Abstract:

The objective of this paper is to assess the usefulness of
accounting earnings to foreign investors by examining the explanatory
power of earnings in explaining stock returns. In order to model the
relationship between earnings and changes in share prices, it is
important to first establish the relationship between earnings and share
price via an earnings valuation model. The paper makes use of
Ohlson's clean surplus earnings valuation model to show that
reported accounting earnings are relevant to foreign investors in
explaining both stock prices (i.e. value) and changes in stock prices
(i.e. stock returns). Further analysis shows that when earnings are
modelled as following a transitory process, a greater explanatory power
is produced with an earnings response coefficient (ERC) as compared to
when earnings are modelled as following a permanent process.

Article Type:

Report

Subject:

Accounting
(Research)

Foreign investments (Analysis)

Foreign investments (Analysis)

Author:

Lamport, Matthew

Pub Date:

02/01/2011

Publication:

Name: Journal of Academy of Business and Economics Publisher: International Academy of Business and Economics Audience: Academic Format: Magazine/Journal Subject: Business; Business, general; Economics; Government Copyright: COPYRIGHT 2011 International Academy of Business and Economics ISSN: 1542-8710

Issue:

Date: Feb, 2011 Source Volume: 11 Source Issue: 2

Topic:

Event Code: 310 Science & research

Product:

Product Code: 9915400 Accounting Methods SIC Code: 8721 Accounting, auditing, & bookkeeping

Geographic:

Geographic Scope: United States Geographic Code: 1USA United States

Accession Number:

260873312

Full Text:

1. INTRODUCTION

Accounting information is one of the most significant sources of financial information for analysis especially when it comes to establishing the intrinsic value of the firm against which active portfolio managers would compare the market price to initiate buy, sell or hold decisions. If accounting information is an important component of intrinsic value determination, we would expect accounting earnings and share prices to be closely connected. Furthermore, accounting fundamentals (book values and earnings) purport to measure value (i.e. capital) and changes in value (i.e. profit) of the firm. Similarly, the price of a share at one point in time also reflects value (i.e. market capitalisation) and the change in price from one point in time to another, the return to investors. In so far as accounting profits and share returns attempt to measure the same characteristic, the change in wealth of the firm, there should be some association between accounting earnings and share prices. If this is the case, then earnings, as reported by companies, should be useful to investors, especially foreign investors, in predicting the return on shares. Indeed, because foreign investors may not be physically present in the investee country, they may not be fully aware of all information, especially non-earnings related information, which may be circulated in the local market and which may have an impact on share prices. These foreign investors will probably, due to their geographical distance, have to rely on published or reported earnings to assess the earnings potential of a particular firm. A review of the literature shows that there that been a scant amount of literature on the accounting earnings-foreign investors hypothesis. In fact the pioneering work stems from Ball and Brown (1968) who studied the usefulness of accounting earnings as an explanatory variable for explaining stock returns or change in share prices. Since then relatively few studies have followed among which features Beaver et al. (1980), Hopwood and McKeown(), Lustgarden and Lev(), Brief-Zarowin ()

The objective of this paper is therefore to assess the extent of the usefulness of accounting earnings to foreign investors by examining the significance of the correlation between earnings and share prices. If earnings can explain a reasonable proportion of the change in share prices, then earnings will have some value relevance in predicting future securities returns. This work is believed to supplement the literature which has so far only scantly dealt with the accounting earnings-foreign investors hypothetised link.

2. Methodology and Analysis: Many of the studies have regressed stock price revisions on unexpected earnings. However, this method to evaluate the value relevance of accounting earnings in explaining stock return depends entirely on the proper measurement of expected earnings. It was also pointed out by Lev ()that unexpected earnings may only convey a small part of the information in earnings and that total earnings might be a better variable as it would capture the impact of the entire information set about earnings that is released throughout the year. Studies by Ohlson and Brief and Zarowin have established the pairing of earnings and book value to explain stock market values. This study proposes to assess the value relevance of earnings to foreign investors using two key independent variables, namely, the level of earnings and the change in earnings, following Ohlson (1991)

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

Ohlson arrived at a model which expresses price as weighted average of book value and total earnings. The weighting attached to book value at time t, [y.sub.t] is [1- [alpha] (R-1)]. The weighting attached to total earnings is [alpha] (R-I). Total earnings are represented by the term [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] i-e. total earnings is arrived at by multiplying clean surplus earnings, [X.sub.t] by a multiple, [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] and subsequently deducting the current dividend, [d.sub.t]. Ohlson's above earnings valuation model shows that the relevance of book value and total earnings depend on the magnitude of the w term which captures the extent to which the current level of residual income is likely to persist in the future.

Modelling the relation between returns and earnings

Having established the relationship between earnings and market value according to Ohlson's earnings valuation model, we can now turn to modelling the relationship between earnings and changes in market value. Since the relevance of earnings in explaining market value depends on the term w, which reflects the extent to which current level of residual income is likely to persist in the future, i.e. on the degree to which earnings follow a permanent or transitory process, it seems logical to keep the same distinction when modelling the relationship between earnings and return.

