Relationship Between Accounting Ratios and Stock Returns: Case Study of Hong Kong

Introduction

For the past years, studies that examine the efficiency of stock market have been of great interest to researchers (Abdolreza & Mehdi 2013). On one hand, there are researchers who believe that information on stock market is not useful, while on the other hand, some researchers have emphasized on the importance of information on stock market for organizational development and effectiveness. With respect to the efficient market hypothesis, current information on the state of the market plays a significant role in the modern financial literature (Bae & Kim 2008). For this reason, it is expected that a sufficient market should have features of current information. Following the significance of financial information to investors especially when making investment decisions, nowadays, individuals require enough knowledge, as well as prior understanding of the state of a given stock market and the accounting reports before deciding to invest in any market (Shliefer & Vishny 2003). According to Strebulaev (2007), companies increase their wealth through stock returns. Stock return is a highly significant factor that investors need for them to decide on the suitable investment option. Businesses make use of accounting information to predict the state of the cash flow entity in the future, as well as to assess the possible investment returns (Adriana 2008). Information that businesses get from the accounting system plays a significant role in influencing the state of stock return in a given stock market (Whinstone 2002). However, there are factors which are responsible for changes in the capital markets, accounting systems, as well as users within a given stock market. These factors are referred to as the economic environment whereby all the necessary components play a significant role in determining an overall stock return in the market. Virginia and Reed (2010) asserted that economic environment is important in the stock market in that businesses are able to know the factors that influence the stock return and the potential users of different accounting information in order to prioritize their needs effectively.

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Considering the fact that market is a part of the economic environment, a research that addresses the state of a given stock market can be an appropriate way to determine the factors that affect the given stock market (Tchisty 2005). As such, for investors to understand the market situation, they need to assess the accounting information for the preferred market. Comparison of financial ratios serves as the only reliable method to ascertain the condition of any given stock market (Weber & Stevenson 2000). Some of the important financial ratios include earnings per share ratio (EPS), market value to book value (M/B), price earnings per share ratio (P/E), and dividends per share ratio (DPS) among others (Bae & Kim 2008). Even though most of these ratios are important in determining the condition of any stock market, many people do not put them into much consideration (Abdolreza & Mehdi 2013). Several studies have showed that the financial ratios such as earnings per share ratio (EPS), market value to book value (M/B), price earnings per share ratio (P/E), and dividends per share ratio (DPS) among others, are very significant in determining the stock return of any given market (Weber & Stevenson 2000; Tchisty 2005). For this reason, there is a need for a research that will investigate the relationship between accounting ratios and stock return. Thus, this paper seeks to find out whether there is any relationship between accounting ratios and stock return with the primary focus on the Hong Kong Stock Market.

Research Background

Financial ratios are very important in predicting the state of any given market. For this reason, Tchisty (2005) asserted that financial ratios are necessary indicators of the expected amount of stock returns from any given investment. As such, ratio analysis refers to a quantitative financial analysis of the financial statements for a given company (Aivazian, Booth, & Cleary 2003). Usually, businesses prepare financial analysis at the end of every trading period (Bae & Kim 2008). The trading period may differ with respect to different companies, taking into consideration that some companies prepare their financial statements on annual, semi-annual basis or even quarterly. Some of the financial statements that are vital for any business are balance sheet, profit and loss account, and the cash flow statement (Adriana 2008). The items that are listed on each of these statements are used as basis for analysis. Such analysis is used to give necessary information about the relationship between different ratios. Usually, the balance sheet and the income statement are used to cite any relationship between the items listed on such statements.

Once the statements are ready, it becomes easy to carry out a comparison of various accounting ratios, which are useful in predicting the market condition (Allen & Welch 2000). This can be attributed to the fact that financial ratios can show different aspects of a company as well as its performance. For this reason, it is evident that ratios can be used in the evaluation of a company’s liquidity, solvency, profitability, as well as the company’s efficiency (Bae & Kim 2008). Liquidity refers to the financial state of a company, whereby it is in a position to settle the company’s obligations as they fall due to the present state of the company’s assets (Allen & Welch 2000). The capacity of any company to generate profits can be assessed through analysis of financial statements and comparison of different financial ratios. Bolton and Xavier (2012) defined a firm’s solvency as the capacity of the firm to operate without threats of bankruptcy in the future. Once the ratios are calculated, companies and investors can make use of them in evaluating trends of a company’s operations as well as its performance (Adriana 2008). When such ratios for a given market are compared it makes it possible for investors to establish the relationship between the accounting ratios and possible returns. In a case whereby the financial ratios show high returns on investment, it implies that the concerned company has a potential to grow in the evaluated market (Babaei, Abdi & Rezaei 2014). On the other hand, financial reports showing low cash flow and low price earnings serve as warning to investors. Allen and Welch (2000) in their study showed that an analysis of financial ratios is required by investors to help them in decision-making, as well as to predict the performance of a given firm in the future. Even though there are quite numerous financial ratios, most users of accounting information find interest in dividends payout ratio, return of equity ratio, debt to equity ratio, price earnings ratio, and the current ratio (Allen & Welch 2000). These ratios interest most investors because they give necessary information about the financial condition of the market (Penman 2003).

The fact that the outlined financial ratios are very important to predict the market condition makes it possible to carry out an analysis of the link between accounting ratios and the stock returns in any market (Adriana 2008). There are various industries in the market and they all refer to such ratios. Thus, when analyzing accounting ratios, the primary aim is to establish the relationship between the ratios and the market trends (Abdolreza & Mehdi 2013). As such, they help to show whether given financial reports are undervalued or overvalued. For instance, if a given company’s acceptable price earnings ratio ranges between 25-30, and the calculated P/E ratio is found to be 20, then such analysis would be indicative of undervaluation. However, for a case whereby the same company has P/E ratio of ranging from 25-30, then the company would be said to be overvalued (Penman 2003). As such, financial ratios can be used in determining the future of any given company considering that such information is required to enable investors make decisions regarding investing in the targeted market (Allen & Welch 2000). However, such comparison can only be done for companies that operate within the same industry.

A series of research studies have been carried out in the past to investigate the relationship between accounting ratios and stock returns (Foye 2013). For example, Fulghieri and Lukin (2001) showed that accounting ratios have a direct link to the state of any given market. In spite of this, few studies have been carried out within the Hong Kong Stock Market to explain how the stock returns in this market relates to ratios such as the Dividend Price Ratio, Price Earnings ratio and the Payout ratio. For this reason, the study seeks to find out such relationship by focusing on retail and tourism sectors, real estate, trading and logistics, banking and finance companies that traded in the Hong Kong Stock Market (Fulghieri & Lukin 2001). These sectors were chosen because they have a direct influence on the Hong Kong Stock Market, as well as are composed of the primary companies within the market under study.

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Problem Statement

The success of any organization largely depends on how much it makes use of available information in making decisions related to the organizational business and corporate strategy (Abdolreza & Mehdi 2013). Studies in the efficiency of stock market have been of great interest to researchers (Abdolreza & Mehdi 2013), especially due to the growing need to provide reliable information that investors can use when making investment-related decisions. Some of the researchers believe that information on stock market is not so efficient, while on the other hand, some researchers have emphasized on the importance of information on stock market for organizational development and effectiveness (Fama and French 2007). Thus, there is a need for organizations to make decisions based on the current information in the market such as the financial ratios, as well as any other predictions on the state of stock return in the future (Foye 2013). Many companies and investors require information on the state of the market. Such information is necessary since it guides the investors in their decision-making process (Abdolreza & Mehdi 2013). However, few studies have been carried out on the relationship between the stock return in Hong Kong Stock Market and the accounting ratios such as the Dividend Price Ratio, Price Earnings ratio, and the Payout ratio (Bolton & Xavier 2012). As a result, it has become quite hard for investors to determine the future of the stock market of Hong Kong due to absence of the necessary information. For this reason, there was a need to review the relationship between the Hong Kong Stock Market returns and three accounting ratios (Dividend Price Ratio, Price Earnings ratio, and the Payout ratio). The findings from this study would be used in providing an insight on the motivations of different investors in Hong Kong Stock Market.

Purpose of Study

The primary aim of this study was to establish whether there is any relationship between the stock returns and accounting ratios (Dividend Price Ratio, Price Earnings ratio and the Payout ratio). As such, the analysis of stock returns was carried out with respect to the Dividend Price Ratio, Price Earnings ratio and the Payout ratio.

Objectives of the study

The study had both general and specific objectives. The general objective of the study was to carry out an analysis on the relationship between stock returns and the accounting ratios.

  1. Specific objectives:
    The specific objectives for the study included:

    • To find out the relationship between Price Earnings ratio and the stock returns of Hong Kong Stock Market.
    • To find out the relationship between the Dividend Price ratio and the stock returns of Hong Kong Stock Market.
    • To find out the relationship between the Payout ratio and the stock returns of Hong Kong Stock Market.

Research Questions

Research questions in any study are used to guide the study in coming up with the solutions for any problems arising in a given setting. Thus, to address all the concerns, it is important to come up with research questions that are designed to help in eliminating a given problem. The variability of the solution to the problem at hand is the fundamental factor in deciding the answer to pick. In the case of the Hong Kong Stock Market, a few studies have been carried out to find out the relationship between the stock returns and accounting ratios noted earlier. Solutions to the problem should be presented in a way that improves the quality of information about the subject under investigation. Thus, research questions can be considered suitable tools used by management and research to investigate the reasons behind a given scenario which affects a number of people. Research questions give description of the actions to take in rectifying the problem and the advantages and disadvantages of the choice of action. The choice of action should provide solutions to eliminate any future chances of the problem reoccurring and ensuring the best results from the situation.

Therefore, the research was based on one research question: is there a significant relationship between the stock returns and accounting ratios (Dividend Price Ratio, Price Earnings ratio and the Payout ratio)? However, for more comprehensive results the research question was broken down into a number of questions:

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  • Is there a relationship between Price Earnings ratio and the stock returns of Hong Kong Stock Market?
  • Is there a relationship between the Dividend Price ratio and the stock returns of Hong Kong Stock Market?
  • Is there a relationship between the Payout ratio and the stock returns of Hong Kong Stock Market?

To answer these questions, this paper closely looks at case study of Hong Kong Stock Market.

Significance of the Research

This research was significant in that the findings from the analysis would benefit investors and businesses within the Hong Kong Stock Market. For example, the results would provide the investors with a basis for investment decision-making. In addition, any recommendations after the analysis will assist all the companies dealing in stock returns within the Hog King Stock Market to make use of the suitable models as a way of winning confidence among investors.

