2012;
Emamgholipour et al., 2013). Though, the stock returns are predicable by using financial ratios (Pontiff & Schall,
1998; Kheradyar et al., 2011). It is evident that stock return predictability is due to market inefficiencies in stock
market (Pesaran & Timmermann, 1995).
Financial ratios are one of the financial statement analysis methods used by financial analysts. They use
genuine data and financial statements analysis in order to study the predictability of stock returns which is based on
financial ratios. Furthermore, financial ratios are calculated from financial reports which are considered as
appropriate indices that can be used to facilitate the sound investment decisions by investors and benefit the users of
financial reports in order to inspect financial ratios of companies (Karami & Talaeei, 2013). So, stock returns are
predictable in inefficient markets instead of efficient market. In the age of globalization, the investors are becoming
smarter and risk averse by investing in stocks of high market capitalization companies. Without stock return

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predictability, the investors are unable to make sound investment decisions which can leads to lower the investor
confidence. The objective of the current study is to investigate the impact of financial ratios on stock returns and
also to investigate the long-term performance of stock returns.

Literature Review

There are a diverse number of literatures available on the impact of financial ratios on stock returns
performance. There are literatures which tried to highlight on the factors that may have impact of financial
ratios and control variables on stock returns performance. Having the view of stock returns predictability, the
following literature survey has been conducted.
Kheradyar et al (2011) studied the role of financial ratios that can predict stock returns in hundred companies
listed on the Malaysian Stock Exchange during period from 2000-2009. The dependent variable is yearly stock
returns and independent variables are dividend yield, earning yield and Book-to-Market (B/M) ratio. They applied
Generalized Least Squares methods to estimate the predictive regressions on panel data. The result shows that the
financial ratios can forecast the stock returns. The B/M ratio has the higher predictive power than dividend yield
and earning yield. Moreover, the financial ratios can raise the predictability stock returns when the ratios are
combined in the multiple predictive regression model. Most of the studies have been hypothesized to predict the
U.S. stock returns. Hence, predictive power of the financial ratios is still unknown in developing markets. Among
financial ratios, dividend yield, earing yield, and B/M ratios have a strong theoretical background and unique
features. In short, financial ratios can predict future stock returns in emerging MSE.
Fun and Basana (2012) examined the impact of Price-to-Earnings (P/E) ratio on stock return in forty-five
companies listed on the Indonesia Stock Exchange during period from 2005-2010. They used Hausman test on panel
data. The result of simple linear regression model shows that there is statistically insignificant relationship between
P/E ratio and stock returns. There is another study done by two scholars such as Maxwell and Kehinde (2012) who
investigated the impact of financial ratios on stock returns. The study was conducted on 50 companies listed in the
Nigerian Stock Exchange (NSE) during the period from 2001-2006. They used panel data and simple linear
regression model. There finding suggest that there is a significant linear relationship between P/E ratio and stock
returns. There is another similar study done by Khan et al (2012) who examined the financial ratios and stock
returns predictability by using Pakistani listed companies. The purpose of their work is to investigate the ability of
dividend yield, earning yield and B/M ratio in order to predict stock returns. The sample of the study consists of 100
non-financial companies listed on the Karachi Stock Exchange. The seven years are used for analysis from 2005-
2011. To find whether earning yield, dividend yield and B/M ratio can predict stock returns. They use regression
analysis on panel data models. The results indicate that earning yield, dividend yield ratios has direct positive
association with stock return whereas B/M ratio has statistically significant and negative relationship with stock
returns. Thus, dividend yield, earning yield and B/M ratios can predict stock returns. Furthermore, as compare to
dividend yield and earning yield, B/M ratio has the highest predictive power. Moreover, when we combine these
financial ratios, the stock returns predictability will improve.
Karami and Talaeei (2013) examined stock returns predictability by using financial ratios in the companies
listed in Tehran Stock Exchange during period from 1998-2007. The aim is to measure correlation between
financial ratios and their impact on predictability of stock returns. The stock returns are the dependent variable
while financial ratios including P/E ratio, B/M ratio, dividend yield and capital gain are the independent variables.
In order to test the research hypotheses, the panel data is used. The results of simple and multiple linear regression
model shows that B/M ratio and capital gain significantly affect predictability of stock returns. There is another
similar study done by Tahir et al., (2013). They studied the distinctive features of the companies have specific
power to predict the stock returns. This study was lead with an attempt to link the literature gap by presenting
empirical evidence about features of companies and their effect on stock returns. They used secondary data of 307
non-financial listed firms of Karachi Stock Exchange during period from 2000-2012. The dependent variable is
stock returns while independent variables are EPS, sales growth, market capitalization, and B/M ratio. First two
independent variables such as EPS and sales growth are used as proxies for size effect of companies while B/M
ratio is used for value effect of companies. They used multiple linear regression models by using panel data.
Furthermore, statistical and econometric techniques such as correlation matrix and multiple linear regression
analysis are applied for empirical testing. The result shows that independent variable of the study had significant
impact on stock returns except sales growth.
Jabbari and Fathi (2014) studied the stock returns predictability by using financial ratios. The dependent
variable is stock returns and independent variables are current ratio, asset turnover ratio, fixed asset turnover ratio,
net income to sales ratio and return on assets. The methodology used in current study is Least Square regression

