Download Proposal on stock prediction return of Pakistan

Chapter – 1
INTRODUCTION
CHAPTER – 1
INTRODUCTION TO REPORT
1.1
BACKGROUND OF THE STUDY
The main idea of the report revolves around the Fama and French, Cambell
and Sheller predicting stock return. Pakistan Tobacco Company is the
cigarette manufacturing company. Basically Pakistan tobacco company
established in 1902 under the name of British American tobacco company to
end war between UK’s imperial tobacco company and American tobacco
company but its operations in Pakistan starts in 1947 as a 1st foreign
investment company.
The study is to predict stock return of Pakistan Tobacco Company in order to
predict FY 2008 returns to give an investor an idea either to invest in Pakistan
Tobacco Company or not for the year 2008. The sample period for this study
is from 2003-2007 for 5 years. Three ratios will be used to predict stock
returns i.e. price to earning ratio, dividend yield and book to market ratio.
1.2
PURPOSE OF THE STUDY
The study is done to predict the stock returns of PTC with the help of Price to
Earning ratio, Dividend yield and Book to Market ratio.
1.3
SCOPE OF THE STUDY
The scope of the study is limited to the prediction of return on PTC shares and
I will give description about the Pakistan Tobacco Company, Tobacco
industry, stock predicting ratios and analysis and findings.
1.4
METHODOLOGY OF STUDY
The data collected based on secondary data.
Secondary data sources
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Internet
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Magazine
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Newspapers

Books
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Chapter – 1
1.5
INTRODUCTION
SCHEME OF THE REPORT
The scheme of the report consist of
1.5.1
Chapter No. 1 which includes background, purpose, scope,
methodology, and scheme of the report.
1.5.2
Chapter No.2 contains Literature review and Theoretical Background
of the study
1.5.3
Chapter No. 3 contains introduction of the Tobacco Company, history
of the Pakistan tobacco company, organizational structure of the
Pakistan tobacco company.
1.5.4
Chapter No. 4 contains introduction of the financial ratios.
1.5.5
Chapter No. 5 contains Ratio Analysis.
1.5.6
Chapter No. 6 consists of finding, conclusions and recommendations
2
Chapter – 2
LITERATURE REVIEW
CHAPTER – 2
LITERATURE REVIEW
Kendall 50 years back observed that stock prices vary time to time. Kendall
tested that price change can be predicted with the help of past returns and later
on predicted some variables, which are price to earning ratio, dividend yield
and book to market value ratios. These three ratios have some common
features i.e. each of them measures price relative to fundamental because in
the above three ratios price comes in denominators, so the ratios should be
positively related to expected return and this is due to the reason that if prices
goes up, expected return will be lower but if prices goes down, expected return
will go up and all the three ratios should be directly or positively related to
expected returns.
Two theories regarding ratios, one is Mis-pricing theory, which says that the
ratio will be low when stocks are overpriced; they predict low future returns as
prices return to fundamentals. The other theory is of rational pricing which
says that the ratio track time variation in discount variations i.e. the ratio will
be low when discounts are low and high when discounts rate are high, due to
information available about the risk premium prediction of return is possible.
These ratios (D/Y, B/M and P/E) also have similar time series properties, at a
monthly frequency. These ratios have auto-correlation near 1 and most of the
movements are caused by price changes in denominators.
From the last 20 years, we can see that stock returns are predictable. At the
aggregate level, Fama and Schwart (1977) Keim, Stamburgh (1886), Fama
and French (1989), and Kothary and Shaken (1997) show that the interest
rates, the yield between high and low grade debt, aggregate dividend yield and
aggregate book to market predict time variation in expected returns.
Leroy and porter and Sheller (1981) argue that the volatility of stock prices is
too high to be explained by a model constant discount rates, which provides
indirect evidence that expected returns change overtime but Fama and French
(1992) said that the size and book to market together explain much of the cross
sectional variation in average returns.
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LITERATURE REVIEW
Jegadesh and Titamen (1993) showed that the past returns contain additional
information about expected returns.
The interpretation of how to predict is more debatable. The empirical patterns
in return are potentially consistent with either market efficiency or irrational
pricing,
In general term, market efficiency refers prices that fully reflect all available
information.
Fama (1976) distinguishes between the probability distribution of returns
perceived by the market based on whatever information investors view as
relevant and the true distribution of returns conditional on all information. If
the distribution is same we can say that market is informational efficient,
market efficiency implies that investors correctly anticipate any cross sectional
or time variation in true expected returns. While Fama’s definition ignores
important issues like heterogeneous belief, it provides a useful framework for
thinking about a broad set of asset pricing questions.