Research Plan

This paper is divided into five chapters, whereby chapter one introduces the primary concept for research, significance, aim and objectives of the study. Chapter two is the literature review whereby the paper looks at past studies related to stock returns and accounting ratios. Such studies will help provide the necessary supporting facts on the subject of stock returns and accounting ratios. Chapter three looks at the methodology and research design used in coming up with the different observations and results of the study. Here, the paper will cover research designs, methods of data collection, as well as methods of recording and analyzing the collected data.

On the other hand, chapter four will cover the analysis part of the research whereby a thorough analysis of the data from the research is carried to examine and find out whether there is any significant relationship between the noted accounting ratios and the stock returns of Hong Kong Stock Market. Chapter 5 is the discussion and conclusion chapter that examines the findings of the study and relates them to theoretical outlook of the subject.

Literature Review

Introduction

This chapter of the research provides a review of several studies that were previously conducted on the relationship between stock returns and the accounting ratios such as the D/P, P/E, market to book ratio, and the Payout ratio. Even though numerous studies have been conducted on this topic, similar research is not available for the Hong Kong Stock Market (Alexander & Britton 2005). For this reason, this study aimed at filling such a research gap. Carrying out a comparison of the different studies on stock returns and a number of accounting ratios will help in the advancement of the research given that credible sources are used.

There have been several studies that examine the link between financial ratios and the stock returns, with these studies using different measures to assess the possibility of any form of relationship between stock returns and financial ratios (Abdolreza & Mehdi 2013). In their study, Adriana (2008) observed that most of the existing literature offers support to the assertion that often capital markets exhibits a certain degree of efficiency. As such, there is no bias in the capital market, implying that the stock market has an effective way of adjusting to the available financial information during the formation of stock prices in a bid to avoid abnormal returns in the market. In a classic paper to establish whether there was any relation between the prices of stocks and accounting ratios, Asiri (2015) established that the prices of stocks in any country are determined by accounting earnings and any other related information. In spite of this, it was evident that, most of the time, stock market in different countries set the anticipated values in the accounting earnings (Abdolreza & Mehdi 2013). However, Foye (2013) argued that there is a high possibility that financial events have an indirect influence on the stock prices in any given company, with such events affecting the investment activity of the concerned organization.

Most researchers have never considered the role that financial markets have on the general capital expenditure, as well as on the state of the stock market in any given country (Abdolreza & Mehdi 2013). In a study to investigate how stock returns relate with unanticipated decreases or increases in capital expenditure, Hadrian and Gilbert (2005) found out that stock returns are closely associated to the state of the capital expenditure, and any available financial information within the market. Different countries have different structures of capital markets. According to Asiri (2015), such structures greatly determine the capacity of an organization’s management to influence the company’s stock price. Usually, investors depend on published reports to carry out analysis of the financial position of any company that they may wish to invest. Adriana (2008) pointed out that such hypothesis is only effective if the information published about a given company is a true reflection of the company’s financial status as depicted from its accounting financial statements. However, the financial statements used in this case should take into consideration future changes within the company. Hadrian and Gilbert (2005) asserted that any given company is likely to face changes in its cash flow, as well as distribution of the company’s dividends.

According to the findings of Fama and French (2007), market to book ratio can be used when explaining the cross-sectional disparities among stock returns for a given market. However, when looking at the determination of stock earning, as well as the market prices, the dividend and book value can be used because they are able to show a prediction of behavior of both stock returns and stock prices (Bolton & Xavier 2012). Therefore, information on the relationship between stock returns and the accounting ratios can be very instrumental in the construction of strong strategies for any given business based on its earnings, book value and dividends forecast. With respect to the mispricing view, whenever the price earnings ratio is low, there will be a consequently high stock returns than for a scenario when the price earnings ratio is high (Abdolreza & Mehdi 2013). On the other hand, high market to book ratio is responsible for consistent low stock returns. The Dividend price ratio shows chances of market undervaluation because the predictive power of the dividend price ratio is based on the ability of the dividends to predict price components within a given market (Asiri 2015). In a similar manner, the price earnings ratio measures the overall condition of businesses within a given market setting (Fama & French 2007). Thus, this concept can predict the suitable time for investors to invest because they can predict the stock returns by evaluating the accounting ratios of the concerned market.

The structure of capital markets of different countries indicates a probable influence of private agents on the stock price in the market (Penman 2003). Such a situation alludes that for any effective capital market, one can be able to find a reflection of all necessary financial information in diverse securities by examining the stock prices (Al-Malkawi 2005). According to the Efficient Capital Market Hypothesis, all the investors within a given market usually have the capacity to access sufficient information that is suitable for analyzing the flow of cash and relate it with the existing accounting data (Bolton & Xavier 2000). In addition, the accounting statements from any given market are used to determine the prevailing stock price, as well as to predict the state of stock price in the future (Hadrian & Gilbert 2005). However, research and analysis show that the reflection of stock price through accounting statements is only possible there is information that depicts unanticipated changes in the distribution of the given company’s dividends, as well as expected cash flows.

According to a study conducted by Allen and Welch (2000), an analysis of financial ratios is required by investors to help them in decision-making, as well as to predict the performance of a given firm in the future. When such ratios are compared for a given market, it makes it possible for investors to establish the relationship between the accounting ratios and possible returns. In addition, such an analysis can also be helpful in establishing any warnings in the future regarding slow movement of the concerned company’s financial situation (Antonio & Ivo 2000). The significant features of any firm such as the efficiency, company size, as well as it growth can be used in predicting stock price in the future. For example, companies that are big, profitable and spend more money on advertising are likely to show high rate of growth and performance. Fama and French (2007) pointed out that companies that are small in size have been known to enjoy stock returns that are averagely high. However, large and other companies that are average in size do not show consistency in the stock returns.

In a study carried out by Penman (2003) to investigate the relationship between stock market and financial ratios showed different markets especially for different country show different characteristics with respect to the role of financial ratios on stock returns. According to Hadrian and Gilbert (2005), such variation can be attributed to the difference in valuation level with respect to difference in development among countries. For example, the state of development in China is different to US. As such, the valuation features such as price-to-book ratios, and price-to-earnings ratios are also different with respect to the state of a country’s development, since according to Bolton and Xavier (2000), the valuation features point to the state of the market stock returns in the given country. With respect to this study, Bolton and Xavier (2000) pointed out that, price-to-book ratios as well as the price-to-earnings ratio can be seen as a value for which any given market can attach to book and earnings value respectively. Bae and Kim (2008) pointed out that a high record of price-to-book ratios, and price-to-earnings ratio can be used to indicate overvaluation in the market with respect to the value of the earnings and market turbulence. On another extend, report of high price-to-book ratios, and price-to-earnings ratio is likely to indicate understatement in terms of the given organization’s fundamental value.

According to a study carried out by Bolton and Xavier (2000), the stock market of any given country is affected by the size of the company and the market, as well as the earning price. In addition, Aras and Yilmaz (2008) analyzed the predictability of market stock returns whereby they made use of predictable variables such as market-to-book ratio, dividend yield and price earnings ratio. According to this study, it was evident that the different accounting ratios used had different effects on the stock market. For example, there is a significant relationship between market to book ratio and the predictability of stock return. On the other hand, Litzenberger and Ramaswamy (2009) in their study tried to establish the link between stock return and dividend yield. These authors found that stock return and dividend yield have a positive relation, though non-linear.

In a study to determine the relationship between earning price ratio, book to market equity ratio, leverage, and size with the stock return, Lam (2002) made use of the Fama and French approach. The study found out that there is a cross-sectional deviation noticeable for the period chosen in the stock returns. Such findings were captured by earnings price and book to market ratios. On the other hand, other variables such as the market and book leverage, as well noted the difference. However, the effects in these cases were strongly showed through earnings price ratio, book to market equity and the size. In support of this study, Perez and Timmermann (2010) noted that stock return varied with respect to economic conditions. For this reason, Bratton (2002) used market and economic condition, along with the size of firm to analyze and the extent of returns and expected risks. The study found out that interest rates play a significant role in stock return sensitivity, as well its volatility.

Simlai (2009) carried out a study to investigate how common stock return performed in comparison to book to market ratio and size. The findings from this study showed that the stock return for any given market is significantly related to size. In addition, the study found out that the use of time as a variable can have a significant effect in supporting the effect of the ratios on the stock return (Burns, Quin, Warren, & Oliveira 2013).

McManus, Gwilym and Thomas (2014) conducted a study to assess how dividend yield and stock return are related in the United Kingdom stock market. In their analysis, the researchers used the asset-pricing model along with data that had a degree of relation to earnings in a type of payout ratio (Caper & Kotabe 2003). Thus, they sought to examine stock return and determine how it relates to dividend yield and payout ratio. Eventually, the study concluded that there is no significant impact of payout ratio on dividend yield or even on the stock return.

Investors’ View of Financial Ratios

The reports on financial ratios are very important in guiding investors on when making decisions related to investments (Asiri 2015). Usually, individuals in any company often estimate the performance of the company by assessing the major financial statements (Penman 2003). Some of these statements that help investors and shareholders to ascertain the financial state and performance of any organization include income statement and balance sheets. For this reason, organizations are compelled to provide figures that accurately depict the financial position of any company. In the view of Simlai (2009), there is a high tendency that high-quality financial reports asymmetrically influence both the company’s and market’s information. For any given market that exhibits efficiency, there is likelihood that the flow of information is reflected in the prices of any given company’s shares. As such, it can be seen that share prices are very suitable in providing an exact reflection of a company’s financial position and its performance. For individuals to invest in any given company, they rely on the financial records and performance of the said company in making decisions. Thus, an investor’s confidence largely depends on the reliability of a company’s financial reporting. As pointed out by Penman (2003), the consistency with which a company reports its financial records can be a precursor to an automatic reinvestment by investors, continued allocation of resources, which can lead to creation of solid values. However, it is important to incorporate any past published figures or past information in share prices for a case that involves an efficient market that is in its semi-strong form. In such a case, there is no generation of systematic abnormal returns, and hence the information from the share prices effectively reflects the true position of the concerned company.

According to Aono and Iwaisako (2010), financial reports are very important in that they help investors make investment decision based on comparison of different company’s records. Such records help the investor to choose the right company to invest in with respect to the possibility of having high stock returns in the future. On the other hand, Bredin and Hyde (2008) asserted that the management of any company is every instrumental in attracting investors because the management is mandated to sell the image of the company to the public. In support of such assertion, Callen, Khan and Lu (2012) pointed that the signals provided by a company’s management to the public ought to be provided in the best form possible, and to depict a true reflection of the concerned company in terms of performance and financial position. According to Cornell (2000), financial ratios are effective tools of provide an overview of a business’s financial health. Whenever, detailed financial analysis is needed, the financial ratios are used due to the fact that they are best indicators of areas in company that are performing, as well as those that are not performing.