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technique in order to investigate the relationship between stock returns and financial ratios. This study provides
empirical evidences by selecting all listed firms of Tehran Stock Exchange during period from 2007-2012. The
result of F-Limer test shows that panel data is appropriate for analysis while result of Hausman test shows that fixed
effect model is suitable for estimation. The result of OLS regression under fixed effect method showed that the
financial ratios predicted 15% of the stock returns and all financial ratios are statistically significant impact on stock
returns. The overall validity of model is check by Fisher F-test value which is 9.37 and P-value of F-test is zero
which is lower than 5% level of significance. Hence, we reject null hypothesis and conclude that model is valid in
predicting stock returns through financial ratios. The Durban Watson test statistics value is 1.91 which signifies that
there is no problem of autocorrelation. The finding shows that all financial ratios have positive and statistically
significant impact on stock returns except fixed asset turnover ratio that have statistically significant but negative
impact on stock returns due to lowest value of its slope coefficient.
Petcharabul and Romprasert (2014) inspected the significant relationship between financial ratios and stock
returns of the Thailand Stock Exchange during period from 1997-2011. They used quarterly data which are
collected from annual reports of technology industry. The dependent variable is stock returns and independent
variables are current ratio, inventory turnover ratio, ROE, debt-to-equity and P/E ratio. The methodology used in
current paper is regression analysis by using ordinary least square in order to test the relationship between financial
ratios and stock returns. They found that only ROE and P/E ratios have a statistically significant relationship with
stock returns. In short, different countries used different methodology which is backed by literature to test the link
between stock returns and financial ratios which causes different results.
Ghale (2015) investigated the role of financial ratios in explaining stock returns and the correlation of stock
returns with financial ratios and earnings quality in Mobarakeh and Khuzestan steel companys case study. The
dependent variable is stock returns and eleven financial ratios are used as independent variables such as current
ratio, inventory turnover ratio, receivables turnover ratio, debt ratio, return on assets, return on equity, liquidity ratio
of profit, earnings ratio, DPS, dividend ratio and cash flow per share. The methodology used in current study is
Spearman correlation test in order to investigate the relationship between stock returns and financial ratios. The
results of this study indicate that there was a positive relationship between current ratios, debt to asset ratio, ROE,
and profit on sale. Based on the findings, these financial ratios show small percentage of the variation in stock
returns.
Tehrani and Tehrani (2015) investigated the effect of financial ratios to predict company profits and stock
returns in Tehran stock Exchange based on sample of 252 companies. They used stock returns as dependent
variable and ten independent variables such as Return on Assets (ROA), margin sales, changes in ROA, and
changes in gross margin sales, changes in inventory turnover, changes in asset turnover, changes in debt-to-equity,
changes in debt, changes in current ratio and changes in annie ratio. They used panel data and fourteen years i.e.
2001 to 2014 by using ordinary least square (OLS) regression technique in order to test the Hausman test to
investigate the possible effects of financial ratios on stock returns and profits of companies. The results show that
profitability ratios and activity ratios can be proper predictive of oncoming efficiency in the stock market of Tehran.
However, there is not a meaningful relationship between financial ratios and companies profits; that this is due to
smoothing of profits in Iranian companies listed on Tehran Stock Exchange.
Anwaar (2016) investigated the impact of financial ratios by using firms performance variables on stock
returns. The aim of his study is to test the impact of firms performance on stock returns by using listed firms of
FTSE 100 Index during period from 2005 to 2014. There are five exogenous variables such as net profit margin,
ROE, EPS, ROA and quick ratio while endogenous variable is stock returns. The methodology is based on panel
regression analysis to analyze and interpret panel data. The result reveals that ROA and net profit margin have
positive and significant impact on stock returns while EPS has got negative and significant impact on stock returns.
If there are raises in EPS than all investors demands to achieve short-term profit and conscious for dividend and
also to sell their stocks in market because of decline of stock returns in near future and excess supply of stocks.
There is insignificant impact of ROE and quick ratio on stock returns.
In short, the literature examines that the significance of predictability of stock returns is not yet to be explored.
No specific study has been done in Pakistan to investigate the stock return predictability by using financial ratios
and control variables in PSX 100 Index Companies. This study tries to fill the gap in academic research as
combination of financial ratios and control variables that includes asset turnover ratio, debt ratio, ROS, EPS, while
control variables are firm size, market return, Tobins-Q, inflation, inflation and GDP that have impact on stock
returns; in order to investigate the significant predicator and impact on stock returns during period from 2001 to
2014.