B/M value explains cross sectional variation in expected returns. The insight is
that the book value in numerator controls the size of the firm i.e. (the firm
expected cash flows) while M/V which comes in denominator gives us
information about discount rates.
Recent events in the stock market have reawakened interest in an old question:
are P/E ratios of any use in predicting subsequent returns? By mid 1990, years
of large increase in stock prices had lifted the market’s average P/E well above
20 which is very high by historical standard. Nevertheless prices continued to
raise giving investors the returns of over 20% each year between 1996 and
1999. However with the start of new century came a bursting of this bubble.
Beginning in March 2000, NASDAQ lost 70% of its value in a period of one
year. This decline seems to prove right those who believe that high P/E ratios
lead to lower returns. Still one is left with wonder that what is the historic
relationship between P/E ratios and its subsequent returns?
In theory, market prices must ultimately maintain a relationship with earnings;
prices cannot drift away indefinitely from earnings. Whenever stock prices
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LITERATURE REVIEW
rises very rapidly without any sharp increase in earnings, concerns are raised
whether the market is over valued and is ready for correction.
Consider the period between 1994 and 1999; the Dow Jones industrial average
increase by the value of over 200%, while the corporate profit rose during the
same period by less than 60%. As P/E ratios rose to the unprecedented high
level, the monitory authorities warned us of ‘irrational exuberance’. So in
theory one would expect that in the long run high P/E ratios cannot be
sustained. If this is true, as prices revert to their equilibrium levels, we would
expect more price decline or modest price increases.
Thus when P/E ratios tend to be high, returns will be low.
A number of studies have examined the predictability of future returns using
different valuation models (ratios) for example (P/E, dividend yield, B/M).
Their findings tend to suggest that future average returns are indeed partially
predictable over longer investment horizons. Fama & French (1989) for
instance, shows the dividend yield at the beginning of the period predicts a
significant portion (R2=25%) of four year returns. However the explanatory
power declines and is not significant over short period of time (R2 less than
5% for subsequent monthly, quarterly or one year returns). Fama and French
conclude that DY and P/E ratios can’t be used for prediction of one year return
but that they are useful for the prediction of four year return.
Fama & French (1995) provide support for the risk hypothesis by showing that
there are size and value factors in earning as well as returns. This suggests that
systematic variation in firm’s cash flow streams may be associated with
systematic variation in stock returns.
Also Fama & French (1996) show that the three factor model can explain most
of the departure from the CAPM prediction discussed in the recent financial
literature included the two way sorts of the Lakonishok, Shliefer and vishny
(1994). However the three factors model could not explain the short-term
momentum in stock prices. The ability of the three-factor model to explain
most of the observed cross sectional empirical results supports a multi-factor
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LITERATURE REVIEW
risk model of expected returns still it is not clear why the three-factor model
can’t explain momentum.
Liew and Vassalou (2000) support the risk based story by showing that SMB
and HML are able to predict future GDP growth in some countries however
the relation between these variables and GDP growth is weak in several
countries and is not existence in the US for the 1957-1998 period.
More recently, Campbell & Sheller also find similar results by using these
valuation ratios. For example dividend yield, significantly explained average
returns over longer time period but were poor predictors in the short run in
addition they found out that P/E is good tool for prediction of stock return than
dividend yield
Furthermore Cale, Helwege, and Laster (1996) found that even in adjusting for
share repurchases and changes in accounting rules, the standard valuation
ratios provide some degree of evidence in predicting of future long-term
returns.
2.1
STOCK RETURNS THE THEORETICAL
BACKGROUND
2.1.1
Markowitiz Portfolio Selection
The discussion of stock price behavior starts with Markowitiz (1952-1959).
The Markowitiz model is for single period; in this case investors form a
portfolio at the beginning of the period.
The main theme of investor is to maximize the expected returns {E(R), is the
main value of probability distribution of possible returns}, subject to an
acceptable level of risk (or minimize risk, subject to an acceptable excepted
return). The assumption of both single period and about investors attitude
toward risk allows risk to be measure by variance (which measure the
dispersion of return distribution, it is the sum of squares of a return deviation
from mean divide by n) or standard deviation (which is the statistical measure
of the degree to which an individual value in a probability distribution tends to
vary from mean of distribution) of the portfolios return.