Grinblatt and Moskowitz (2004) carried out a study to investigate the impact that investors have on a company’s market value. According to this study, it was found that accounting-based ratios are in close relation to investing in inventory turnover, liquidity, profitability, capital structure, and assets. It was evident from a study by Hai, Diem and Binh (2015) that the management of any organization plays a significant role in providing reliable signals to investors that can help them in making investment related decisions. Accounting-based ratios, according to Heston, Rouwenhorst and Wessels (2009) have immense impact in a company’s market value. The examination on the ratios that most investors consider showed that the price-to-earnings ratio and book-to-market ratios are significant when used to provide reliable information on the value of a given market (Gauri 2014). In addition, the market value is significantly affected by the rate of return on assets (Jiang & Lee 2012). As such, it was evident that financial ratios are very important as measures of the financial position of any company, as well as investors’ decisions on given investments.

Theoretical Literature Review

In this theoretical literature review, the primary concern will be on dividend payout ratio, price earnings ratio and the dividend price ratio. An analysis of these ratios will shed light on how they are used in determining the state of a market’s stock return.

Dividend Payout Ratio

The dividend payout ratio refers to the amount of profits or even earnings, which shareholders receive in a given trading year (Contractor 2002). It is calculated by evaluating the amount of dividends payable over the net income for any given company.

Dividend Payout Ratio = Dividends/Net Income

Thus, it can be seen as a share of profit for which a given company retains to reinvest is compared to the percentage of the profits that shareholders get in form of dividends (Kadilli 2015). Investors use the dividend payout ratio as a source of information on the operations of any given company (Coyne, Scott, Williams, & Wood, 2010). When such ratios are compared for a given market, it makes it possible for investors to establish the relationship between the accounting ratios and possible returns (Kang, Liu & QI 2010). Such information can be used in predicting the stock returns expected from a section of market for a given country.

Usually, companies that are at their early stages of growth are not in a position of paying dividends to their shareholders (Asiri 2015). This can be attributed to the fact that such companies are in need of large amounts of capital to expand which explains why they would not use any money they have to pay dividends (Creswell & Miller 2000). For example, when Apple Inc. was launched in the early seventies, it did not pay its shareholders any dividends until 2012 (Lewellen 2000). On the other hand, some other companies tend to attract investors by paying out higher dividends irrespective of their size. This strategy is used to make companies appear as though they are profitable, hence are able to attract investors (Bae & Kim 2008). Therefore, carrying out an analysis of any given dividend payout ratio is necessary since it provides the exact statistics of a company’s profitability, and the expected stock return.

Research and analysis have showed that investors will tend to be interested in a company that gives out dividends since the amount of dividends for any given trading period signifies the progress of the company in terms of growth and development (DeMarzo & Yuliy 2006). For instance if the amount of dividends issued to members for company A has been 20% for the last ten years, this shows lack of progress in such a company given that the amount of dividends issued is determined by the net income from a company (Li 2000). This implies that an increase in the amount of profit from a company’s investment will subsequently increase the amount of dividends issued (Li, Ayling & Hodgkinson 2003). As such, a positively increasing amount of dividends is more preferred since it shows a sign of stability and profitability for the concerned company (Davids & Forest 2014). If the dividends reduce, investors would be scared away which implies that the stock price will depreciate. However, a strong dividend policy can be showed by a ratio that is stable (Liz & Cynthia 2008).

Different companies have different dividend policies. For example, there are those companies that are guided by a policy that requires the company to reinvest all the profits realized from its investment (Deshmukh 2003). Usually, such a policy is adopted to enhance growth and expansion of the company. Companies pay dividends either as cash of stock (Luciano 2013). For a case where the dividends are paid in stock, the implication is that all the retained earnings has been taken in as shares or ownership stake and paid out either as rights issue of bonus. This allows stockholders to get more shares that are converted into capital (Olson & Mossman 2003). As for the rights issue, the shareholders are given the opportunity to buy more shares from the company at a discount (Dodd & Graham 2010). Evidently, investors use the payout ratio as a means to understand the possibility of earnings from a given company to cater for dividends payments.

Dividend Payout Decision

Dividend decision refers to a calculated course of action that a given company adopts to help in changing its capital structure (Ehrhardt 2008). It is the obligation of companies to pay dividends to its shareholders by cash. However, stock dividends are at times preferable in a case where the concerned company has financial constraints. Cash payment requires transactions to be entered in books of accounts, whereby there is transfer of entries in the balance sheet (Farinas & Lourdes 2000). For example, the retained earnings entries are taken to the ordinary share capital following cash payment of dividends to shareholders.

Sometimes, a company may be willing to purchase all the outstanding shares held by members in cash as opposed to giving out cash dividends. Such types of shares are referred to as the treasury stock (Fishman 2007). Usually, when a company repurchases some of the outstanding shares, the rest of the shares are left un-purchased. In an event whereby the left shares along with the ones purchased back do not have any negative effect on the company and its shareholders, chances are that there will be an in increase in the earning per share (EPS) of the un-purchased shares. Research and analysis show that whenever the earning per share increases, the (MPS) market price per share also increases. Such a scenario results in the substitution of the capital gains by the dividends. Thus, companies can use stock repurchasing whenever they wish to make critical decisions like reconstruction of the structure of capital within the company through the change of the percentage of equity to debt ratio. In spite of this, McManus, Gwilym and Thomas (2014) pointed out that companies ought to be careful with such decisions because if stock repurchasing based on false market statistics can result to decrease in the value of the shares past the prevailing price in the market.

A higher payout ratio implies that the concerned company has the ability to pay dividends as opposed to retaining them (Omran & Ragab 2004). For this reason, if the payout ratio is significantly positive, the implication is that the investors can effectively predict the stock returns of the company in the future. Thus, with such an effective stock returns pointer, investors can plan their investments based on the results from the company’s payout ratio. This ratio is suitable for use in predicting the future of a company’s stock returns because the dividend payout ratio effectively outlines a company’s earnings and the amount the company is paying out as dividends to its shareholders (Oscar 2014). As such, for any company to make any form of financial, as well as investment decision there is a need to consider the effect of the decision on the dividends and the stock price (Frank & Vidhan 2007).

Dividend Policies

There are four types of dividend policies. Such policies can be useful for any company whenever they make dividend-related decisions. First, the residual dividend policy requires the company to put back all the profit earned during a particular trading period (Osman 2004). This has the implication that no dividends are paid out since all the money is invested back into the company as a source of capital for growth and development (Simlai 2009). Secondly, the fixed dividend policy requires the concerned company to set a percentage of the profit that it has to issue constantly for a selected period without putting into consideration the generated earnings. Thirdly, the constant payout ratio requires the concerned company to set out a certain percentage of the profits earned as the dividend payable to shareholders (Pandit 2009). In this case, equal changes are noticeable in the earnings and dividends per share. Lastly, the constant dividend per share plus an extra is set to ensure that there is a compromise between the postulates of the fixed dividends policy and the constant payout ratio. In this type of dividend policy, the company is at will to offer higher amount of dividends to its shareholders whenever the profits are high (Allen & Welch 2000).

Evidently, for smooth dividends payments, companies are required to adopt a policy that is geared at the optimization of shareholders’ wealth while increasing the value of the concerned company’s shares. Thus, it can be seen that investors hold be aware of the types of dividend policies adopted by different companies since it dictates the state of stock returns in the end (Asiri 2015).

Price Earnings Ratio

The price earnings ratio refers to an expression of the stock prospects within a particular market. In this form of ratio, the value of stock is expressed with respect to the company’s earnings (French 2001). The price earnings ratio, commonly abbreviated as PE, is obtained through expression of the market price per share over the earnings per share:

PE= MPS/ EPS.

The price earnings ratio is important for investors and other users of accounting information in that it evaluates and predicts the state of the stock price in the market (Subrahmanyam 2005). Usually, companies that have high EPS are likely to have a high stock value, which translates to high dividend payout (Gibbons 2004). Through speculation, investors are in a position to increase the value of the stock by evaluating the current earnings per share when calculating the likely value of stock. In such cases, the price earnings ratio is considered a multiple ratio. In addition, the price earnings ratio is calculated at the end of any trading period.

During the calculation of the price earnings ratio, it is important to note that the trading and market value of shares are often equal (Goldstein, Nengjiu, & Hayne 2001). Investors and other financial analysts understand that a company whose price earnings ratio is high is likely to increase its performance in the future. On the other hand, low price earnings ratio is an indication of a declining performance. Trends of a deteriorating market performance in the future tend to scare away investors.

Dividend Price Ratio

Dividend price ratio refers to the expression of the amount of dividends that a particular company shares with its shareholders of ordinary shares (Fama 2002). It is often known as the dividend yield and is expressed by the division of the dividend per share of any company with the price per at the market.

Dividend Price Ratio=dividend Per Share/ Market Price per Share.

Usually, the dividend price ratio is related to the value of shares in the market (Trejo, Noguer & White 2015). Whenever the divided price ratio is higher, it is an indication that the concerned company has the ability to pay dividends, and thus does not retain them (Asiri 2015). Therefore, investors look out for companies that have significantly positive payout ratio, which can be attributed to the significant role of this ratio in predicting the financial position and performance of any company in the future. Thus, the amount of money paid to the shareho0klders as dividends acts as a pointer to the future of any company because it effectively outlines a company’s earnings and the amount the company is paying out as dividends to its shareholders. As such, information from the assessment of the state of dividend yield in the market can be useful in predicting the amount of returns that the investors can expect (Graham & Campbell 2001). However, the amount of dividends payable to shareholders depends on the dividend policy that the concerned company has adopted as discussed above.

Conclusion

This chapter covered a review of existing literature on accounting ratios and their significance in predicting stock returns. The literature review in this study presented a number of studies that had been carried out previously on the subject of ratios and stock return. The literature review covered studies from different parts of the world with the primary focus on establishing the relationship between accounting ratios and stock returns. It was evident that the condition of stock returns changed with respect to different industries and trading period. Thus, when analyzing accounting ratios, the primary aim is to establish the relationship between the ratios and the market trends. The price earnings as well as book ratios provided an insight into the future of stock returns. In addition, the literature review revealed that information about the stock returns of any company could be captured as well by considering the dividend price ratio, and payout ratio. However, the effects in these cases were strongly showed through earnings price ratio, book to market equity and the size. The review showed that stock return varied with respect to economic conditions. Thus, the literature review found out that the volatility and sensitivity of the stock return is largely influenced by prevailing interest rates.

Lastly, findings from the review showed that the stock return for any given market is significantly related to the size of the market. In addition, comparing all the studies reviewed it was suffice that there is no significant impact of payout ratio, price earnings ratio and dividend price ratio on the stock returns for any market. However, most of the studies showed that accounting ratios can only be used in the prediction of stock returns, but they do not influence the returns.