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Research Hypothesis

The following are the research hypothesis of the current study.

H1: There is a significant relationship between asset turnover ratio and stock returns.
H2: There is a significant relationship between debt ratio and stock returns.
H3: There is a significant relationship between return on sales and stock returns.
H4: There is a significant relationship between EPS and stock returns.
H5: There is a significant relationship between firm size and stock returns.
H6: There is a significant relationship between market return and stock returns.
H7: There is a significant relationship between Tobins-Q and stock returns.
H8: There is a significant relationship between inflation and stock returns.
H9: There is a significant relationship between Interest Rates and stock returns.
H10: There is a significant relationship between GDP and stock returns.

Methodology

The current study is an applied research in terms of objectives and it is a descriptive and correlational one in
terms of nature and methodology. The current study is based on Ordinary Least Square (OSL) method on panel data
on sixty five listed companies of PSX 100 Index from the period 2001 to 2014 (Jabbari & Fathi, 2014; Tehrani &
Tehrani, 2015). Furthermore, OLS is used for estimating the unidentified parameters. This technique minimizes the
sum of squared vertical distances between the observed responses in the dataset and the responses predicted by the
linear approximation (Hunjra et al., 2014). Descriptive analysis, correlation analysis, F-Limer test and Hausman
test have been conducted in current study. The focus of current study is based on short panel having sixty-five
cross-sectional and fourteen-time series units which is a balanced panel.

Econometric Model

It is clear from below equation 1 that dependent variables of the model is stock returns while financial
variables are asset turnover ratio, debt ratio, return on sales, earnings per share. The control variables are of two
types such as firms specific and macroeconomic variables. The firm size, market returns and Tobins-Q are firms
specific variables while inflation, interest rates and GDP are macroeconomic variables. Based on the examination of
literature pertaining to the topic, the following econometric model is investigated by the using various financial
ratios and control variables.

Rit = + 1 ATRit + 2 DRit + 3ROSit + 4 EPSit +5 FSit + 6MRit + 7 TQit + 8 INFt + 9 INTt + 10 GDPt +it (1)

Where,

Rit = Stock Returns of ith firm in year t

= Intercept
to 10 = 10 slope coefficients of respective independent and control variables
ATRit = Asset Turnover Ratio of ith firm in year t
DRit = Debt Ratio of ith firm in year t
ROSit = Return on Sales of ith firm in year t
EPSit = Earnings Per Share of ith firm in year t
FSit = Firm Size of ith firm in year t
MRit = Market Return of ith firm in year t
TQit = Tobins Q of ith firm in year
INFt = Inflation of Pakistan in year t
INTt = Interest Rates of Pakistan in year t
GDPt = Interest Rates of Pakistan in year t
it = Random Error Term of the ith firm in year t
i = 1,2,3, 65
t = 1,2,3, 14

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Research Variables and their Measurements

Table 1. List of Variable and their Measurements.