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LITERATURE REVIEW
GRAPH 2.1
Portfolio Return
Efficient Protfolio Frontier
31%
30%
30%
29%
29%
28%
28%
27%
27%
26%
26%
0.045, 30%
0.036, 30%
0.029, 29%
0.0234, 29%
0.0196, 28%
0.0176, 28%
Efficient Protfolio Frontier
0.0174, 28%
0.019, 27%
0.022, 27%
0.027, 26%
0.034, 26%
0
0.01
0.02
0.03
0.04
0.05
Portfolio Risk
The figure shows that the investor is trying to go as far North West as possible
As the securities are added to the portfolio the expected return and the
standard deviation change in which the added securities co-vary with other
securities in the portfolio. The investors always wants to further move towards
northwest which is the upper half of the hyperbola as shown in the above
figure, this curve is known as efficient frontier. According to Markowitiz
model investor select the portfolio along the curve according to their tolerance
for risk.
An investor who wants to live with a lot of risk should go for portfolio A,
while a more risk averse investor would be more likely to choose portfolio B
2.1.2
Capital Asset Pricing Model
William Sharpe in 1964, Litner in 1965 and Mossin in 1966 independently
developed capital assets pricing Model (CAPM). This model assumes that
investor use the logic of Markowitiz in forming portfolios. This theory posits a
liner relationship between an assets risk and its required rate of return. This
linear relationship is called Security market line (SML).
SML depicts the relationship between risk (beta) and expected rate of return.
Beta is plotted on the X axis and return is plotted on Y axis. A security having
higher actual return than the RRR will be above SML and considered underpriced.
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LITERATURE REVIEW
GRAPH 2.2
0.7
Under priced
0.6
SML
0.5
Return
0.4
0.3
Over priced
0.2
0.1
0.01
0.02
0.03
0.04
BETA(Risk)
0.05
0.06
0.05
0.06
GRAPH 2.3
0.7
0.6
0.5
Return
M
0.4
0.3
0.2
0.1
0.01
0.02
0.03
0.04
BETA(Risk)
The straight line in the figure 2.3 which shows the risk free rate as its
interceptor and is tangent to efficient frontier, is now the northwest boundary
of the investment opportunity set, investor will choose portfolio along this line
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LITERATURE REVIEW
i.e. (capital market line) which shows combination of the risk free asset and
the risk portfolio M. In order for market to be in equilibrium i.e. (quantity
supplied = quantity demanded) the portfolio M must be market portfolio and
the risk free asset and only risk that investor are paid for bearing is the risk
associated with market portfolio, which lead to CAPM equation
E (Rj) = Rf +βj [E(Rm)-Rf]
E(Rj) and E(Rm) are expected returns to asset j and the market portfolio
respectively, Rf is the risk free rate, and βj is the beta, is the coefficient for
asset j. βj measure the tendency of asset j to co-vary with the market portfolio
it represent the part of the asset's risks that can't be diversified away and this is
the risk that investor are compensated for bearing.
The CAPM equation says that the expected return of any risk asset is a linear
function of its tendency to co-vary with the market portfolio. So, if the CAPM
is in accurate description of the way asset are priced, this positive linear
relation should be observed when average portfolio returns are compared to
portfolio betas. When beta is included is in explanatory variable, no other
variable should be able to explain cross-sectional differences in average
returns. Beta should be all that maters in a CAPM world
2.1.3
Arbitrage Pricing Theory
The CAPM is a simple model that is based on sound reasoning; some of the
assumption that underlies the model is unrealistic. Some extensions of the
basic CAPM were proposed that relaxed one or more of these assumption
(e.g., black, 1972).
Ross in (1976) doesn’t extend an existing theory but he addresses this concern
by developing a completely different model i.e. the arbitrage pricing theory
(APT).
Unlike the CAPM, this is a model of financial market equilibrium, the APT
start with the initiative that arbitrage opportunities should not be present in
efficient financial market. This assumption is much less restrictive than those
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LITERATURE REVIEW
required to derive the CAPM.
The APT starts by assuming that there are n factors which cause asset return to
systematically deviate from their expected values. The theory does not specify
how large the number n is, nor does it identify the factors it simply assumes
that these n factors cause return to vary together. There may be other, firmspecific reason for returns to differ from their expected values but these firmspecific deviations are not related across stock. Since the firm-specific
deviations are not related to one another, all return variations are not related to
the n common factors can be diversified away. Based on these assumption
Ross shows that in order to prevent arbitrage, an asset’s expected return must
be a linear function of its sensitivity to the n common factors
APT
E(Rj) =Rf+ βjlλl + βjλ2+……+βjnλn
sensitivity of asset j to risk factor k and λκ represent the risk premium for
factor k. As with CAPM, we have an expression for expected return that is a
linear function of the assets sensitivity to systematic risk. Under the
assumptions of APT, there are n sources of systematic risk, where there is only
one in a CAPM world
2.1.4
Intertemporal Capital Asset Pricing Model
Both the CAPM and the APT are static or single period models. They ignore
the multi-period nature of participation in the capital markets.