Modelling earnings as a transitory process If earnings follow a transitory process, w is deemed to be zero and market value would equal book value. In other words, the market to book value ratio would be equal to one. If we represent [V.sub.jt] as the value of firm j at the end of year t, then a market-to-book value of unity would imply that [B.sub.jt] (the book value of firm j at the end of year t) is equal to [V.sub.jt]. Since [V.sub.jt] is equal to [B.sub.jt], then the return of firm j for year t, [R.sub.it] would be given by:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

Where:

[E.sub.jt] is the total clean surplus earnings for firm j for year t

[D.sub.jt] is the dividend for firm j for year t

[V.sub.jt-1] is the value of firm j at the start of year t

The above expression defines return for year t simply as the capital gain over year t plus the dividend received for year t, expressed as a ratio of opening market value of equity. Since market value tracks book value, the return for year t would be the increase in book value of equity from year t-1 to year t plus the dividend for year t (i.e. clean surplus earnings for year t) expressed as a ratio of opening book value of equity, [B.sub.jt-1] As previously stated, defining earnings according Ohlson's clean surplus expression is in line with IASC's definition of profit, namely that profit is the net increase in economic benefits in the form of net inflows or increases in net assets that result in increases in equity without considering distribution to equity participants as a decrease in economic benefits. Modelling earnings as a permanent process

If earnings are deemed to follow a permanent process, Ohlson's earnings-based valuation model suggests that the cum div value of equity capital would be a multiple of clean surplus earnings as follows:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

The proposition that share price in the market is a multiple of earnings is similar to the concept that the market value of firm j at the end of year t is the product of reported earnings after tax of company j for year t and the price-earnings ratio for firm j. Therefore, where earnings follow a permanent process, value can be expressed as:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

Where [beta] represents the price earnings ratio or multiple for company j. The return of firm j for year t is:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

The equation captures the idea that if earnings increase by Rs1 a [beta] value of say 10 would imply that market value would increase by Rs10. Because earnings are permanent, i.e current earnings persist into the future, earnings become less volatile and more predictable. Consequently for such higher quality earnings, investors would be prepared to pay'S' times earnings to buy shares in the company.

Regression Equations

The regression equations which would model equation whereby earnings are deemed to follow a transitory process and equation whereby earnings are deemed to follow a permanent process can be specified as follows:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] [E2]

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] [E3]

Because in reality the value of w in Ohlson's residual income valuation model is likely to be somewhere between 0 and 1, earnings could consist of both transitory and permanent components. To capture this possibility, equation [E3] includes two independent variables, the total earnings level and the change in earnings.

Findings and an analysis

Table 1 summarizes the regression results of the three regression equations together with key statistical significance tests, namely the t and the F statistics.

The following observations can be made from the information contained in Table above. First, it appears that Model 3 produces the highest [R.sup.2] and, therefore, is more useful in explaining stock returns. However, an important property of [R.sup.2] is that it is a non-decreasing function of the number of explanatory variables present in the model. Thus, as the number of explanatory variables increases, R" almost invariably increases and never decreases. Because Model 3 contains two independent variables, its [R.sup.2] cannot be compared with those of Models 1 and 2 which contain only one independent variable. It is better to use the adjusted [R.sup.2] to compare the explanatory power of several models because the adjusted [R.sup.2] calculates a coefficient of determination which takes into account the number of independent variables present in the model. On the basis of adjusted [R.sup.2], Model 1 has the highest explanatory power at 19.48 %.

Model 1 models earnings as following a transitory process to explain changes in stock prices. Model 2 on the other hand models earnings as following a permanent process to explain stock returns. The [R.sup.2] of Model 1(20.78 %) is significantly higher than that of Model 2 (3.6 %). Therefore, the market considers that it is earnings level as a whole rather than change in earnings which are, to a certain extent, relevant in explaining stock market returns on the SEM. This implies that book value or change in book value has partial value relevance in explaining stock returns. The term 'partial' is used because Model 1 reports an [R.sup.2] of only 20.78 % which means that 20.78 % of the total variation in stock returns is explained by earnings level deflated by market capitalisation at the start of the 12-month return period. Indeed, if earnings are deemed to follow a transitory process, i.e. there is little or no permanence in the composition of earnings, market value would track book value and therefore stock returns, measured by change in market values, would be 'proxied' by changes in book value. Changes in book value or net assets are essentially caused by the earnings or profits after tax generated by the company during the year. Therefore, modelling change in stock prices with the earnings level as an independent variable is in fact mirroring the value relevance of book value. This confirms the conclusion arrived at by Brief and Zarowin, namely, that when earnings are transitory, as opposed to permanent, book value has the greatest value relevance.