Research Design and Methodology

Introduction

The systematic planning of actions that are applied in the collection of information and subsequent analysis of data in a logical manner that help in realization of the purpose of the study is called the study design. Examples of the study designs include descriptive, cross-sectional, experimental, and explorative researches. Research methodology refers to the principles and processes that are applied to collect data that can be utilized in decision making, in business and/or social setting. This chapter will therefore concentrate on the research methodologies and design to be used in the research. Research designs, target population, sample frame, sampling techniques, methods of data collection and data analysis are therefore presented under this chapter. Thus, the chapter will focus on the research methods used in conducting this study to establish the relationship that exists between accounting ratios and stock return for thirty-one companies listed in the Hong Kong Stock Market.

Research Designs

The research on stock returns and accounting ratios will focus on what has been achieved and the relationship that the variables have (Creswell & Miller 2000). In addition, through the analysis of the relationship between the variables, the research will cite the predictability of the accounting ratios on the state of market stock return with the primary focus on the stock market of Hong Kong. The study will also get quantitative data that relate to the performance of Hong Kong Stock Market from the different companies listed in this market. The research adopted a comprehensive study design. The descriptive research and statistical research designs were applicable to this study. For the case of descriptive design, it is very crucial in assisting to provide answers relating to how research problem has affected a given societal situation. For instance, in order to gauge the effectiveness of the accounting ratios to predict the future of stock return, the tangible effects and reasons behind the effects will be described. On many occasions, the descriptive study is applied as a precursor for a quantitative one. The descriptive study also gives indexes to the variables that need to be examined. In addition, the descriptive study leads to reliable data, from which inferences and recommendations can be drawn.

The research on the accounting ratios and stock return will cover a large geographical area, large amount of data will be necessary if the results are to be reliable and valid. Research and analysis show that descriptive studies are appropriate in collection of large amount of data. However, there are obvious shortcomings of the descriptive study. For instance, the study is mainly depended on instrumentation of measurements and observation. There is thus need for a study design that will complement the descriptive study and ensure that quantitative data is obtained. The descriptive study will provide a chronology of what has been happening in the Hong Kong stock market. Statistical study design will be used to complement the descriptive study. The choice of the statistical study design was guided by the fact that it was in line with the study’s scope considering that there were samples to be indentified from the target population. In addition, the drawing of inferences from a particular study population can only be possible through statistical techniques.

Statistical study can be of much help in giving the snapshots of the role of accounting ratios in stock return. Through the statistical studies, the research it will be possible to compare the findings from the literature review and data on the 29 companies which were analyzed. The statistical studies can be carried out repeatedly to give pseudo longitudinal study. Analysis of the literature review and the chosen companies will be imperative to draw inferences.

The study used the quantitative research approach. The choice of this research approach was guided by the fact that the quantitative approach enabled analysis of all the aspects of stock returns and accounting ratios under investigation. In addition, through the quantitative approach, the research was able to analyze the subject under investigation by the use of diverse tools in order to ascertain the accuracy of the data used and findings.

Quantitative research approach takes into consideration the analysis of data in an attempt to generate data that can be used for rigorous analysis. In such analysis, the approach can use experimental approach, simulation approach or the inferential approach. The inferential approach is used to form database from a given sample, as well as make inferences of any features or even the relationships among the samples used. The experimental approach refers to a quantitative research approach that takes great control of the environment by manipulating some of the variables in the study. On the other hand, the stimulation approach involves fixing a temporary environment that can be used for the generation of relevant information, as well as data for the subjects under study. After the setting up of the necessary environment, a mathematical model is vital in the stimulation approach because it is used as a representation of a dynamic process.

Target Population

Target population involves the entire people or units which the study intends to collect information from and draw inferences. The total number of the companies listed in Hong Kong Stock Market is 1615. Out of these, 776 companies are from the mainland of China, 102 from abroad countries including Kazakhstan, Cambodia among others, while the rest (737) are from Hong Kong. These targeted units were identified from the sampled companies. Usually, the target population depends on the phenomenon to be studied and the data that is desired. The research targeted the companies in real estate, banking and finance, tourism and retail, and trading and logistics industries.

Sampling Design

A sample is a subsection of the target population. To arrive at a sample size, proper sampling techniques should be applied. A sample should be a representative of the target population. Sampling design comprises of the sampling frame, sampling techniques and sample size.

Sample Frame

The sampling frame in this study included the companies listed on Hong Kong Stock Market that are in real estate, banking and finance, tourism and retail, and trading and logistics industries. These companies are the beneficiaries of information related to accounting ratios. A sample is usually drawn from the target population. Sampling frame represents the working population that is to be utilized in the study. The sample frame excluded some of the target populations that did not qualify the research criteria. Research and analysis showed that if a sample frame is taken correctly it will lead to a sample that can be used for the population as a whole. Thus in orders to obtain the sampling frame, all the companies were arranged with respect to the industries that they operate in and the right sampling technique used.

Table 3.3.1 Sampling frame

Industry No. of companies Name of companies
Real estate Twelve CK Hutchison Holdings Ltd Co.
China Overseas Company
Henderson Land Company
Hang Lung ppt Company
Link Ret Co.
New World Dev. Co.
SHK ppt
Sino Land Co.
Sino Lands
Swire Pacific A Co.
Tencent holdings HK
Wharf holdings,
Banking and Finance Eight Bank of East Asia
Bank of China SS
Bank Comm.
BOC Hong Kong
China Construction bank
Hang Seng Bank
HISC Holdings
ICBC
Tourism and Retail Eight Belle international
China resources company
Heng Intl Group Ltd-H
Lenovo Group Co.
Li and Fung Co.
Power Assets Co.
Tingyi Co.
Want Want China Co.
Trading and Logistics Three China Mer Hold
HKEK Company
MTR Corporation Co
Total 31

Sampling Techniques

The sampling technique applied is a convenient sampling procedure. This method allowed the research to be very inclusive, bearing in mind that the study is aimed at covering a wide geographical area, which has many companies. The convenient sampling gave all the companies in the sample frame an equal chance of being represented in the sample. Convenient sampling is very effective in getting a representative sample from a large sample group since it allows flexibility in terms of finances, distance and time. Convenient samples refer to types of non-profitability samples that are not restricted and the researcher enjoys the freedom of choosing the data sources. If correctly administered, the technique leads to highly representative sample population.

Even though convenient sampling is commonly used in research, the procedure does not have any regulations to the extent as far as precision and accuracy of results are concerned. Usually, this type of sampling technique serves to examine the ideas of subjects under study, as well as to gain an understanding of the area of study. In addition, researchers use convenience sampling at the early stages of exploratory research, particularly in assisting the researcher to understand the research topic.

Sample Size

The determination of the sample size is depended on the number of replication that can be applied in drawing inferences about the population/units. The type of data required for the research normally determines the sample size. Sample sizes are important in determining precision of the research. In a research, a sample size can be small or large; the researchers, resources available and the purpose of the research again dictate this. In order to obtain the sample size, the research used the formula below:

n=N/ (1+N (e2))

In this case, N and e represent the target population and degree of freedom respectively. Thus n, becomes:

n=31/ (1+31 (0.052))

n=31/1.0725

n=28.9

≈ 29

The Central Limit Theorem states that for a sample size that is larger than 30% of the study population, the x-bar is approximated to be normally distributed without considering the shape of the population. From the table 3.3.2, it was evident that most of the companies listed in the Hong Kong Stock Market were in the real estate industry. For consistency with the sample size after calculation, two companies, Hang Lung ppt Company and CK Hutchison Holdings, in the real estate industry were not included in the study.

Table 3.3.3: Sample Size

Industry No. of companies Name of companies
Real estate Ten China Overseas Company
Henderson Land Company
Link Ret Co.
New World Dev. Co.
SHK ppt
Sino Land Co.
Sino Lands
Swire Pacific A Co.
Tencent holdings HK
Wharf holdings,
Banking and Finance Eight Bank of East Asia
Bank of China SS
Bank Comm.
BOC Hong Kong
China Construction bank
Hang Seng Bank
HISC Holdings
ICBC
Tourism and Retail Eight Belle international
China resources company
Heng Intl Group Ltd-H
Lenovo Group Co.
Li and Fung Co.
Power Assets Co.
Tingyi Co.
Want Want China Co.
Trading and Logistics Three China Mer Hold
HKEK Company
MTR Corporation Co
Total 29

Data Collection Methods

The research is aimed at determining the relationship between accounting ratio, such as the Dividend Price Ratio, Price Earnings ratio, and the Payout ratio, and stock return with the focus on the Hong Kong Stock Market. In order to fulfill the objectives, the research sought to answer the research questions by collecting the necessary data. As a result, the type of data collection, that would ensure that comprehensive data was gathered, was applied. The method of data collection is normally influenced by the research strategies, the point of collection, and the person to carry out the research. The main types of data collection methods used in any study include both the primary and secondary sources of data collection. The primary sources are the ones that are the first-hand sources of data, while the secondary ones refer to sources of information from records as in books, journals, magazine, and other related media. In this case, the secondary sources of data were preferred considering that through such sources the research was able to obtain the necessary data with ease. However, a lot of care was necessary when using the secondary data in order to ensure that the collected data was accurate and suitable to be used for analysis.

Data Analysis

After data was collected, it was necessary for it to be analyzed in order to find out how the accounting ratios studied related to the stock return of Hong Kong market. In this case, the regression analysis method was used in conjunction with other software such as Excel and Google Docs. The research adopted a number of assumptions during the regression analysis. First, it was assumed that the regression line was consistent with the equation R=60% that was used for t-test and allowed the reject level for the p-value at 5%. Secondly, the study assumed that the independent variables can be used to offer explanation of the dependent variable at the p-value and t-test value adopted. Thirdly, it was assumed that the coefficients’ signs were in line with the postulate of the economic theory and the literature review used.

Regression Model

For the study to analyze the correlation between ratio variables and the stock returns, it was necessary to adopt the least square regression technique. The formula for the model was: Y= α+β1X1+ β2X2+ β3X3.

Where,

Y= Dependable variable; tock return

α= value of Y at value zero

β= parameter that shows changes in Y, and has a close relation to changes in X.

X= Independent Variable

For the case of Hong Kong Stock Market, X1, X2, and X3 represented the Dividend Price ratio, Price Earnings ratio, and the Payout ratio respectively.

The least squares method uses the concept of minimizing calculation errors by approximating a number of the functions used during the research. The least square regression method was preferred because it gives accurate data compared to other methods such as scatter graphs.

Other Formulae

Other formulae were very instrumental in the completion of this research, as well as in the determination of the relationship between the accounting ratios and the stock return of Hong Kong Market. Such were the formulae for each ratio, which are discussed below.