Merton’s
(1973) intertemporal capital asset pricing model (ICAPM) was developed to
capture the multi period aspect of financial market equilibrium. The ICAPM
framework recognizes that the investment opportunity set (i.e. might shift over
time, and investors would like to hedge themselves against unfavorable shifts
in the set of available investments). If a particular security tends to have high
returns when bad things happen to the investment opportunity set, investors
would want to hold this security as a hedge. This increased demand would
result in a higher equilibrium price for the security (all else constant). One of
the main insights of the ICAPM is the need to reflect this hedging demand in
the asset pricing equation.
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LITERATURE REVIEW
The resulting model is;
ICAPM
Note that the form of the ICAPM is very similar to that of the APT. There are
slight differences, however. The first factor of the ICAPM is explicitly
identified as being related to the market portfolio. Further, while the APT
gives little guidance as to the number and nature of factors, the factors that
appear in the ICAPM are those that satisfy the following conditions;
1.
They describe the evolution of the investment opportunity set over time.
2.
Investors care enough about them to hedge their effects.
If there might be a priced factor for unexpected changes in the real interest rate
such a change would certainly shift the investment opportunity set (e.g. the
intercept of the line in the figure 2.3 would move) and the effect would be
pervasive enough that investors would want to protect themselves from the
negative consequences. We still don't know exactly how many factors there
are but the ICAPM at least gives us some guidance.
2.1.5
Consumption-Oriented Capital Asset Pricing Model
The consumption based model of Breedon (1979) provides a logical extension
of the previous work in asset pricing. His model is based on intuition that an
extra dollar of consumption is worth more to a consumer than when the level
of aggregate consumption is low. When things are going smooth people can
afford a comfortable way of living so dollar consumption can’t make us feel
better off, but in hard times a few dollar consumption on goods is very much
welcomed.
Based on this “diminishing marginal utility consumption” security that have
higher returns will attract investors when aggregate consumption is low,
hiking their prices and lowering their expected return. In contrast, stocks that
co vary positively with aggregate consumption will require higher expected
returns since they provide high returns during states of the economy where
high returns do the least good.
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LITERATURE REVIEW
Based on this line of reasoning, Breedon derives a consumption based capital
asset pricing model of the form:
CCAPM
E(Rj) = Rf + βjc [E(Rm) - Rf]
In this model, βjc measure the sensitivity of the return of asset j to changes in
aggregate consumption, βjc is referred to as the consumption beta of asset j.
2.2
EARLY EMPIRICAL WORK
Early cross sectional studies of stock return (e.g. Nicholson, 1960) did not
receive much importance due to small samples used to conduct the empirical
tests, but then computed databases become available and research could
construct large samples to produce reliable results consequently for a few
years. After the development of CAPM there was no reliable way to test the
model prediction against variables like book to market or priced to earning.
2.2.1
Price /Earning
Basu (1977) early studied the prediction of CAPM; Basu showed that stocks
with high Earning/Price ratio (or low P/E ratio) earned significantly higher
return than stock with low P/E ratio, his result indicate that difference in beta
could not explain these return differences. In follow up study in1983 by Basu
showed that this P/E effect is not just observed among small cap stocks.
A later study by Jaffee, Keim and Westerfield in 1989 confirmed this finding
and also showed that P/E effect does not just appear in month of January as
claimed by researchers. The P/E is the direct contradiction of the CAPM; beta
should be all that matters.
2.2.2
Firm Size
Banz (1981) uncovered another apparent contradiction of the CAPM by
showing that the stock of the firms with low market capitalization (the value
of a company as determine by the market price of its issues and outstanding
common stock. It is calculated as the product of market price and shares
outstanding) have higher average returns than large cap stocks. Basu says that
the size effect is distinct
From the P/E effect, small firms tends to have higher returns, even after
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controlling for P/E proponent of the CAPM are quick to point out the small
firm, tend to have higher betas than large firms, so we could expect to see
higher average returns for small firms. However the beta differences are not
large enough to explain the observed return differences. Once again the
CAPM predictions are violated.
2.2.3
Long Term Return Reversals
Debondt and Thaler (1985) identified "losers” as stocks that had poor returns
over the past three to five years. "Winners” are those stocks that had high
returns over a similar period. The main result of Debondt and Thaler is that
losses have much higher average returns than winners over the next three to
five years. Chopra, Lakonishok and Ritter in1992 show that beta can't account
for this difference in average returns. This tendency of returns to reverse over
long horizons (i.e. Losers become winners) is yet another contradiction of the
CAPM. Losers would have to have much higher betas than winners in order to
justify the return difference. Chopra, Lakonishok and Ritter in1992 showed
that the beta difference required to save the CAPM is not there.