The higher explanatory power of Model 1 with respect to Model 2 can be confirmed by carrying out statistical tests to check whether the regression earnings response coefficients (slopes) are significantly different from the hypothesized coefficient of zero. A hypothesized coefficient of zero (the null hypothesis) implies that the independent variable has no explanatory power. For Model 1, since the observed t value (4) is greater than the critical value at the 5 % level of significance (2) with 61 degrees of freedom, it can be concluded that b = 222.02 is significantly different from zero. For Model 2 on the other hand, since the observed t-statistic for the slope (1.5) is less than the critical value of t at 5 % level of significance, it can be concluded that d = 106 is not significantly different from zero. This means that for Model 2 we should accept the null hypothesis namely that the coefficient for d, change in earnings, is statistically zero.

When combining earnings and change in earnings as independent variables (Model 3), the regression coefficient for earnings (b' = 218.72) is statistically significant because its t statistic (3.61) is beyond the critical value for t at 5 % level of significance. On the other hand, the regression coefficient for change in earnings in Model 3 (d' = 9.87) is statistically insignificant meaning that the true coefficient of d is in fact zero and that the fact that d, the regression coefficient, is different from zero is merely due to chance. This conclusion is supported by the fact that the t statistic for d is 0.14 which is less than the critical t value of 2. It is quite clear that if Model 3 generates an adjusted [R.sup.2] of 18.16 % it is entirely because of the explanatory power of earnings level alone. The larger the F value, the more meaningful is the regression model in explaining stock returns. Because the F value of Model 2 (2.28) is below the critical value of F at the 5 % level of significance (4), Model 2 is not statistically significant in explaining stock returns implying that the slope of the model is zero. Model 1 has the greatest F value (16) suggesting that it is the most useful in explaining stock return: the F value of Model 1 (16) is very much higher than the critical F value of 4. This result is not surprising as Model 1 also has the greatest adjusted [R.sup.2].

Furthermore, the fact that adding change in earnings as an additional independent variable to Model 1 produces a significant drop in the F value from 16 to 7.88 in spite of the fact that the critical value also shifts from 4 to 3.15, suggests that this variable should not be added. This conclusion can be confirmed by assessing the incremental contribution of the variable, change in earnings, after allowing for the contribution of total earnings level. The F statistic to assess this incremental contribution would be:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

'newk' represents the number of new regressors. At 5% level of significance, the addition of the variable 'change in earnings' does not increase the explanatory power of the model.

Interpreting the regression results in the context of the local market setting

Skewness of the stock market: The Mauritius stock market can be considered quite atypical of other more developed stock markets for two key reasons. Firstly, key components of the Mauritius stock market do not, unlike other developed stock markets, mirror those of the economy. Textiles represent a key contributor to GDP for the Mauritian economy, yet not a single textile company is listed. Secondly, the top ten companies make up 75% of the total market capitalisation as at 31st December 1999 and the top six make up 61% of total market capitalisation as at the same date.

Family-owned companies: Furthermore, since most Mauritian companies are family owned, most of the shares will be locked in the sense that they will be held for family reasons and for the long term. Therefore, it is evident that any change in earnings will not be considered as a permanent change warranting investors to revise their forecasts and change their shareholding which would cause a revision in stock prices. The fact that only a small portion of the shares in issue are traded suggests that shareholders do not consider changes in earnings form one year to the next as a permanent change since the shareholders will hold on to most of their shares and only trade a small portion.

Theoretical relevance of total earnings in stock valuation: If shareholders wish to maintain their shareholding in the blue chip companies, it can be shown theoretically that under certain assumptions, it will be total earnings that will be relevant in stock valuation. Clearly, earnings are important to stockholders because earnings provide the cash flow necessary for paying dividends. Dividends however are also important because they are what stockholders actually receive from the firm and are the focus of dividend valuation models. Earnings of a firm can either be used to pay dividends or to fund positive net present value (NPV) projects and this could perhaps explain why total earnings have greater explanatory power in explaining stock return movements: the dividends accruing to shareholders depend on total earnings minus investment opportunities financed from such earnings.

The impact of foreign investors :Since mid 1994, foreign investors have been authorised to invest in listed as well as in newly issued shares, with a limit however for sugar companies: no foreign investor, be it an individual or a company, can hold more than 15% of the issued share capital of a sugar company. Although there is no legal restriction to the proportion of shares that can be held in companies outside the sugar sector, some companies in their Memorandum and Articles of Association or in their prospectus limit the proportion of total shares that can be subscribed by foreign investors. Analyzing foreign net purchases/sales from 1995 to 1999 will shed further light on the reasons behind the greater explanatory power of deflated total earnings as an independent variable in the return-earnings regression. Analysis of the top five companies shows relatively good earnings momentum However, except for SBM and MCB, the earnings per share (EPS) and the dividend per share (DPS) tend to fluctuate, increasing at times and decreasing at others. Do shareholders view these signals as permanent changes in future profits requiring a change in shareholding? The answer is of course, no since as mentioned before most of the shares are not actively traded. Shareholders tend to hold on to their shares for the long term and seek capital growth. This seems to be confirmed by the low dividend payout ratio.