Divided Price Ratio

The calculation of this ratio required an analysis of the sampled companies to ascertain their prices based on each month for a period of one year. In this case, the data that was used was obtained from the Hong Kong Stock market website. Thus, the Dividend Price Ratio was calculated as follows: Dividend Price Ratio= Dividend per share/ Price per Equity Share

Payout Ratio

The payout ratio shows a reflection of the yearly earnings of a given country with respect to the amount that the company pays its shareholders. If the data depicts a low payout ratio, chances are that the concerned company operates under the residual dividend policy, a strategy that ensures that no dividends are given to the shareholders. In such a case, the profits are ploughed back to the company for reinvestment. However, whenever a company registers a high payout ratio, this implies that the concerned company pays out dividends to shareholders because the company has a dividend paying policy. The ratio is calculated as follows: Payout Ratio= Dividend per share/ Earnings per share.

Stock return

In this study, an analysis of the relationship between the stock return in Hong Kong market and the accounting ratios was the primary aim of the study. Stock return can be explained as the amount of profit that a given company gets after investing. The dividend adjusted approach was used in the calculation of the stock return for the mark

Total Stock Return= [(P1-Po) +D]/Po

Whereby, P1, Po and D, are the initial and end stock price, and Dividend respectively.

Price Earnings Ratio

A company that shows high Price Earnings ratio can be said to have grown within the given market. The price earnings ratio is used in the determination of the stock return. The Price Earnings ratio can be calculated as follows:

Price Earnings Ratio = Market Value per Share/Earning Per Share

Data Presentations

The data collected was presented in forms of tables and graphs. Such methods were convenient in that the regression, as well as the correlation between the independent and dependent variables, could be explained easily.

Limitations of the study

In any given study, there are areas and aspects of the study that do not go as expected, or make the results from the study a little bit unreliable. Such aspects are the limitations for the study. Study limitations tend to affect the study and its results adversely. However, limitations in any study can often be eliminated by adopting better methods, but perhaps for other related studies in the future.

In this case, there were a number of limitations. First, even though the study was aimed at finding the relationship between stock returns in Hong Kong Stock Market and a number of accounting ratios, it was not a guarantee that the results from the study would change the behavior of the investors with respect to the stock returns. Essentially, the study offers the necessary structures, which require combination with the goals and objectives of diverse investment options that can be depended on several accounting ratios. For this reason, it becomes hard for investors and companies to implement the recommendations in this study without putting into consideration the internal and external elements within the stock market of Hong Kong.

Secondly, the results of the study only featured a small section of the industries in Hong Kong Market. For this reason, the results and recommendations cannot be easily generalized as applicable in all the companies in Hong Kong or even all the industries in Hong Kong. On the same note, some of the industries in Hong Kong were not included in the research. This implies that the study was limited in terms of even coverage during the choice of the sample frame and sample size.

In addition, the collection of data was equally challenging, which can be partly attributed to the type of data required, the scope of data, as well as the identification of the sample to include in the study. Such factors could have had immense contributions on the understanding, as well as illustration of how the accounting ratios are related to the stock return of the selected companies listed in Hong Kong Stock Market.

Lastly, there was the need to make comparison of findings from different studies in order to provide reliable findings on the relationship between stock returns and financial ratios. However, few studies have been carried out on the relationship between the stock return in Hong Kong Stock Market and the accounting ratios such as the Dividend Price Ratio, Price Earnings ratio, and the Payout ratio (Bolton & Xavier 2012). For this reason, it was hard to have adequate number of studies based on the Hong Kong market for effective comparison. As such, the study used the available studies, along with case studies from other areas.

Data Presentation, Analysis, and Interpretation

Introduction

The primary aim of this study was to establish whether there is any relationship between the independent variables (accounting ratios) and dependent variable (stock returns ) with respect to the stock market of Hong Kong. Specifically, the study aimed at finding out the relationship between Price Earnings ratio, Dividend Price ratio, as well as the Payout ratio and the stock returns of Hong Kong Stock Market. Therefore, in order to achieve the objectives of the study, secondary sources of data were used with the primary source being the stock market website of Hong Kong. Thus, in this chapter presents data from the thirty-one companies that had been selected initially. However, the sample size was reduced to twenty-nine, which implies that data analyzed herein is from 29 companies.

Data Analysis for the period ending 2014

Several studies have been conducted in a bid to investigate on the relationship between financial ratios and the stock returns using different measures to assess the possibility of any form of relationship between stock returns and financial ratios (Asiri 2015). For example, from a study carried out by Zacheaus (2015), it was observed that most of the existing literature offers support to the fact that financial ratios are very important in predicting the financial position of any company, as well as a market’s potential. With findings, it is expected that investors and other business individuals can use financial ratios in their decision-making process. Zhang (2015) carried out a study to find out any significant relationship between the prices of stocks and accounting ratios, and found out that stock prices for any given market have an inclination to the accounting earnings. Often, organizations and business individuals require reliable information for any given market, because the financial ratios for any company and/or market are very useful as guides to investors whenever making decision about a given investment opportunity (Abdolreza & Mehdi 2013). However, few studies have been carried out on the relationship between the stock return in Hong Kong Stock Market and the accounting ratios such as the Dividend Price Ratio, Price Earnings ratio, and the Payout ratio (Bolton & Xavier 2012).In spite of this, it was evident that, most of the time, stock market in different countries set the anticipated values in the accounting earnings. However, Kabajeh, Nu’aimat and Dahmash (2012) argued that there is a high possibility that financial events have an indirect influence on the stock prices in any given company, with such events affecting the investment activity of the concerned organization. Often, different countries have different structures of capital markets, as well as variations in stock returns. According to Phan and Zhou (2014), such structures greatly determine the capacity of an organization’s management to influence the company’s stock price. Usually, investors depend on published reports to carry out analysis of the financial position of any company that they may wish to invest.

Research and analysis has shown that investors require reliable accounting information in order to make the right decisions when it comes to investment. For this reason there is a need for clear understanding of the relationship between accounting ratios and the stock returns. Such understanding will help the investors and companies to make informed decisions at all times. Simlai (2009) asserted that accounting system plays a significant role in influencing the state of stock return in a given stock market. However, unless investors understand the calculation and influences of different financial ratios, it will be hard for them to make the right decisions. This section, thus, presents the data analysis of the stock market of Hong Kong with the key focus on four industries. First, it is important to notice that there are a number of factors that are responsible for changes in the capital markets, accounting systems, as well as users within a given stock market (Asiri 2015). Such factors are very important in influencing investment decisions for any given industry or firm. As such, for investors to understand the market situation, they need to assess the accounting information for the preferred market. Carrying out a comparison of financial ratios serves as the only reliable method to ascertain the condition of any given stock market. The data analysis was focused on the accounting ratios and the stock returns of Hong Kong Stock Market. Thus, the research analyzed the stock returns of this market alongside the Price Earnings Ratio, Payout Ratio, and the Dividend Price Ratio. These ratios were chosen because the modes of calculation of the ratios predict the future of stock returns for any given market.

Dividend Price Ratio

The Dividend Price ratio can be calculated based on data about a company’s dividend per share and the price per equity. In this case, considering the case of Bank of China, the dividend price ratio can be calculated as follows.

The dividend per share is expressed through assessing the amount of dividends with respect to the total number of shares for the concerned company and the price per equity: Dividend Price Ratio = Dividend per Share (DPS)/ Price per equity (PPE).

Thus, DPS = Dividends/Number of shares.

On the other hand, Dividends = Net Income * Dividend Ratio (Dividend yield).

The income statement of the Bank of China was used as the source of the net income, which was found to be $ 169.595 million for the period ending in 2014.

Dividends = 169.595 * 0.046 = $ 7.801billion

Number of shares = 410.5984 billion

DPS = Dividends/Number of shares

DPS = 7.801/ 410.5984

DPS = 0.01899 ≈ 0.019

According to the financial statement of Bank of China, the PPE is 4.13

Thus,

Divided Price Ratio = 0.19/4.13

= 0.046

= 4.6%

Results of the other list of 29 companies are shown in the table 4.2 below.

Payout Ratio

The Payout Ratio is expressed through assessing the amount of dividends per share with respect to the total earnings per share for the concerned company: Payout Ratio = Dividend per Share/Earnings per share.

Thus, DPS = Dividends/Number of shares

On the other hand, Dividends = Net Income * Dividend Ratio (Dividend yield). The income statement of the Bank of China was used as the source of the net income, which was found to be $ 169.595 million for the period ending in 2014.

Dividends = 169.595 * 0.046 =$ 7.801billion

Number of shares = 410.5984 billion

DPS = Dividends/Number of shares

DPS = 7.801/ 410.5984

DPS = 0.1899 ≈ 0.19

According to the financial statement of Bank of China, the EPS is 0.0059

Thus,

Divided Price Ratio = 0.19/0.59

= 32.26

Results of the other list of 29 companies are shown in the table 4.2 below.

Price Earnings Ratio (PE)

The Price Earnings Ratio is expressed through assessing the market value per share with respect to the earnings per share for the concerned company.

Price Earnings Ratio= Market Value per Share / Earnings per share (PE).

The income statement of the Bank of China was used as the source of the data, which showed that the market value per share was 0.042 for the period ending in 2014.

Thus,

Earnings Price Ratio = 0.042/0.0059

= 7.13

Results of the other list of 29 companies are shown in the table 4.2 below.

Stock Returns

The stock return was used as the dependent variable for this study. It can be calculated through the formula below:

The balance sheet indicated that the values of P0, P1, and D were $360.476 billion, $279.365 billion, and $ 7.80137 billion respectively.

Therefore,

=0.25

The total stock returns of the other 28 companies are shown in the table 4.2 below.

Dividend Price Ratio, Payout Ratio, Price Earnings, and Stock Returns

Table 4.2 shows a list of all the companies analyzed with their dividend price ratio, payout ratio, price earnings ratio and stock returns shown. The income statements of all the companies analyzed were very instrumental in providing data for the necessary accounting values such as the income and the market value per share among others.

Table 4.2: Dividend Price Ratios, Price Earnings Ratio, and Stock Returns value for 29 companies

Correlation between Stock Returns and Ratio Variables

The regression analysis model was used in the determination of the relationship between the stock returns and ratio variables. The following model was used:

With respect to the Hong Kong Market, X1, X2, and X3 represented the Dividend Price ratio, Price Earnings ratio, and the Payout ratio respectively. Correlation of variables implies that the variables become independent. Usually, in any form of correlation computation, the study involves correlation coefficients ranging between -1 and +1.

For a case of positive correlation, if one of the variables exhibits an upward trend, the other variables also tend to have similar trends. On the other hand, a perfectly negative correlation implies that for an upward movement of one variable, a downward movement of the other variable is present. In a case of zero correlation, the concerned variables are not correlated in any way.