2.2.4
Book-To-Market Equity
Rosenberg, Reid and Lanstein (1985) provided yet another evidence against
the CAPM by showing that stocks with high ratio of book value of common
equity to market value of common equity (also known as book-to-market
equity, or B/M) have significantly higher return than stocks with low B/M (the
reasons might be bad management or risky operations or liquidity problems
facing the company). Since the sample period for this study is fairly short i.e.
from 1973 to 1984, the empirical results did not receive as much attention as
some of the other studies discussed above. However, when Chan, Hamao and
Lakonishok in 1991 found similar return in the Japanese market, B/M began to
receive attention as a variable that could produce dispersion in average returns.
2.2.5
Momentum
Jegadeesh (1990) found that stock return tend to exhibit short-term
momentum, momentum means that if a stock performs well or worse, it will
continue for some time period to perform well or worse. Research has
uncovered an intermediate (3 to12 months) momentum in U.S. stocks. This
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suggests that strong or weak industry performance is followed by strong or
weak performance over a period of time.
2.2.6
Leverage
Bhandari in 1988 found that firms with high leverage i.e. (high debt to equity
ratio) have higher average returns as compared to low leverage firms due to
high riskiness attached with the debt which is another deviation from CAPM
prediction
2.3
TURNING POINT
In 1992, an influential paper was published that pulled together much of the
earlier empirical work.
Fama and French in 1992 brought together size, leverage, P/E, B/M and beta
in a single cross-sectional study. Their results were controversial. First, they
showed that the previously documented positive relation between beta and
average return was an artifact of the negative correlation between firm size
and beta. When this correlation is accounted for, the relation between beta and
return disappears. Below figure show these results,
GRAPH 2.4
0.7
0.6
0.5
Return
0.4
0.3
0.2
0.1
0.01
0.02
0.03
0.04
BETA
0.05
0.06
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Figure 2.4 plots beta and average returns for 8 portfolios formed by ranking
stocks on firm size, the positive relation between return and beta is highly
linear as predict by the CAPM. Based on this evidence it appear that the
CAPM nicely explain the higher return that small firms have earned
Given that beta does a poor job of explaining average return, what variable can
do a better job? This is the second main point of the Fama & French study.
They compared the explanatory power of size leverage, P/E, B/M and beta in
cross sectional regression that spend the 1963 to 1990 period that B/M and
size are variables that have the strongest relation to returns.
The explanatory power of the other variables when these two variables are
included in regression, the cross-sectional of average stock returns can be
nicely described by two variables.
The Fama & French (1992) result dealt a severe blow to the view that the
single period CAPM is the way securities are actually priced the model that
has been taught more than any other in business school does not seem to work
2.4
DATA MINING
If an academic paper is judged by the amount of dissolution that it generates,
then Fama & French (1992) was an unparallel success, the reaction was not
timid. One of the first replies was from Black in 1993, who suggested that the
Fama & French results were likely an artifact of data mining. Hundreds of
researchers in an attempt to write publishable papers spend a great deal of time
looking for relationships between stocks returns and other variables. Only the
successful tests are submitted for publication. The unsuccessful ones never see
the light of the day. A few variables are bound to show a statistical relation to
returns, just by chance, since Fama & French choose there explanatory
variables based on the result of earlier empirical studies, the observed
explanatory power of these variables could be due to a massive data mining
exercise on the part of the authors of these earlier studies. Based on this, Black
contended that some of the statistical tests in Fama & French (1992) were not
properly specified. He also suggested that, since the relation between returns
and size, B/M, etc were likely an artifact of data mining; they would disappear
if another time period or another data source were analyzed. MacKinlay in
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1995 also mentioned data mining as a potential cause of the observed results.
Another criticism of the Fama & French results came from Kothari, Shanken
and Sloan in 1995. Their attack proceeded along two main fronts; survivorship
bias and beta mis-measurement.
2.4.1
Beta Estimation
The other main criticism of Fama & French (1992) put forth by Kothari,
Shanken and Sloan (1995) is related to the estimation of beta. Levhari &Levy
in (1977) showed that beta coefficients estimated with monthly returns are not
the same as betas estimated with annul returns. Since they are different, the
result of empirical study will depend upon which beta estimation convention is
used. Kothari, Shanken and Sloan argue that annual betas are more suitable
than monthly betas since the investment horizon for a typical investor is
probably closer to a year than a month. They show that the relation between
beta and return is stronger when betas are estimated using annual returns.