S.No. Variables Formulas

Dependent Variables
Pt
1 Stock Returns R it = ln ( )
Pt1
Independent Variables
Total Sales
1 Asset Turnover Ratio ATR it = Total Assets
Total Liabilitiess
2 Debt Ratio DR it = Total Assets
Net Income After Interest and Taxes
3 Return on Sales ROSit = Net Sales
TOtal Income Afetr Interrest and Taxes
4 Earnings Per Share EPSit = Average Outsatnding Shares
Control Variables
1 Firm Size FSit = ln(Market Cap)
PSX 100 Index Pricet
2 Market Return R mt = ln ( )
PSX Index Pricet1
Market Value of Firm
3 Tobins Q TQ it = Total Assets of Firm
4 Inflation Consumer Price Index (CPI) is taken as proxy for Inflation.
5 Interest Rates A money market rates are taken as proxy for interest rates.
GDPt = Consumer Spending + Govt. Spending
6 Gross Domestic Product
+Invesment on Capital + (Exports Imports)

Results

Data analysis means actual results of data mining and information gathering in order to obtain reasonable
results to be used in investment decisions by investors (Ghale, 2015). In this section, data are collected, sorted and
then processed to test the research hypotheses. Furthermore, the financial ratios and control variable are collected
from annual reports of companies and World Bank website. Test and analysis are performed by using MS-Excel
and STATA 13 software. The result of descriptive statistics, correlation matrix, F-Limer and Hausman test and
Random Effect Model are briefly explained as under.

Descriptive Analysis

Table 2. Descriptive Statistics.

Measures Mean SD Minimum Maximum

Stock Returns 14.29 57.80 -301.67 214
Asset Turnover Ratio 8.41 31.56 0.000 36.68
Debt Ratio 0.60 0.23 0.000 1.17
ROS 5.55 13.30 -58.20 153.21
EPS 16.82 31.62 -47.58 367.92
Firm Size 22.55 1.69 15.50 26.75
Market Returns 21.85 38.01 -87.55 75.24
Tobins-Q 0.92 1.30 0.000 12.48
Inflation 8.98 4.60 2.91 20.29
Interest Rate 9.97 2.29 7.00 14.00
GDP 4.12 1.91 1.61 7.70

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It is clear from above Table-2 that mean value of stock return is 14.29% while variability of stock returns is quite
higher as compared to market return which is 57.80%. The average value of asset turnover ratio (ATR) is 1.58 times
and its variability is slightly lower than stock returns which is 31.05%. The minimum value of ATR is zero, which
is the signification in some companies that assets are not efficiently utilized to generate sales. Further, the
maximum value of ATR is 36.69 times that means the companies uses its assets efficiently to generate sales. This
measure having greater interest to management of companies because it shows the companys operations are
financially efficient. The average value of debt ratios (DR) is 0.60% and its variability is very less which is only
0.23%. The minimum value of DR is zero which signifies that less money of others peoples in firms is not properly
generating profits. Furthermore, lower value of DR shows that some firms pay its total liabilities from its total
assets. The maximum value of DR is 1.17% which means that the firm could finance of its assets with debt and
more money of other peoples invested in firms is properly generating its profits. The higher value of debt ratio is
the indication of greater degree of indebtedness and having more financial leverage.
The average value of return on sales (ROS) is 0.05% and its variability around the mean value is slightly low
which 0.59% is. The minimum value of ROS is -1.20% while maximum value is 15.67%. The lower value shows
that some companies uses it net income after interest and taxes less efficiently to generate sales while higher value
signifies that the majority companies uses its net income after interest and taxes to generate its profits. It is due to
less financial risk found in higher value of ROS of PSX 100 Index companies. The mean value of EPS is 16.82 and
its variability is slightly lower than stock return which is 31.62%. The minimum value of EPS is -47.58 which
means some companies suffer losses due to ineffectively managing production capacity thats why its value is
negative while highest value of EPS is 367.92 which means the positive growth in EPS is due to effectively
maximizing the utilization of production capacity and as well as better sales mix. The average value of firm size is
22.55 and its variability around mean value is 1.69%. The minimum value of firm size is 15.50 and maximum value
is 26.75. Furthermore, the fluctuation is due to dispersion between two positive values of firm size which are
actually positive market capitalization value regarding all listed non-financial firms of KSE 100 Index. The positive
value of firm size is the attaining the economies of scale by producing more on reducing the cost of production that
leads to improved efficiency of companies. The average value of market return is 21.85% and its variability around
mean value is 38.01%. The lowest value of market return is -87.55 while highest value is 75.24%. The fluctuation is
due to the dispersion between the higher and lower values. Furthermore, the negative value of market return is due
to financial crises occurred in 2008 and increased after financial crises of 2008. The average value of Tobins-Q is
0.92 times and its variability around mean value is 1.30%. The minimum value of Tobins-Q is zero while higher
value is 12.48. The lower value of Tobins Q signifies that it is less than one. Hence, firm will do not replace
capital, while higher than one value is the signal of those companies will buy more capital to raise the market value
of firm. So, investor must set criterion to invest in those companies that have Tobins-Q value greater than one
which is more worthy and valuable firms for investments because market value of firm is greater than book value of
firm.
The mean value of inflation is 8.98% and its variability around mean value is 4.60%. The minimum value of
inflation is 2.91% in year 2003 while higher value is 20.29% in year 2008 and it drop down to 7.19% in year 2014
is due to strong monetary and fiscal policies. The average value of interest rates is 9.97% while its variability is
2.29% around mean value. The minimum value of interest rates is 7% in year 2003 and higher value is 14% in year
2009 and its value drop down further to 9.50% in year 2014 is mainly due to changing law and order situations in
Pakistan that externally influencing PSX 100 Index companies. The average value of GDP rate is 4.12% and its
variability around mean value is 1.91%. The GDP is fluctuating between 1.61% (2010) and 7.7% (2009). It is due to
instable economy that leads to poor economic reforms, poor governance of country and changing law and order
situation in Pakistan.