One can argue that the fact that the absolute level of PAT is positive and undergoing steady growth has prompted foreign investors to buy stocks of the top ten companies on the SEM. There is no doubt that foreign investors have had a positive impact on the growth of the stock market and have also contributed to making the Mauritian stock market more efficient. Because foreign investors tend to bring technical expertise it is not uncommon for local investors to mimic the behaviour of foreign investors. Indeed the SEMDEX dipped from January 1995 to November 1995, it subsequently picked up in December 1995 and January 1996 probably because of the sustained net foreign purchases from May 1995 onwards. The significant foreign net buying impetus from May 1995 to May 1998 gave local investors greater confidence to buy shares and this obviously resulted in a rise in the SEMDEX from November 1996 to August 1998.

It must be realised, however, that restrictions on foreign ownership prevent the market from being more liquid. For instance, foreign investors cannot hold more than 3% of the shares of SBM and 2.5% of the shares of MCB. Limited foreign intervention and the absence of a strong and active domestic investor base--most of the shareholders hold on to their shares and only trade a small portion--are constraints which prevent the market from gaining liquidity. Low liquidity leads to high price volatility and renders entry and exit conditions difficult. An investor may have to pay an unduly high price on just a small number of shares if little sellers are forthcoming which makes entry to the market difficult. Similarly, a shareholder wishing to sell may need to unduly lower the price if buyers are not forthcoming which makes it difficult for the shareholder in question to sell his shares and exit the market. We should not be too surprised therefore if the 12-month cumulative returns for all companies exhibit considerable volatility over time. This seems to be confirmed by the negative intercept of 21.31% of regression Model 1 which is significant at the 5% level (the observed t statistic for the intercept is -2.44 which is greater than the critical t value of 2 at 5% level of significance). Because the volatility in return is induced by an illiquid market, we cannot expect returns to fully reflect the information contained in reported earnings. However, total earnings (profits after tax) run a greater chance of explaining some movement in stock returns. The increase in net foreign purchases from 1994 to June 1998 contributed to increasing the SEMDEX which meant that there were more positive cumulative 12-month returns observations from 1994 onwards to match positive absolute earnings figures. In fact from 1994 onwards, there were 53 cumulative return observations, of which 31 were positive. In other words, although earnings may be subject to fluctuations, the overall trend is for the absolute level of total earnings to increase. This is perhaps why deflated total earnings can explain around 20% of the movement in 12-month cumulative stock returns.

The [R.sup.2] of 20.8% generated by Model 1 would have been higher had it not been for the financial crises experienced by Asia, Latin America and Russia from mid 1997 to January 1999. Since most global funds experienced huge losses from the financial turbulence which hit these emerging markets, it is not surprising that these funds decided to liquidate Mauritian holdings and realise some profits to compensate the above-mentioned losses. Furthermore, the meltdown in such emerging markets could cause investors to revise upwards the risk factor in other emerging markets like Mauritius even though the economic fundamentals of these other emerging markets had not altered significantly. Because information is costly, it could be optimal for one investor to follow the lead of another perceived to have an information advantage. Such herd behaviour would cause many foreign investors to disinvest and even cause local investors to do the same.

4. Conclusion: The above analysis has shown that reported accounting earnings are relevant to foreign investors in explaining both stock prices and changes in stock prices However, it is important when quantifying the extent of the usefulness of accounting earnings, to appropriately model the return-earnings relationship. Indeed, when earnings are modelled as following a transitory process, an [R.sup.2] of 20.78% is produced with an earnings response coefficient which is significant at 5% level of significance. When earnings are modelled as following a permanent process, an [R.sup.2] of only 3.6% is produced with an ERC not significantly different from zero at 5% level of significance. These regression results were achieved by pooling 63 pairs of return-earnings observations for the period 1990-1999 for 12 companies which have been at least once listed on the SEM 7. Because the SEM 7 includes the largest 7 Mauritian companies by market value which satisfy the liquidity criteria--both in terms of value traded and trading frequency--laid down by the Index Management Committee, the share prices of listed companies which have been included in the SEM 7, either regularly or intermittently, run a greater chance of capturing the information contained in accounting earnings. The marked difference in the [R.sup.2] of the two models confirms that the model used to evaluate the significance of the contribution of earnings in explaining stock returns does have an impact on the regression results and, therefore, on the estimation of the value relevance of accounting earnings.

REFERENCES

(1.) Ball, R. and Brown, P. (1968) "An Empirical Evaluation of Accounting Numbers", Journal of Accounting Research, Autumn.

(2.) Beaver, W. (1989) " Financial Reporting: An Accounting Revolution", Second Edition, Prentice Hall.

(3.) Brief, R. and Zarowin, P. "The Value Relevance of Dividends, Book Value and Earnings". Working Paper, New York University.

(4.) Lev. B 1989) "On The Usefulness of Earnings and Earnings research: Lessons and Directions from Two Decades of Empirical Research", Journal of Accounting Research.

(5.) Ohlson. J. (1991) "Earnings, Book Values and Dividends in Security Valuation", Working Paper.