Based on the data mining, selection bias, and beta estimation, criticisms of
Fama & French 1992, many researchers in the early to mid 1990s believed that
the explanatory power of B/M should not be taken seriously. A number of
authors argued that the CAPM was still the best model of expected returns,
claiming that the empirical results contradicting the CAPM are unreliable
2.5
THE RESPONSE
One of the early responses to the criticisms of Fama &French (1992) was
Dawis in 1994, who constructed a database of book values for large US
industrial firms for the 1940-1963 period, a period for which the Computed
coverage is either poor or non existent? This database was constructed to be
free of survivorship bias, and it covers a period that proceeds the period
studied by Fama and French. If the Fama & French results are a result of data
mining, this independent time period should produce different results. A
spurious relation in one period is not likely to carry over to a different period.
Also the beta coefficients in this study were estimated using annual returns to
address one of Kothari, Shanken and Sloans (1995) main criticisms.
The results of Dawis in 1994 generally confirmed those of Fama & French
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(1992), the explanatory power of B/M was observed in the 1940-1963 period
although the magnitude of the return dispersion was somewhat smaller. This is
probably caused by the fact that the database for the pre-Computed period
contain only large firms, in addition the relation between beta average return
was flat betas based on annual returns could not improve the CAPM’s
performance during the 1940-1963 period.
Chan, Jaggedness and Lakonish in 1995 provide further evidence that the
Fama & French results were not due to survivorship bias. Examining the
1968-1991 period they found that when the firms on CRSP and computer were
properly matched, there were not enough firms missing from computer to have
a significant effect on the Fama & French results. They also formed a database
of large firms for this period that is free of survivorship bias. Using this data
set they found a reliable B/M effect. Barber and Lyon (1997) presented a
clever way to address the issue of data mining. Noting that empirical results
that are caused by data mining should not carry over to other independent
samples, they formed a sample of financial firms for the 1973-1994 period and
found a reliable B/M effect among these firms. Since financial firms were
purposely excluded from the Fama & French sample, the result of Barber and
Lyon provide independent evidence of the explanatory power of B/M.
Further independent evidence came from Fama & French (1998), who found a
reliable B/M effect in several developed countries for the 1975 -1995 period.
They also found a reliable value premium in several emerging markets.
Capauls, Rowley and Sharpe in 1993 also found evidence of a B/M effect in
the US and 5 other developed countries for the 1981-1992 period. This
international evidence casts even more doubt on the data mining criticisms of
the US results
2.6
THE EXPLANATION
The results of Fama & French were subjected to a high degree of scrutiny
because of their controversial nature. Based on the papers that supported the
Fama & French results, most researches reached to the conclusion that the size
and book-to-market effect are real since they have been observed over several
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decades in the US and in other countries as well the next topic to be debated is
why? The issue is no longer whether size and B/M are able to produce crosssectional dispersion in average returns, the two primary explanations are risk
and inefficiency.
The risk based story starts when Fama & French who shows that factors
related to size and B/m are able to explain a significant amount of the common
regression of the form
F/F 3-factor
Rjt – Rft = aj + bj (Rmt – Rft) + sj SMBt + hj HMLt + ejt
Where Rjt is the return to portfolio j for month t, Rft is the risk free (T-Bill
return) return for month t and Rmt is the return to CRSP value weighted index
for month t. SMBt is the realization on the capitalization based factor portfolio
that buys small cap stock and sells large cap stocks. Similarly HMLt is the
realization on a factor portfolio that buys high B/M stocks and sells low B/M
stocks. The sj and hj coefficient measure the sensitivity of the portfolio return
to the small minus big and high minus-low factors respectively. Portfolio of
value stock will have a high value for h, while growth portfolios will have a
negative h.
Large cap portfolios will have a negative effect on SMB(s will be negative)
and small cap portfolios will have a positive value for s.
They observed that historically average returns are high on:

Stocks of small firms

Stocks of firms with high B/M ratio
The above two may be proxies for exposure to systematic risk that is not
captured by CAPM i.e.
Small stocks may be more sensitive to changes in business conditions (macroeconomic factors)
And firms with high B/M ratio are more likely to be in financial distress.
These variables capture sensitivity to macro economic risk factors
Stocks with the above two features will be more risky, and the required rate of
return should be higher on them.
18
Chapter – 2
LITERATURE REVIEW
The time series averages of SMB and HML can be interpreted as the average
risk premium for these risk factors.
2.7
CONCLUSION
The issue of whether the value and size factors are caused by risk or
inefficiency may never be resolved to everyone’s satisfaction. Feelings run
strong on both sides of argument.
There are two crucial points that investors should remember i.e.
1.