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Correlation Analysis

Table 3. Correlation Matrix.

Variables SR ATR DR ROS EPS FS MR TQ INF INT GDP

SR 1
ATR -0.012 1
DR -0.025 0.183 1
ROS 0.136 0.091 0.061 1
EPS 0.077 -0.083 -0.210 0.216 1
FS 0.098 -0.241 -0.075 0.156 0.259 1
MR 0.639 0.004 -0.005 0.098 -0.023 0.482 1
TQ 0.210 -0.134 -0.271 -0.018 0.391 0.353 0.069 1
INF -0.488 0.003 -0.011 -0.109 0.056 0.176 -0.599 -0.023 1
INT -0.206 0.005 0.049 -0.115 -0.010 -0.049 0.180 -0.140 0.346 1
GDP 0.288 -0.012 -0.044 0.139 0.026 0.126 0.161 0.161 -0.376 -0.763 1

Table-3 shows a slightly weak correlation found between stock returns and assets turnover ratio which is 0.012
while slightly higher and positive correlation is found between stock return and market returns which is 0.639. The
negative and weak correlation is found between a GDP and asset turnover ratio while higher correlation is with debt
ratio which is 0.1830. There is slightly strong but negative correlation found between GDP and interest rates which
is -0.763 and less than 0.80. In short, overall result of correlation matrix shows that there is no problem of
multicollinearity. Furthermore, the linear association between stock returns and financial ratios and control
variables are conduct by multiple linear regression analysis which will show better results because regression
analysis is more flexible and accurate than correlation matrix.

F-Limer and Hausman Test

Table 4. Result of F-Limer test and Hauman test.

Measures F-Limer test Hausman Test

Cross-section F-stat 2.01 ----
P-value of F-stat 0.00 ----
Cross-section Chi-square 130.17 1.50
P-value of Chi-square 0.00 0.6829
Decision Panel Data Random Effect Model

It is clear form above Table-4, the P-value of cross-section F-statistics and chi-square test statistics is less than 5%
level of significance for model. Hence, we reject null hypothesis of F-Limer test and conclude that panel ordinary
least square (OLS) is used to estimate the model. Furthermore, the P-value of Chi-square under Hausman test is
greater than 5% level of significance. Hence, we are not being able to reject Ho and conclude that results are
statistically insignificant and we use random effect model for estimating the model.

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Regression Analysis

Table 5. Results of Random Effect Model.

Variable Coefficient Std. Error t-Statistics P-Values

Intercept -242.4684* 40.5485 -5.9797 0.0000
Asset Turnover Ratio -0.2576** 0.1133 -2.2732 0.0233
Debt Ratio 21.0634** 10.2076 2.0635 0.0394
Return on Sales 0.7593* 0.1563 4.8576 0.0000
EPS -0.1345*** 0.0694 -1.9382 0.0529
Firm Size 13.4790* 1.8553 7.2652 0.0000
Market Return 0.7327* 0.0501 14.6249 0.0000
Tobins-Q 3.9153** 1.7362 2.2551 0.0244
Inflation -3.3549* 0.4473 -7.5009 0.0000
Interest Rates -2.7822* 0.9803 -2.8379 0.0047
GDP -5.1201* 1.2481 -4.1021 0.0000
N= 910, R= 73.19%, R2 = 53.57%, F-stat = 13.02, Prob. (F-stat) = 0.0000 and DW- test = 2.06
Where ***and *** indicates the level of significance at 1, 5 and 10 percent.