(6.) Rees. B. "Financial Analysis", Prentice Hall, Second Edition.

(7.) Samuels, J. M. Wilkes, F. M. and Brayshaw, R. E. "Management of Company Finance", Chapman and Hall, Fifth Edition.

(8.) Strong, N. (1993) "The Relation between Returns and Earnings: Evidence from the UK", Accounting and Business Research.

Matthew Lamport, University of Mauritius, Reduit, Mauritius

Accounting information is one of the most significant sources of financial information for analysis especially when it comes to establishing the intrinsic value of the firm against which active portfolio managers would compare the market price to initiate buy, sell or hold decisions. If accounting information is an important component of intrinsic value determination, we would expect accounting earnings and share prices to be closely connected. Furthermore, accounting fundamentals (book values and earnings) purport to measure value (i.e. capital) and changes in value (i.e. profit) of the firm. Similarly, the price of a share at one point in time also reflects value (i.e. market capitalisation) and the change in price from one point in time to another, the return to investors. In so far as accounting profits and share returns attempt to measure the same characteristic, the change in wealth of the firm, there should be some association between accounting earnings and share prices. If this is the case, then earnings, as reported by companies, should be useful to investors, especially foreign investors, in predicting the return on shares. Indeed, because foreign investors may not be physically present in the investee country, they may not be fully aware of all information, especially non-earnings related information, which may be circulated in the local market and which may have an impact on share prices. These foreign investors will probably, due to their geographical distance, have to rely on published or reported earnings to assess the earnings potential of a particular firm. A review of the literature shows that there that been a scant amount of literature on the accounting earnings-foreign investors hypothesis. In fact the pioneering work stems from Ball and Brown (1968) who studied the usefulness of accounting earnings as an explanatory variable for explaining stock returns or change in share prices. Since then relatively few studies have followed among which features Beaver et al. (1980), Hopwood and McKeown(), Lustgarden and Lev(), Brief-Zarowin ()

The objective of this paper is therefore to assess the extent of the usefulness of accounting earnings to foreign investors by examining the significance of the correlation between earnings and share prices. If earnings can explain a reasonable proportion of the change in share prices, then earnings will have some value relevance in predicting future securities returns. This work is believed to supplement the literature which has so far only scantly dealt with the accounting earnings-foreign investors hypothetised link.

2. Methodology and Analysis: Many of the studies have regressed stock price revisions on unexpected earnings. However, this method to evaluate the value relevance of accounting earnings in explaining stock return depends entirely on the proper measurement of expected earnings. It was also pointed out by Lev ()that unexpected earnings may only convey a small part of the information in earnings and that total earnings might be a better variable as it would capture the impact of the entire information set about earnings that is released throughout the year. Studies by Ohlson and Brief and Zarowin have established the pairing of earnings and book value to explain stock market values. This study proposes to assess the value relevance of earnings to foreign investors using two key independent variables, namely, the level of earnings and the change in earnings, following Ohlson (1991)

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

Ohlson arrived at a model which expresses price as weighted average of book value and total earnings. The weighting attached to book value at time t, [y.sub.t] is [1- [alpha] (R-1)]. The weighting attached to total earnings is [alpha] (R-I). Total earnings are represented by the term [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] i-e. total earnings is arrived at by multiplying clean surplus earnings, [X.sub.t] by a multiple, [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] and subsequently deducting the current dividend, [d.sub.t]. Ohlson's above earnings valuation model shows that the relevance of book value and total earnings depend on the magnitude of the w term which captures the extent to which the current level of residual income is likely to persist in the future.

Modelling the relation between returns and earnings

Having established the relationship between earnings and market value according to Ohlson's earnings valuation model, we can now turn to modelling the relationship between earnings and changes in market value. Since the relevance of earnings in explaining market value depends on the term w, which reflects the extent to which current level of residual income is likely to persist in the future, i.e. on the degree to which earnings follow a permanent or transitory process, it seems logical to keep the same distinction when modelling the relationship between earnings and return.

Modelling earnings as a transitory process If earnings follow a transitory process, w is deemed to be zero and market value would equal book value. In other words, the market to book value ratio would be equal to one. If we represent [V.sub.jt] as the value of firm j at the end of year t, then a market-to-book value of unity would imply that [B.sub.jt] (the book value of firm j at the end of year t) is equal to [V.sub.jt]. Since [V.sub.jt] is equal to [B.sub.jt], then the return of firm j for year t, [R.sub.it] would be given by:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

Where:

[E.sub.jt] is the total clean surplus earnings for firm j for year t

[D.sub.jt] is the dividend for firm j for year t

[V.sub.jt-1] is the value of firm j at the start of year t

The above expression defines return for year t simply as the capital gain over year t plus the dividend received for year t, expressed as a ratio of opening market value of equity. Since market value tracks book value, the return for year t would be the increase in book value of equity from year t-1 to year t plus the dividend for year t (i.e. clean surplus earnings for year t) expressed as a ratio of opening book value of equity, [B.sub.jt-1] As previously stated, defining earnings according Ohlson's clean surplus expression is in line with IASC's definition of profit, namely that profit is the net increase in economic benefits in the form of net inflows or increases in net assets that result in increases in equity without considering distribution to equity participants as a decrease in economic benefits. Modelling earnings as a permanent process