Factors based on value and size has explained much of the variation in
US stock returns for the past three quarters of the century.
2.
Value and size premiums have been observed in several other countries,
with the value premium being observed in nearly every country that has
been observed.
While these observations are being consistent with a risk based story, they
don’t prove anything. Nevertheless something very fundamental would have
to change in financial markets in order for these premiums to change.
Furthermore, the returns observed during 1999 in US market shows that
“value minus Growth” is not a low risk strategy.
The inability of Fama and French three factors model to explain three factor
models is a problem for the model’s proponents. However the problem may
not be that serious. Consider the following facts:
Pure momentum strategies involves very high turnover. Consequently
transaction costs and taxes can significantly erode the momentum profits.
Most of the returns to “winner minus losers” momentum portfolio are due to
the poor performance of the losers. So, in order to capture the bulk of the
momentum effect, short positions are necessary. This is not feasible for some
investors. The momentum effect is stronger among small cap stocks, which
tend to be less liquid. Trying to implement a high turnover strategy with small
cap stock is unrealistic.
These facts suggest that momentum strategies probably do not represent a real
opportunity for investors to earn abnormal profits, at least not to the extent
implied by recent studies.
19
Chapter – 3
INTRODUCTION TO PTC
CHAPTER – 3
INTRODUCTION TO PAKISTAN TOBACCO
COMPANY
3.1
INTRODUCTION
In tobacco industry the market leaders are Pakistan Tobacco Company and
Lakson Tobacco Company. Sales of tobacco decline from 2550.9 million units
in 2003 to 2256 million units in 2008(first half of 2008), mainly due to anti
smoking laws and consumer awareness, while sales increases from $432.1
million to $478.1 million the same period. Tobacco is the only crop sown in
Pakistan where per hectare yield matches with that of US and other European
countries i.e. average yield of 1900 KGS per hectare. It has the largest yield of
any crop in the country and over 1 million people are economically dependent
on this industry. The area under tobacco cultivation increased by 30 per cent
during 1990-91 to 1998-99, from 44,000 hectares to 57,000 hectares. The
production has increased even more significantly during the same period — by
145 per cent from 75,000 tonnes to 109,000 tonnes. The value-added sector,
the cigarette production, depicted a far more unproportionate increase of 72
per cent — from 29.8 billion units to 51.5 billion units during the same period
By contributing some 28 billion rupees per years to government income,
Pakistan Tobacco Company has become a dependable source of income for
government of Pakistan. This amount is equal to 4.5% of Pakistan’s GDP.
This translates in the full time equivalent of 312,500 jobs supporting
approximately 1.2 million people.
Lakson Tobacco Company is considered market leader in terms of volume and
is being awarded best 25 companies for Karachi stock exchange for three
consecutive years i.e. from 1997 to 1999. According to prestigious
Advertising magazine ‘Age’ Lakson tobacco spent a good sum amount of $6.4
billion on publicity making it the third largest business advertiser in 1998. In
1990 Lakson Tobacco Company announced an annual profit after tax which
amounted to Rs. 15 million which went down to 14 million in 1991, which
went to Rs. 25 million in 1992, then a total of Rs. 45 million was declared in
20
Chapter – 3
INTRODUCTION TO PTC
1993 which increased to 65 million in 1994 showing a good growth in profit
after tax in this period.
In case of Pakistan tobacco company, it registered a total turnover of 8060
million in 1991 which went up to 8663 million in 1992,in 1993 the figures
shows a slight decline which stood 8642 million which picked up again
registering figures of 8788 million in 1994 and 10151 in 1995.
So the robust figures from the two major players (Pakistan Tobacco Company
and Lakson Tobacco Company) shows that industry is doing well irrespective
of certain local and international problems facing like inflation and the
increase in prices of wrapping materials in the international markets.
According to independent estimates, the Pakistani government collected
Rs.1705.3 million as tax revenue from tobacco in 2006.
The profit after tax for the whole industry was Rs.1390.1 million in 2002, Rs.
1426.7 million in 2003, then a robust increase of Rs. 2360.3 million in 2004,
Rs. 3165.9 million in 2005 and Rs 3544.1 million in 2006.This increasing
trend in profit after tax for the period shows that the industry is doing well
irrespective of the hike in oil prices, raw materials in the international market
and vulnerable law and order situation in Pakistan.
There were 33 cigarette companies in 1993 (three of which were major
companies,
affiliated
with
multinational
companies)
operating
35
manufacturing plants. There are many small organizations producing tobacco
products on a very small scale. In 1990 the tobacco contribution to GNP was
0.7%.