It is clear from above Table-5 that the slope coefficient of all variables are positive in multiple linear regression
model except intercept, asset turnover ratio, EPS, inflation, interest rates and GDP but all statistically significant
and better predictor of stock returns. The coefficient of correlation (R) is 73.19% which signifies that there is
slightly strong but positive linear correlation found between dependent and independent variables. The coefficient
of determination (R2) is 53.57% which means that the 53.57% variations in stock returns are explained by financial
ratios and control variables. The closer the value of R2 to 1 the better the regression line describe the connection
between dependent and independent variables and in particular the predication made with equation will be more
accurate. The probability associated with the F-statistic is 0.0000 which can support the validity, usefulness and
statistically significant of model. The Durbin Watson statistics value is 2.06 which is slightly equal to 2. It implies
that there is no autocorrelation present in panel data which signifies that errors are independent. The below equation
2 is predicated multiple linear regression model of the current study.

Rit = 242.47 0.2580 ATRit + 21.06 DRit + 0.7593 ROSit 0.1345 EPSit + 13.48 FSit +
0.7327MRit + 3.92 TQit 3.35 INFt 2.78 INTt 5.12 GDPt + it (2)

In above equation 2 there are four independent variables such as asset turnover ratio, debt ratio, return on
sales, EPS while six control variables such as firm size, market return, Tobins Q, inflation, interest rates and GDP.
It is clear from the above equation 2 that the slope of model is negative but statistically significant. There is one unit
increase in asset turnover ratio, the stock returns will decrease by 0.2580 units. This is because of reduction in sales
to generate assets for PSX 100 Index companies. However, the negative impact of assets turnover ratio on stock
returns is due to slightly weak working capital management and high labor cost. If one unit increases in debt ratio,
the stock returns will increases by 21.06 units. The reason for increase in stock returns that the companys debt
policy is quite satisfactory. The highest variation in stock returns is due to debt ratio because the companies fulfill
the short term and long term debts from total assets which is signals of no debt risk. According to Korajczyk et al
(1992) provide the signal of clustering equity issuance. Companies frequently issue equity in good times, as their
own equity price has an unusual rise, and hence, reduce the level of leverage. But, Levy (2000) stated that firms
managers are more likely to issue debt when their compensation is lower. If unit increases in EPS, the stock returns
will decreases by 0.1345 units. The reason for reduction in stock returns is due to fluctuation in stock returns which
is not balanced in reaction towards good news and bad news. However, the increase of investors for a particular
company is a good new to purchase the company shares but bad news for investor when company suffers losses and
company lose many investors in such regard. Thats why fluctuation in stock returns will happen in stock market
due to high inflation. According to Siegel (2002) who said that investors are concerned about the growth in EPS.
The result of the current study is consistent with Zeytinoglu et al (2012) and Emamgholipour et al (2013).
If one unit increases in firm size than the stock returns will increases by 13.48 units. It is better predicator for
potential investors that not only gives second highest variation in stock return by 13.48 units but also benefit from
economies of scale. Normally, larger firms intend to hold reserve more cash to maintain the high level and quality