If earnings are deemed to follow a permanent process, Ohlson's earnings-based valuation model suggests that the cum div value of equity capital would be a multiple of clean surplus earnings as follows:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

The proposition that share price in the market is a multiple of earnings is similar to the concept that the market value of firm j at the end of year t is the product of reported earnings after tax of company j for year t and the price-earnings ratio for firm j. Therefore, where earnings follow a permanent process, value can be expressed as:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

Where [beta] represents the price earnings ratio or multiple for company j. The return of firm j for year t is:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

The equation captures the idea that if earnings increase by Rs1 a [beta] value of say 10 would imply that market value would increase by Rs10. Because earnings are permanent, i.e current earnings persist into the future, earnings become less volatile and more predictable. Consequently for such higher quality earnings, investors would be prepared to pay'S' times earnings to buy shares in the company.

Regression Equations

The regression equations which would model equation whereby earnings are deemed to follow a transitory process and equation whereby earnings are deemed to follow a permanent process can be specified as follows:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] [E2]

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] [E3]

Because in reality the value of w in Ohlson's residual income valuation model is likely to be somewhere between 0 and 1, earnings could consist of both transitory and permanent components. To capture this possibility, equation [E3] includes two independent variables, the total earnings level and the change in earnings.

Findings and an analysis

Table 1 summarizes the regression results of the three regression equations together with key statistical significance tests, namely the t and the F statistics.

The following observations can be made from the information contained in Table above. First, it appears that Model 3 produces the highest [R.sup.2] and, therefore, is more useful in explaining stock returns. However, an important property of [R.sup.2] is that it is a non-decreasing function of the number of explanatory variables present in the model. Thus, as the number of explanatory variables increases, R" almost invariably increases and never decreases. Because Model 3 contains two independent variables, its [R.sup.2] cannot be compared with those of Models 1 and 2 which contain only one independent variable. It is better to use the adjusted [R.sup.2] to compare the explanatory power of several models because the adjusted [R.sup.2] calculates a coefficient of determination which takes into account the number of independent variables present in the model. On the basis of adjusted [R.sup.2], Model 1 has the highest explanatory power at 19.48 %.

Model 1 models earnings as following a transitory process to explain changes in stock prices. Model 2 on the other hand models earnings as following a permanent process to explain stock returns. The [R.sup.2] of Model 1(20.78 %) is significantly higher than that of Model 2 (3.6 %). Therefore, the market considers that it is earnings level as a whole rather than change in earnings which are, to a certain extent, relevant in explaining stock market returns on the SEM. This implies that book value or change in book value has partial value relevance in explaining stock returns. The term 'partial' is used because Model 1 reports an [R.sup.2] of only 20.78 % which means that 20.78 % of the total variation in stock returns is explained by earnings level deflated by market capitalisation at the start of the 12-month return period. Indeed, if earnings are deemed to follow a transitory process, i.e. there is little or no permanence in the composition of earnings, market value would track book value and therefore stock returns, measured by change in market values, would be 'proxied' by changes in book value. Changes in book value or net assets are essentially caused by the earnings or profits after tax generated by the company during the year. Therefore, modelling change in stock prices with the earnings level as an independent variable is in fact mirroring the value relevance of book value. This confirms the conclusion arrived at by Brief and Zarowin, namely, that when earnings are transitory, as opposed to permanent, book value has the greatest value relevance.

The higher explanatory power of Model 1 with respect to Model 2 can be confirmed by carrying out statistical tests to check whether the regression earnings response coefficients (slopes) are significantly different from the hypothesized coefficient of zero. A hypothesized coefficient of zero (the null hypothesis) implies that the independent variable has no explanatory power. For Model 1, since the observed t value (4) is greater than the critical value at the 5 % level of significance (2) with 61 degrees of freedom, it can be concluded that b = 222.02 is significantly different from zero. For Model 2 on the other hand, since the observed t-statistic for the slope (1.5) is less than the critical value of t at 5 % level of significance, it can be concluded that d = 106 is not significantly different from zero. This means that for Model 2 we should accept the null hypothesis namely that the coefficient for d, change in earnings, is statistically zero.

When combining earnings and change in earnings as independent variables (Model 3), the regression coefficient for earnings (b' = 218.72) is statistically significant because its t statistic (3.61) is beyond the critical value for t at 5 % level of significance. On the other hand, the regression coefficient for change in earnings in Model 3 (d' = 9.87) is statistically insignificant meaning that the true coefficient of d is in fact zero and that the fact that d, the regression coefficient, is different from zero is merely due to chance. This conclusion is supported by the fact that the t statistic for d is 0.14 which is less than the critical t value of 2. It is quite clear that if Model 3 generates an adjusted [R.sup.2] of 18.16 % it is entirely because of the explanatory power of earnings level alone. The larger the F value, the more meaningful is the regression model in explaining stock returns. Because the F value of Model 2 (2.28) is below the critical value of F at the 5 % level of significance (4), Model 2 is not statistically significant in explaining stock returns implying that the slope of the model is zero. Model 1 has the greatest F value (16) suggesting that it is the most useful in explaining stock return: the F value of Model 1 (16) is very much higher than the critical F value of 4. This result is not surprising as Model 1 also has the greatest adjusted [R.sup.2].