Table 4.3: Showing correlation between stock returns and dividends price ratio, payout ratio, and price earnings ratio

Stock returns Dividend Price Ratio Payout Ratio Price Earnings Ratio
Pearson Correlation 1 -0.003 -0.265 -0.195
Sig. (2-tailed) 0.990 0.182 0.311
N 29 29 29 29

Interpretation

The data analysis presented in table 4.3 showed that the dividend ratio analyzed for all the companies in the sample did not relate in any way with the stock returns. In this case, the correlation was -0.003, which does not fall anywhere near the expected range of -1 to +1. In addition, such results were supported by a higher value of the p-value that was expected to be 0.05. Such findings imply that there is no significant correlation between the dividends ratio and the stock returns in Hong Kong Stock Market. In a similar manner, there is an insignificant correlation between the payout ratio and the stock returns (Aras & Yilmaz 2008). This can be attributed to the fact that the p-value is 0.182, and has a correlation coefficient of -0.265. As well, the p-value for the price earnings ratio was greater than 0.05, which showed that there is no correlation between the stock returns and price earnings ratio for all the companies analyzed.

Regression Analysis to predict Relationship between Stock Returns and Ratio Variables

It was important to predict the type of relationship that existed between the financial ratios and the stock returns of Hong Kong Market. As such, graphs were plotted to determine the relationship. By analyzing the graphs, it was easy to determine the type of relationship between the independent variables and the dependent variables for the study.

Stock Returns Vs Dividend Price Ratio

Regression analysis was carried out to ascertain the relationship between the dividend price ratio and the stock returns. In this case, the stock return was used as the dependent variable while the dividend price ratio was the independent variable.

Stock Returns Vs Dividend Price Ratio
Table 4.4.1 Stock Returns Vs Dividend Price Ratio

Payout Ratio Vs Stock Returns

A graph plotted for the independent variable and the dependent variable showed the relationship between the stock returns and payout ratio. The stock returns ratio is depended on the payout ratio and thus the payout ratio was plotted on the X-axis and the stock returns on the Y-axis. The graph below illustrates the relationship between the stock returns and the payout ratio.

The relationship between the stock returns and the payout ratio.

Earning Price Ratio Vs Stock Returns

The study used regression analysis to ascertain the relationship between the dividend price ratio and the stock returns. In this case, the dependent variable was the stock returns while the dividend price earnings ratio was the independent variable.

Earning Price Ratio Vs Stock Returns

From the above analysis, it is evident that no significant relationship can be noted between the financial ratios and the stock returns for the stock market of Hong Kong. The findings from the graph analysis are consistent with previous findings on the correlation analysis. The results of the regression analysis can be summarized as shown on table 4.4 below. This table shows the summary of the regression analysis for the ratio variables including the model used and the coefficient for the chosen model (Y= α+β1X12X23X3).

Constant 0.757 0.209 3.622 0.11
Dividend price ratio -0.544 1.391 -0.081 -0.391 0.699
Payout ratio -0.006 0.004 -0.258 -1.238 0.228
Price earnings ratio -0.003 0.005 -0.101 -0.485 0.632

Using the regression analysis model, the stock returns could be calculated based on the data from the correlation analysis. Y= α+β1X12X23X3

α= 0.757, β1=-0.544, β2= -0.006, β3=-0.003, replacing these values in the regression model above, the equation becomes;

Y=0.757-0.544 X1 -0.006 X2-0.003 X3

The study made use of both regression and correlation in a bid to determine whether the variable ratios were related in any way to the stock returns of Hong Kong market. The research was able to calculate the accounting ratios of all the sampled companies getting the necessary data from the companies’ financial statements, such as balance sheets, among others (Grullon & Bhaskaran 2002). As such, the payout ratio, price earnings ratio, dividend price ratio and the stock returns were calculated for comparison. A statistical analysis was also employed to understand how the independent variables affected the dependent variables. These were the major analyses on which the findings of this study were based.

From the analysis, it was evident that the variables used for the study did not show any significant correlation with one another. There was no significant relationship between price-to-earnings ratio and the market stock returns. Secondly, the comparison between the dividend price ratio and the market stock returns also did not show any significant relationship. On the other hand, the payout ratio and the stock returns were insignificantly related. The implication of such findings was that the variables are not related in any way. The regression analysis was very much instrumental in offering support to such findings through graphs (Graham 2003). After finding out the regression coefficients, a regression model in Y and Xi was obtained. The model can be used in predicting the state of stock returns in the future, where the variable Xi is known. In this case Xi represented the accounting ratios. As such, the adopted model can be very useful to investors as a guide when analyzing the performance and financial position of any company. Such analysis can then be used when making any investment decisions as the investor is able to ascertain the rate of return of any invested capital and the potential risks of such investment.

Findings from the literature review

The literature review covered studies from different parts of the world with the primary focus on establishing the relationship between accounting ratios and stock returns.

  • It was evident from the study that financial ratios are very important both to organizations and investors (Allen & Welch 2000; Antonio & Ivo 2000; Fama & French 2007).
  • The review of literature showed that stock returns vary with respect to economic conditions ().
  • Findings from the review showed that the stock return for any given market is significantly related to size (Simlai 2009).
  • Comparing all the studies reviewed it was suffice that there is no significant impact of payout ratio, price earnings ratio and dividend price ratio on the stock returns for any market (Hennessey 2004).
  • Most of the studies showed that accounting ratios can only be used in the prediction of stock returns, but they do not influence the returns (Mocciaro, Destri, Picone, & Mina, 2012)

Chapter conclusion

This chapter presented the data from the correlation computation, as well as the findings from the literature review. The price-to-earnings ratio, dividends price ratio and the payout ratios were analyzed using correlation analysis and the results presented in graphs. In addition, this chapter covered the findings from the literature review. The finding from the literature review and the correlation analysis are discussed in depth in the following chapter.

Discussion, Conclusion, and Recommendations

Introduction

The previous chapter analyzed and interpreted data that was obtained from the secondary sources. The convenient sampling technique was used since it was applicable given the type and scope of study. The results from the study regarding the relationship between accounting ratios and stock returns were also presented. In this chapter, a review of the previous chapters will be carried in form of a summary whereby the primary areas of the study will be revisited. In addition, this chapter will take a look at the findings as analyzed in chapter four, and discuss a few aspects of the findings and thereafter offer recommendations. In the discussion section, the findings from the study are compared with findings from the literature review in a bid to reach to a comprehensive conclusion on whether there is any significant relationship between stock returns and financial ratios.

Summary

The primary aim of this research was to study and analyze the accounting ratios and stock returns of Hong Kong Stock Market in an attempt to establish any significant relation between the variables. The empirical investigation into this subject was guided by the fact that a research gap existed in the Hong Kong Stock Market on the influence of accounting ratios on stock returns (Gugler & Burcin 2003). In addition, a few studies have been carried out concerning the relationship between the stock return in Hong Kong Stock Market and the accounting ratios such as the Dividend Price Ratio, Price Earnings ratio, and the Payout ratio (Hart & Bengt 2002). As a result, it has become quite hard for investors to determine the future of the stock market of Hong Kong due to absence of the necessary information. Maskell and Baggaley (2003) pointed out that there was a need to review the relationship between the stock market returns and three accounting ratios (Dividend Price Ratio, Price Earnings ratio, and Payout ratio).

The research was thus limited to companies listed in the stock market of Hong Kong, with a sample size of 29 companies from real estate, banking and finance, tourism and retail and trading and logistics fields. In order to collect the required data, secondary sources of data were used, whereby the Hong Kong Stock Market website provided the necessary data for all the sampled companies. In addition, several studies that touched on the role of financial ratios on any given stock market.

Chapter one of the research primarily covered the introduction of the research study, aims, research questions, significance and objectives of the study. In addition, chapter one covered the problem statement, whereby problem was stated and clarification of a number of concepts done.

Chapter two was the literature review chapter, which focused on reviewing a number of past studies that are related to accounting ratios and stock returns. In this chapter, it was evident that accounting ratios and stock returns are very important in any market.

Chapter three of this research study was the methodology and research design chapter. This chapter therefore concentrated on the research methodologies and design used in the research. Research designs, target population, sample frame, sampling techniques, methods of data collection, and data analysis were also presented under this chapter. The chapter focused on the research methods used in conducting this study to establish the relationship that exists between accounting ratios and stock return for thirty-one companies listed in the Hong Kong Stock Market.

Chapter four covered the data analysis and presentation part. The analysis of the data was done by the use of both regression and correlation analysis methods to find the relationship between the dependent and independent variable. The analysis was instrumental in obtaining the results from the study. Following the above summary, the following section offers a discussion of the findings from the study.

Findings

With respect to the review of past studies on the relationship between the accounting ratios and stock returns, as well as the findings from the regression and correlation analysis, the research recorded a number of findings. These findings can be looked at in the form of two categories: findings from the analysis and those from the literature review.

Literature Review Findings

The literature review covered studies from different parts of the world with the primary focus on establishing the relationship between accounting ratios and stock returns. First, it was evident from the study that financial ratios are very important both to organizations and investors (Allen & Welch 2000; Antonio & Ivo 2000; Fama & French 2007). Individuals in any company often estimate the performance of the company by assessing the major financial statements. Some of these statements that help investors and shareholders to ascertain the financial state and performance of any organization include income statement and balance sheets. Auret and Sinclaire (2001) pointed out that the reliability of such information in investment decisions makes it important for organizations to provide figures that accurately depict the financial position of any company. In a study to find out investors’ motivation to any given country, Aono and Iwaisako (2010) observed that investors tend to look at the flow of information in their company of interest as such information can be used to ascertain the level of efficiency in a particular company or market.

In another study, Bredin and Hyde (2008) discovered that share prices of any company are suitable in providing an exact reflection of a company’s financial position and its performance.

For individuals to invest in any given company, they rely on the financial records and performance of the said company in making decisions (Wang, Chang & Jin 2014). According to Cornell (2000), the management of any company also relies on their financial records to ascertain whether or not they are in line with the organizational goals and objectives, and the possibility of achieving the projected return on investment. On the other hand, Auret and Sinclaire (2001) observed that while such information is very useful to the organization, it is also required by investors in deciding where and when to invest. Such findings according to Gauri (2014) can be attributed to the fact that the confidence of any investor largely depends on the reliability of a company’s financial reporting.