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of operations and investment chances. In large firm size, lower investor reaction leads to invest in stock of
companies as compared to small size firm where the investor reaction is more that leads to avoid investment. The
potential investors not only focus on huge returns for investing in smaller market capitalization companies but also
investing in large market capitalization companies. If one unit increases in market return than there will be 0.7327
units increases in stock returns. There is positive and statistically significant impact found between stock returns
and market returns. The stock returns is increased due to the fact that large market cap companies can earn excess
profits from their investment while small market cap companies fail to earn excess returns and their cost of capital
that behave differently with market returns of country as compared to small size of firm. But in large market cap
companies, the stock return will not behave differently with market returns. If one unit increases in Tobins Q than
there will be 3.92 units increases in stock returns. There is positive and statistically significant impact found
between stock returns of high market capitalization companies and market returns. Hence, the null hypothesis is
rejected. These companies have higher access to growth and investment opportunities due to reasons that firms
value is increasing that will directly increase the stock returns for investors. The results are consistent with
Davidson et al (2002).
If unit increases in inflation than there will be 3.35 units decline in stock returns. There is negative and
statistically significant impact found between stock return and inflation. Hence, the null hypothesis is rejected. The
decrease in stock returns is due to decline in actual profits that shareholder earns in the form of EPS. However,
stock returns are not only negatively affected by the inflation but also decrease the savings and increased the
consumption. If the savings of investors are decreased so the investment in PSX 100 Index companies also
decreased. This result is inconsistent with Samadi et al (2012). There is statistically significant and positive impact
of inflation on stock returns. Some companies offer high stock return will lead to high stock prices (Ahmad et al.,
2013). The result of current study is also consistent with Abbas et al (2015) who investigated the impact of inflation
on stock returns. They result shows that there is negative and significant relationship between stock returns and
inflation. The negative effects are however most pronounced and comprise a decline in the actual value of money
and other monetary variables over time and vice versa. As a result, uncertainty over future inflation rates may
reduce investment and savings, and if inflation levels rise quickly than there may be shortages of goods as
consumers begin to hoard out of uneasiness that is the prices may increase in the future (Kimani & Mutuku, 2013). It
is desirable to keep the inflation below 6% because it may be beneficial for the achievement of maintainable economic
growth and investment (Nasir & Saima, 2010). Hence, investors must sift through the confusion to make wise
investment decisions on how to invest in periods of inflation. Majority non-financial firms stocks seem to perform
better during periods of high inflation.
If one unit increase in interest rates than there will be 2.78 units decline in stock returns. There is negative and
statistically significant impact found between stock return and interest rates. Hence, the null hypothesis is rejected.
This result is consistent with Leon (2008). One unit increase in GDP than there will be 5.12 units decline in stock
returns. There is negative and statistically significant impact found between stock return and gross domestic
product. The negative impact of GDP on stock return is due to high price-to-earnings ratio. Furthermore, the higher
price-to-earnings ratio is the indication of greater investors confidence in buying the shares of companies (Gitman
Lawrence, 2004). Economic growth happens from high individual savings rates, greater participation of
employment force and change of technology and monopolies of companies. The results are consistent with previous
work done by Ritter (2005) who focused on cross-country correlation actual stock returns and GDP growth during
period from 1900-2002 is negative. Furthermore, the result is consistent with Abbas et al (2015) which signifies that
GDP has a negative and significant impact on stock returns.

Discussion and Conclusion

Current study has empirically examined the impact of financial ratios and control variables on stock returns by
taking Pakistan Stock Exchange (PSX) 100 Index Comapnies during the period from 2001 to 2014. The stock
returns are predictable by using financial ratios (Kheradyar et al., 2011). But to fill the gaps of previous studies by
using control variables. Ten variables are found to be better and significant predictor among the various variables
such as asset turnover ratio, debt ratio, return on sales and earnings per share, and control variables such as firm
size, market returns, Tobins-Q, inflation, interest rates and GDP. I have used F-Limer test and Hausman test to
estimate the random effect model on panel data. Furthermore, all variables are statistically significant but some
variables have negative impact on stock returns performance such as asset turnover ratio, earnings per share,
inflation, interest and gross domestic product. However, the debt ratio, return on sales, firm size, market return and
Tobins-Q have positive impact on better performance of stock returns. In addition, potential investors not only

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focus on huge returns for investing in smaller market capitalization companies but also investing in large market
capitalization companies of PSX 100 Index companies due to reason that large firms benefit from economies of
scale rather than the small market capitalization companies.
Empirically, results of the current study are similar with Kheradyar et al (2011). Zeytinoglu et al (2012) and
Emamgholipour et al (2013) and Ghale (2015). The results of multiple linear regression model show that 53.57%
variation in stock returns are explained by financial ratios and control variables. The linear relationship between
stock returns and financial ratios and control variables is 73.19% which shows that there is slightly strong
correlation exits between dependent and independent variables. Hence, overall model is valid and significant which
is specified by P-value of F-test of random effect model which is zero. Hence, it is concluded that financial ratio
and control variables are statistically significant and slightly strong relationship are observed and predictability of
stock returns is 53.57%. Furthermore, the stock market is inefficient thats why stock returns are predictable in
listed firms PSX 100 Index. Additionally, it is scrutinize from literature that Karachi Stock Exchange is not an
efficient market thats why stock returns are predictable in listed firms of PXS 100 Index. Moreover, modern
investor also set an investment criterion that is based on firm size and Tobins-Q to earn excess returns in market.

Conflict of interest
The authors declare no conflict of interest.

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