Furthermore, the fact that adding change in earnings as an additional independent variable to Model 1 produces a significant drop in the F value from 16 to 7.88 in spite of the fact that the critical value also shifts from 4 to 3.15, suggests that this variable should not be added. This conclusion can be confirmed by assessing the incremental contribution of the variable, change in earnings, after allowing for the contribution of total earnings level. The F statistic to assess this incremental contribution would be:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

'newk' represents the number of new regressors. At 5% level of significance, the addition of the variable 'change in earnings' does not increase the explanatory power of the model.

Interpreting the regression results in the context of the local market setting

Skewness of the stock market: The Mauritius stock market can be considered quite atypical of other more developed stock markets for two key reasons. Firstly, key components of the Mauritius stock market do not, unlike other developed stock markets, mirror those of the economy. Textiles represent a key contributor to GDP for the Mauritian economy, yet not a single textile company is listed. Secondly, the top ten companies make up 75% of the total market capitalisation as at 31st December 1999 and the top six make up 61% of total market capitalisation as at the same date.

Family-owned companies: Furthermore, since most Mauritian companies are family owned, most of the shares will be locked in the sense that they will be held for family reasons and for the long term. Therefore, it is evident that any change in earnings will not be considered as a permanent change warranting investors to revise their forecasts and change their shareholding which would cause a revision in stock prices. The fact that only a small portion of the shares in issue are traded suggests that shareholders do not consider changes in earnings form one year to the next as a permanent change since the shareholders will hold on to most of their shares and only trade a small portion.

Theoretical relevance of total earnings in stock valuation: If shareholders wish to maintain their shareholding in the blue chip companies, it can be shown theoretically that under certain assumptions, it will be total earnings that will be relevant in stock valuation. Clearly, earnings are important to stockholders because earnings provide the cash flow necessary for paying dividends. Dividends however are also important because they are what stockholders actually receive from the firm and are the focus of dividend valuation models. Earnings of a firm can either be used to pay dividends or to fund positive net present value (NPV) projects and this could perhaps explain why total earnings have greater explanatory power in explaining stock return movements: the dividends accruing to shareholders depend on total earnings minus investment opportunities financed from such earnings.

The impact of foreign investors :Since mid 1994, foreign investors have been authorised to invest in listed as well as in newly issued shares, with a limit however for sugar companies: no foreign investor, be it an individual or a company, can hold more than 15% of the issued share capital of a sugar company. Although there is no legal restriction to the proportion of shares that can be held in companies outside the sugar sector, some companies in their Memorandum and Articles of Association or in their prospectus limit the proportion of total shares that can be subscribed by foreign investors. Analyzing foreign net purchases/sales from 1995 to 1999 will shed further light on the reasons behind the greater explanatory power of deflated total earnings as an independent variable in the return-earnings regression. Analysis of the top five companies shows relatively good earnings momentum However, except for SBM and MCB, the earnings per share (EPS) and the dividend per share (DPS) tend to fluctuate, increasing at times and decreasing at others. Do shareholders view these signals as permanent changes in future profits requiring a change in shareholding? The answer is of course, no since as mentioned before most of the shares are not actively traded. Shareholders tend to hold on to their shares for the long term and seek capital growth. This seems to be confirmed by the low dividend payout ratio.

One can argue that the fact that the absolute level of PAT is positive and undergoing steady growth has prompted foreign investors to buy stocks of the top ten companies on the SEM. There is no doubt that foreign investors have had a positive impact on the growth of the stock market and have also contributed to making the Mauritian stock market more efficient. Because foreign investors tend to bring technical expertise it is not uncommon for local investors to mimic the behaviour of foreign investors. Indeed the SEMDEX dipped from January 1995 to November 1995, it subsequently picked up in December 1995 and January 1996 probably because of the sustained net foreign purchases from May 1995 onwards. The significant foreign net buying impetus from May 1995 to May 1998 gave local investors greater confidence to buy shares and this obviously resulted in a rise in the SEMDEX from November 1996 to August 1998.