Antonio and Ivo (2000) linked the success of any company to its honesty in providing true financial statements to the public hence; attracting investors. Such sentiments were also shared by Fama and French (2007), by arguing that the information on any company and/or market can be estimated from the financial statements of the concerned market or company. According to a study carried out by Grinblatt and Moskowitz (2004) the level of a company consistency in reporting its financial statements is very important since it acts as a means through which investors can investigate the financial position of the concerned company and the market involved. In a study to investigate the impact that investors have on a company’s market value, Heston, Rouwenhorst and Wessels (2009) observed that accounting-based ratios are closely associated with the market stock returns, and that they are used in the provision of reliable signals to investors that can help them in making investment related decisions. In addition, most of the studies showed accounting-based ratios have immense impact in a company’s market value (Fama & French 2007).

The examination on the ratios that most investors consider when making investment decisions, showed that the price-to-earnings ratio and book-to-market ratios are significant when used to provide reliable information on the value of a given market (Philip 2005). In addition, the market value is significantly affected by the rate of return on assets. As such, it was evident that financial ratios are very important as measures of the financial position of any company, as well as investors’ decisions on given investments. These findings proved that financial ratios of any company, which are often included in the financial statements of the concerned company, are very instrumental in determining the stock returns for a given market and/or company (Rashki 2015).

As evident from a study that was conducted by Allen and Welch (2000), investors largely depend on information from financial ratios to make investment-related decisions, as well as to predict the future of a given company’s performance and rate of return on any invested resources. This assertion was also evident from the study by Antonio and Ivo (2000). In this study, Antonio and Ivo (2000) discovered that financial ratios are very when used to establish any abnormalities in the stock returns of a given market, as well as to explain the general financial position of any company. In support of the significance of financial ratios in providing reliable information about the stock returns of any market, Fama and French (2007), argued that the significant features of any firm such as the efficiency, company size, as well as its growth can be used in predicting stock price in the future. In the light of this, high rate of economic growth is likely to be witnessed in companies that enjoy economies of scale, and those that have high performance (Allen and Welch 2000). On the other hand, Fama and French (2007) observed that relatively low stock returns are common in companies that are small in size. Antonio and Ivo (2000) observed that stock returns are not consistent for companies that are average in size.

A comparison of several studies showed that the condition of stock returns deviated with respect to different industries and trading period (Hennessey & Whited 2007). The review of literature showed that price earnings and book ratios provide insight about the future of stock returns (Harte 2001). In addition, the literature review revealed that information about the stock returns of any company could, as well, be captured by considering the dividend price ratio, and payout ratio (Hennessey 2004). However, the effects in these cases were strongly showed through earnings price ratio, book to market equity and the size (Hennessey & Whited 2007).

Secondly, the review of literature showed that stock returns vary with respect to economic conditions. Fama and French (2007) observed that the volatility and sensitivity of the stock return is largely influenced by prevailing interest rates. In addition, the study also found out that the role of financial ratios in influencing stock returns varies with regions. In a study carried out by Auret and Sinclaire (2001) to investigate the relationship between stock market and financial ratios showed different markets especially for different country show different characteristics with respect to the role of financial ratios on stock returns. In support of this, Jiang and Lee (2012) pointed out that such variation can be attributed to the difference in valuation level with respect to the state of development among countries. Bolton and Xavier (2000) argued that valuation features such as price-to-book ratios, and price-to-earnings ratios are also different with respect to the state of a country’s development, since such characteristics are reliable as indicators of the state of the market stock returns in the given country. Such observation was consistent with the findings of a study by Kadilli (2015), whereby it was evident that price-to-book ratios, and the price-to-earnings ratio represent values attached to book and earnings value for any given market (Auret & Sinclaire 2001).

Thirdly, findings from the review showed that the stock return for any given market is significantly related to size. In addition, comparing all the studies reviewed it was suffice that there is no significant impact of payout ratio, price earnings ratio and dividend price ratio on the stock returns for any market (Hennessey 2004). However, most of the studies showed that accounting ratios can only be used in the prediction of stock returns, but they do not influence the returns (Mocciaro, Destri, Picone, & Mina, 2012). Lewellen (2000) pointed out that a high record of price-to-book ratios, and price-to-earnings ratio can be used to indicate overvaluation in the market with respect to the value of the earnings and market turbulence. On another extend, report of high price-to-book ratios, and price-to-earnings ratio is likely to indicate understatement in terms of the given organization’s fundamental value.

As evident from a study carried out by Bolton and Xavier (2000), stock returns in any market are not influenced by accounting ratios. Instead, the size of the concerned company, market, and earning price are some of the key pointers to the stock returns of any company and/or market.

Findings from the analysis

The research analyzed data using the regression and correlation techniques with the primary concern being to fulfill the research study’s objectives. From the analysis, the research had the following findings.

PE Vs Stock Returns

The study aimed to find the relationship between the price earnings ratio and the stock returns with respect to the companies listed in the stock market of Hong Kong. The collected data was analyzed and it was found out that stock returns and the price earnings ratio did not have any form of correlation (Huergo & Jordi 2004). This was attributed to the fact that the correlation coefficient fell outside the recommended range of -1 to +1, while the p-value was also larger than reference 0.05. Usually, data analysis through correlation technique requires the coefficient to lie between -1 and +1 for the subject under study to have a form of correlation (Morellec 2004).

In addition, plotting a graph of price earnings ratio and stock return revealed that the two variables were not related. The lack of correlation between the stock returns and PE consists with the findings from the literature review. For example, Bolton and Xavier (2000) in their study found out that there is accounting ratios do not influence the satock returns of any market. However, investors use such ratios to predict on the future of the stock returns in any market (Auret & Sinclaire 2001). In support of such assertion, Aras and Yilmaz (2008) observed different accounting ratios could be used to predict different scenarios in the future of stock returns for any given market and/or company. In this study, it was evident through the use of predictable variables such as market-to-book ratio, dividend yield and price earnings ratio, that there is a significant relationship between market to book ratio and the predictability of stock return (Aras & Yilmaz 2008).

Payout ratio vs. stock returns

The second objective of the study was to establish whether there was any relationship between the payout ratio and the stock returns with respect to the companies listed in the stock market of Hong Kong (Jain 2006). The Hong Kong Stock Market was used as the source of data, which was collected and analyzed using both the regression and correlation techniques (Kieso & Weygandt 2007). It was evident that stock returns and the payout ratio did not have any significant correlation. The correlation for this case was –0.265, and the p-value (0.182) was also larger than reference 0.05. Additionally, the data for the two variables from 29 companies was plotted on a graph that revealed the two variables were not related. Such findings were in line with the findings of Aras and Yilmaz (2008). As pointed above, Arias and Yilmaz (2008) observed that financial ratios such as payout ratio and price earnings ratios, among others are only used as indicators of the state of the stock returns in the future, but have no significant effect on stock returns of any company or market. Fama and French (2007) argued that accounting ratios such as payout ratios, dividend price ratio, and the price-to-earnings ratio are very significant to investors in estimating the financial position and performance of any company and market. Such ratios are only used when an individual wants to make investment in a given company to ascertain the chances of high returns on investment (Simlai 2009).

Dividend price ratio vs. stock returns

Regression and correlation analysis of the data on dividend price ratio and stock returns of Hong Kong market showed that dividend price ratio and stock returns were not correlated, neither there was any significant relationship from the graph. The correlation was found to be –0.003, which is less compared to the range of -1 to +1. The p-value was 0.99, which was bigger than the expected 0.05 implying that the two variables did not have any significant correlation. In this study, if the correlation had been skewed towards +1 or even -1, the two variables would be said to be related. Such findsings were in line with the findings from the literature review. For example, Fama and French (2007) in their study observed that dividend price ratio is used when assessing the financial position and performance of any company. Moreover, In addition, Simlai (2009) investigated the performance of common stock returns with respect to accounting ratios and established that the stock returns in any market are only related to the size of the market.

Discussion

From the analysis, as well as from the literature review, it was evident that there is a need for companies to have clear knowledge of all the accounting ratios, as well as whether or not they influence the stock returns for any given industry (Kundu 2003). Such knowledge is essential especially for the investors since it prepares them during decision-making process (Myers 2000). The study found out that even though information on financial ratios and the way the ratios relate to stock returns is very vital, there are no studies carried out in Hong Kong to provide an insight on the same (Kotabe & Srinivasan 2002). Thus, in this study a comparison of the 29 companies listed in the stock market of Hong Kong was done.

From the analysis, it was evident that financial reports are very important in that they are used by investors when making decisions (Auret & Sinclaire 2001). This can be attributed to the fact that financial ratios tend to portray the financial position of any company making it possible for investors to evaluate the actual performance of the concerned company. Simlai (2009) showed that investors’ decision regarding any given investment opportunity is largely depended on the availability of financial records. Investors need such information to make informed decision regarding their investment in various companies. In a case whereby the financial ratios show high returns on investment, it implies that the concerned company has a potential to grow in the evaluated market (Babaei, Abdi & Rezaei 2014). On the other hand, financial reports showing low cash flow and low price earnings serve as warning to investors. Allen and Welch (2000) in their study showed that an analysis of financial ratios is required by investors to help them in decision-making, as well as to predict the performance of a given firm in the future. Fama and French (2007) supported such findings by pointing out that the comparison of financial ratios for a given market is important in that it makes it possible for investors to establish the relationship between the accounting ratios and possible returns. Therefore, investors should be on the lookout for financial information about any market or company in which they want to invest.

A review of the literature revealed that the independent variables did not have any significant relationship with the dependent variable. Such results were consistent with the results from the literature review. For instance, Labardin and Marc (2009) in their study showed that the stock market of any given country is affected by the company and market’s size, as well as the earning price. Such findings were similar to observations made by Fama and French (2007). When analyzing accounting ratios, the primary aim is to establish the relationship between the ratios and the market trends (Abdolreza & Mehdi 2013). As such, they help to show whether given financial reports are undervalued or overvalued. In their study, Fama and French (2007) pointed out that accounting ratios are used in the prediction of the financial position and performance of any company or market. Thus, they do not influence the stock returns of any market (Babaei, Abdi & Rezaei 2014). However, when Aras and Yilmaz (2008) analyzed the predictability of market stock returns whereby they made use of predictable variables such as market-to-book ratio, dividend yield and price earnings ratio, these researchers found that the different accounting ratios used had different predictable effects on the stock market. For example, a degree of significance was noticeable between market to book ratio and the predictability of stock return, which was consistent with observations made by Myra (2003). However, Myra (2003) pointed out that there was an indirect relationship between financial ratios and market stock returns. In the light of this assertion, low cash flow, price earnings for a given market tend to discourage investors from carrying out any reasonable investment in such findings. As a result, the stock returns for that company and/or market tend to remain unfavorable and unattractive to investors (Luciano 2013).