It must be realised, however, that restrictions on foreign ownership prevent the market from being more liquid. For instance, foreign investors cannot hold more than 3% of the shares of SBM and 2.5% of the shares of MCB. Limited foreign intervention and the absence of a strong and active domestic investor base--most of the shareholders hold on to their shares and only trade a small portion--are constraints which prevent the market from gaining liquidity. Low liquidity leads to high price volatility and renders entry and exit conditions difficult. An investor may have to pay an unduly high price on just a small number of shares if little sellers are forthcoming which makes entry to the market difficult. Similarly, a shareholder wishing to sell may need to unduly lower the price if buyers are not forthcoming which makes it difficult for the shareholder in question to sell his shares and exit the market. We should not be too surprised therefore if the 12-month cumulative returns for all companies exhibit considerable volatility over time. This seems to be confirmed by the negative intercept of 21.31% of regression Model 1 which is significant at the 5% level (the observed t statistic for the intercept is -2.44 which is greater than the critical t value of 2 at 5% level of significance). Because the volatility in return is induced by an illiquid market, we cannot expect returns to fully reflect the information contained in reported earnings. However, total earnings (profits after tax) run a greater chance of explaining some movement in stock returns. The increase in net foreign purchases from 1994 to June 1998 contributed to increasing the SEMDEX which meant that there were more positive cumulative 12-month returns observations from 1994 onwards to match positive absolute earnings figures. In fact from 1994 onwards, there were 53 cumulative return observations, of which 31 were positive. In other words, although earnings may be subject to fluctuations, the overall trend is for the absolute level of total earnings to increase. This is perhaps why deflated total earnings can explain around 20% of the movement in 12-month cumulative stock returns.

The [R.sup.2] of 20.8% generated by Model 1 would have been higher had it not been for the financial crises experienced by Asia, Latin America and Russia from mid 1997 to January 1999. Since most global funds experienced huge losses from the financial turbulence which hit these emerging markets, it is not surprising that these funds decided to liquidate Mauritian holdings and realise some profits to compensate the above-mentioned losses. Furthermore, the meltdown in such emerging markets could cause investors to revise upwards the risk factor in other emerging markets like Mauritius even though the economic fundamentals of these other emerging markets had not altered significantly. Because information is costly, it could be optimal for one investor to follow the lead of another perceived to have an information advantage. Such herd behaviour would cause many foreign investors to disinvest and even cause local investors to do the same.

4. Conclusion: The above analysis has shown that reported accounting earnings are relevant to foreign investors in explaining both stock prices and changes in stock prices However, it is important when quantifying the extent of the usefulness of accounting earnings, to appropriately model the return-earnings relationship. Indeed, when earnings are modelled as following a transitory process, an [R.sup.2] of 20.78% is produced with an earnings response coefficient which is significant at 5% level of significance. When earnings are modelled as following a permanent process, an [R.sup.2] of only 3.6% is produced with an ERC not significantly different from zero at 5% level of significance. These regression results were achieved by pooling 63 pairs of return-earnings observations for the period 1990-1999 for 12 companies which have been at least once listed on the SEM 7. Because the SEM 7 includes the largest 7 Mauritian companies by market value which satisfy the liquidity criteria--both in terms of value traded and trading frequency--laid down by the Index Management Committee, the share prices of listed companies which have been included in the SEM 7, either regularly or intermittently, run a greater chance of capturing the information contained in accounting earnings. The marked difference in the [R.sup.2] of the two models confirms that the model used to evaluate the significance of the contribution of earnings in explaining stock returns does have an impact on the regression results and, therefore, on the estimation of the value relevance of accounting earnings.

REFERENCES

(1.) Ball, R. and Brown, P. (1968) "An Empirical Evaluation of Accounting Numbers", Journal of Accounting Research, Autumn.

(2.) Beaver, W. (1989) " Financial Reporting: An Accounting Revolution", Second Edition, Prentice Hall.

(3.) Brief, R. and Zarowin, P. "The Value Relevance of Dividends, Book Value and Earnings". Working Paper, New York University.

(4.) Lev. B 1989) "On The Usefulness of Earnings and Earnings research: Lessons and Directions from Two Decades of Empirical Research", Journal of Accounting Research.

(5.) Ohlson. J. (1991) "Earnings, Book Values and Dividends in Security Valuation", Working Paper.

(6.) Rees. B. "Financial Analysis", Prentice Hall, Second Edition.

(7.) Samuels, J. M. Wilkes, F. M. and Brayshaw, R. E. "Management of Company Finance", Chapman and Hall, Fifth Edition.

(8.) Strong, N. (1993) "The Relation between Returns and Earnings: Evidence from the UK", Accounting and Business Research.

Matthew Lamport, University of Mauritius, Reduit, Mauritius

Table 1: Summary of regression results and significance statistics 1(E1) 2(E2) 3(E3) Intercept a -21.31 C 36 a' ERC b 222.02 D 16 b' 72 d' 7 SE of: Intercept E(a) 8.73 SE(c) 17 SE(a') 8 ERC E(b) 55.50 SE(d) 73 SE(b') 57 SE(d') 48 [R.sup.2] 20.78% 0% 0% Adjusted [R.sup.2] 19,48% 2% 6% No. Of 63 63 63 observations Observed t statistic 1(b) 4 t(d) 51 t(b') 1 for ERC t(d') 4 Critical t value 2 2 2 Observed F statistic 16 2.28 7.88

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