Nonetheless, a study conducted by Oldroyd and Dobie (2008) to establish the link between stock return and dividend yield showed that the stock return and dividend yield had a positive relation. However, this study also noted that the relationship between stock returns and the dividend yield was not linear and hence could not be used to adequately provide any necessary information about the state of the stock returns (Babaei, Abdi & Rezaei 2014). In another study to find out the relationship between earning price ratio, book to market equity ratio, leverage, and size with the stock return, Lam (2002) made use of the Fama and French approach, and found out that there was a cross-sectional deviation noticeable for the period chosen in the stock returns. The findings were captured by earnings price and book to market ratios, which were consistent to observations from a study conducted by Aras and Yilmaz (2008). In this study, Aras and Yilmaz (2008) found out that the size of the market, companies involved and the price earnings provided information on the stock returns of a given market.

The study only investigated a limited number of accounting ratios. Even though most of the studies reviewed did not show any significant relationship between stock returns, a few of the studies showed chances of some financial ratios having an influence on the stock returns. For instance, Lam (2002) conducted a study to determine the relationship between earning price ratio, book to market equity ratio, leverage, and size with the stock return. Lam (2002) made use of the Fama and French approach. The study found out that there was a cross-sectional deviation noticeable for the period chosen in the stock returns. Such findings were captured by earnings price and book to market ratios. On the other hand, other variables such as the market and book leverage, as well noted the difference. However, the effects in these cases were strongly showed through earnings price ratio, book to market equity and the size. In support of this study, Litzenberger and Ramaswamy (2009) noted that stock return varied with respect to economic conditions. For this reason, Perez and Timmerman (2010) used market and economic condition, along with the size of firm to analyze and the extent of returns and expected risks. The study found out that interest rates play a significant role in stock return sensitivity, as well its volatility.

The findings from the analysis and graphs showed some level of consistency with results given by Simlai (2009). When using correlation to study the relationship between variables, the correlation coefficients should range between -1 and +1. In a case where the correlation coefficient is positive, it has an implication that if one of the variables exhibits an upward trend, the other variables also tend to have similar trends (Babaei, Abdi & Rezaei 2014). On the other hand, a perfectly negative correlation implies that for an upward movement of one variable, a downward movement of the other variable is present. In a case of zero correlation, the concerned variables are not correlated in any way. From the regression analysis, the dividend ratio analyzed for all the companies in the sample did not show any significant relationship with the stock returns. This was attributed to the fact that the regression analysis gave a correlation coefficient of -0.003, which does not fall anywhere near the expected range of -1 to +1. The negative coefficient implied that the dividend ratio of all the companies analyzed had an upward movement the stock returns depicted a downward movement and vice versa. In addition, such results were supported by a higher value of the p-value that was expected to be 0.05. Such findings imply that there was no significant correlation between the dividends ratio and the stock returns in Hong Kong Stock Market. In a similar manner, there was an insignificant correlation between the payout ratio and the stock returns (Aras & Yilmaz 2008). This can be attributed to the fact that the p-value is 0.182, and has a correlation coefficient of -0.265. As well, the p-value for the price earnings ratio was greater than 0.05, which showed that there was no correlation between the stock returns and price earnings ratio for all the companies analyzed. These findings were in agreement with the findings from the literature review. For example, in his study, Simlai (2009) showed that the stock return for any given market is significantly related to size. However, the study also found out that the use of time as a variable can have a significant effect in supporting the effect of the ratios on the stock return. In the case of Hong Kong, the research did not put the element and effects of time into consideration and thus it might have played a significant role in the final findings.

A study conducted by Lam (2002) showed that a company’s financial ratios can only be used in the prediction of the state of the market in the future, and thus they do not influence the market stock returns. Relating the findings from a study conducted by McManus, Gwilym and Thomas (2014) to assess how dividend yield and stock return in the United Kingdom stock market, it was found that there was no significant impact of payout ratio on dividend yield or even on the stock return. Thus, the findings from the analysis of the relationship between accounting ratios and stock return in the stock market of Hong Kong can be said to be reliable given that a great percentage of them were consistent with studies from other parts of the world, such as the United Kingdom (Luciano 2013). The analysis from the study along with the literature review provided information that was necessary to answer all the research questions. Thus, the findings were helpful in fulfilling both the primary and specific objectives of the study. For example, through the analysis of both the data from the regression and correlation calculation and the literature review, it was evident that there was no significant relationship between the dividend price ratio, and the stock returns of the stock market of Hong Kong. The analysis showed that the coefficient correlation was higher than the reference coefficient, while the p-value price earnings ratio and the payout ratio did not have any significance relationship with the stock returns for all the sampled companies. However, it was also evident that even though such accounting ratios did not have any significant relation to the stock returns, they could be used in predicting stock return for any company.

Conclusion

From the literature review and the analysis, it was evident that the study achieved all the set objectives. The aims of the study included:

  • The general objective of the study was to carry out an analysis of the relationship between stock returns and the accounting ratio.
  • To find out the relationship between Price Earnings ratio and the stock returns of Hong Kong Stock Market.
  • To find out the relationship between the Dividend Price ratio and the stock returns of Hong Kong Stock Market.
  • To find out the relationship between the Payout ratio and the stock returns of Hong Kong Stock Market.

From the study, it was evident that accounting ratios are very useful especially when predicting the state of any given market in terms of its performance and potential (Powell 2001). For this reason, accounting ratios are crucial indicators of the expected amount of stock returns from any given investment (Fama & French 2007). The study identified ratio analysis as a quantitative financial approach of the financial statements for a given company in an attempt to forecast a given market. Often, businesses are required to carry out financial analysis at the end of every trading year. Different companies have different aspect of the trading period and this explains why a number of companies prepare their financial statements on yearly basis as others prepare them semi-annually or even quarterly. Such analysis is used to give necessary information about the relationship between different ratios, and predictability of the financial position of the concerned company in the future (Simlai 2009).

The study had the following conclusions:

The general objective of the study was to carry out an analysis of the relationship between stock returns and the accounting ratio. As such, the study used findings from the literature review and the regression and correlation methods to carry out an analysis of the relationship between price earnings ratio, dividend price ratio, payout ratio with the stock returns for selected companies in Hong Kong market. Carrying out such analysis fulfilled the primary objective of this study, which was to carry out an analysis into the relationship between the independent variables and the dependent ones.

Secondly, the study aimed at finding out whether there is any relationship between Price Earnings ratio and the stock returns of Hong Kong Stock Market. In order to achieve this objective, the study used two methods: analyzing the variables based on the literature review and the other one was through the regression and correlation analysis. The findings from both the literature review and the analysis showed that the two variables do not have any form of relationship. This was evident from the correlation coefficient because it fell way outside the range of -1 to +1. Even though the study showed that the price earnings ratio and the stock returns have no significant relation, it was also evident that price earnings ratio for any company is very important to investors. Investors make use of the price earnings ratios to make future investment decision relating to the concerned company.

Thirdly, the other objective of the study was to find out the relationship between the Dividend Price ratio and the stock returns of Hong Kong Stock Market. The research was limited to literature review and regression and correlation methods of analysis. The findings from both the literature review and the analysis showed that the two variables do not have any form of relationship. This was evident from the correlation coefficient because it fell way outside the range of -1 to +1, and a number of studies. For example, Aras and Yilmaz (2008) observed that dividend price ratios are not related in any way with the market stock returns. On the other hand, Simlai (2009) showed that the stock returns for any given market are significantly related to size, even though the study also found out that the use of time as a variable can have a significant effect in supporting the effect of the accounting ratios, such as dividend price ratios, on the market stock returns. Moreover, findings from a study conducted by Lam (2002) were consistent with the results from the correlation analysis in that dividend price ratio can only be used in assessing the financial stability of any company and its capacity to remain in market even after paying out dividends to shareholders.

Finally, the research study achieved its fourth objective of finding out whether there was any significant relationship between the payout ratio and the stock returns of Hong Kong Stock Market. Through the literature review and the data analysis, it was evident that payout ratio referred to the expression of the amount of dividends per share with respect to the total earnings per share for the concerned company, and thus did not have any relationship with the stock returns in Hong Kong market.

Generally, the study was able to achieve all its objectives: through the analysis of both the data from the regression and correlation calculation and the literature review, it was evident that the dividend price ratio, price earnings ratio and the payout ratio did not have any significance in relation to the stock returns for all the sampled companies. However, it was also evident that even though such accounting ratios did not have any significant relationship with the stock returns, they could be used in predicting stock return for any company.

Recommendations

Having carried out the necessary literature review and research analysis, it was evident that there is a research gap as far as the subject of interrelationship of accounting ratios and stock returns in Hong Kong Stock Market is concerned. Companies and investors need to be informed on how the relationship between accounting ratios and stock return in this market influence the entire market (Rhodes-Kropf & Viswanathan 2003), and how such information can be helpful to both the companies and investors as far as investment-related decisions are concerned.

Therefore, for all the concerned stakeholders to gain the necessary understanding of the relationship between accounting ratios and stock returns for companies listed in the stock market of Hong Kong, the following highlights are paramount.

Extensive Research

There is a need for more studies; as such, it would be easy to compare results and findings from each study in order to ascertain accuracy and precision of the results given by all studies. For example, studies on the relationship between accounting ratios and stock returns are scarce in Hong Kong market (Rulgrok & Wagner 2003). For this reason, more studies would help in criticizing the existing ones.

Future research studies to include more financial ratios

For better understanding of the relationship between accounting ratios and stock returns in the Hong Kong market, there is a need for studies that take into consideration more ratios. Through such an approach, it would be easy to ascertain the extent of correlation between given ratios and the stock returns (Sannikov 2007). In addition, presence of such studies will outline the ratios that are useful in predicting stock returns as well as those that can have a degree of influence on the stock returns of a given market. As pointed out by Sheridan and Tsyplakov (2007), some of the other accounting ratios that can be incorporated for analysis include solvency ratios, profitability ratios, efficiency ratios and liquidity ratios.

Analysis based on history of the market

Further, the study recommends the incorporation of projected financial along with historical information whenever carrying out any study on the relationship between accounting ratios and stock returns. Use of such information can give chance for improved methods of data analysis such as mathematical stimulation. Such an approach can be very instrumental especially to avoid study bias.

Lastly, this research study identified a research gap. As such, further studies are necessary to find out how dividend policies and dividend ratios are related, and whether there is any significant influence of one of these variables on the other. In addition, more studies are required to explain how financial ratios are related to dividend decisions. Is there a significant relationship between accounting ratios such as price earnings ratio, dividend price ratio, book to market ratio, etc. and dividend decisions? As well, considering that this research did not put a lot of consideration on individual industries in which the different companies sampled for the study operate, it is likely that lack of such consideration had dome degree of influence on the final results. For this reason, it is important for future studies to carry out the analysis based on specific industry. Such an approach would help to get the real scenario to explain the relationship between stock returns and the independent variables.

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