During the past 20 years, adult per capita consumption of manufactured
cigarettes has fluctuated between 650 and 700 cigarettes per annum; recorded
tobacco consumption per adult has been about 1200grams. However, two
thirds of population lives in villages where the tobacco consumption is in non
cigarette forms. Therefore it is likely that more tobacco is used for smoking in
bidis and hookah as well as for chewing and snuffing than is smoked as
cigarettes
21
Chapter – 3
INTRODUCTION TO PTC
3.2
HISTORY OF PAKISTAN TOBACCO COMPANY
3.2.1
British American Tobacco
In 1902, the business of British American tobacco was originally established
which result in an end of an intense trade war between British and American
tobacco companies i.e. the imperial tobacco company of the United Kingdom
and American Tobacco Company of the United States agreed to form a joint
venture “the British American tobacco limited”.
The BAT starts its business in countries like Germany, New Zealand, China,
Canada, Japan, Australia and Denmark, but not the US or UK. By 1910 its
operations had extended to India, Srilanka, West Indies, East Africa, Nigeria,
Malaysia and Java. In 1912 BAT was listed on the London stock exchange and
British investors acquired most of its American parent’s shares.
BAT held strong market positions around the world and had leadership in
more than 50 markets. Since 1994, the group has increased its global market
share from 10.7% to over 16 %.
BAT has 86 factories in 64 countries. It uses more than 700 million kilos of
tobacco and has 25 leaf growing projects and also 23 leaf processing plants,
with over 300 brands in BAT portfolio with a market share of 16%, make the
cigarette chosen by one in seven of the world’s one billion adult smokers.
BAT differentiated portfolio of brands consist of well established international
brands such as Benson and hedges, 555, luck strike, Kent, Dunhill, gold leaf,
pall mall, viceroy, and john player. Bat is the second largest tobacco group
with annual shipment of more than 800 billion cigarettes.
Pakistan Tobacco Company was incorporated in 1947 immediately after
partition by taking the business from imperial Tobacco Company (India), so
making it the first multinational company of Pakistan and recently completed
60 years of its operations in the country.
The company is the member of the multinational British American tobacco
group, which employs over 200000 persons and operates in 180 countries.
It was incorporated into Pakistan and is listed on three stock exchanges of the
country. It was established on the year when Pakistan came into being i.e.
22
Chapter – 3
INTRODUCTION TO PTC
1947 and took over the business of imperial tobacco company. It has three
branches namely Karachi, Akhora khattak and Jhelum but Karachi factory has
been closed since 1992 due to heavy losses and some other technical reasons.
The 1st plant’s setup was in a warehouse in Karachi port with monthly
production of 30 million cigarettes against sales of 60 million, the gap
between supply and demand was then filled up by import.
When Pakistan came into being all tobacco was imported in for production of
cigarettes but in 1952 a development project was initiated in NWFP and the
top quality American tobacco found way to Pakistan.
A factory was established in 1955 at Jhelum and Pakistan Tobacco Company
became a public limited company in the same year. In 1975 a new cigarette
factory was setup at Akhora khattak to meet the increasing demand of
cigarette in the country.
3.2.2
Pakistan Tobacco Company (Akhora khattak factory)
When Pakistan came into being all the tobacco used for production of cigarette
was imported. But in 1952, a development project was initiated in NWFP and
top quality American tobacco found way to Pakistan.
In 1975 a new cigarette factory was setup in Akora Khattak to meet the
increasing demand of cigarette. Recently Akora Khattak factory so many large
numbers of projects such as:

Learning resource centre for the community

Installation of modern high technology such LOGA max machines

Modernization of green leaf thrashing plants

Up gradation of primary and secondary manufacturing departments
Akora Khattak factory has adopted the concept of product stewardship, where
PTC takes the social responsibility as an important aspect of its business and
strives to conserve the natural resources to protect the environment.
Akhora Khattak factory is making effective contribution in a number of areas
that impact the overall economy and the social welfare of the region.
23
Chapter – 3
INTRODUCTION TO PTC
PTC takes immense pride in its distinguished trade record of being a
responsible corporate citizen of Pakistan. It is part of PTC corporate
philosophy to contribute towards the conservation of environment as it
consider this to be an extremely important area deserving attention of all
inhabitants of the earth. Ideally 25% of total area of a country should consist
of forests.
Pakistan is an arid (with low rainfall) to a semi arid country and the area that
cover the forest is less than 5%, which is a very low ratio and this is very
dangerous. To overcome this, the company has come up with a systematic and
extensive forestation program in the country. This forestation program has
facilitated the plantation of 22 million tree saplings since then with more than
70% survival rate. Leaf department being the owner of this noble cause i.e.
forestation, has played a tremendous role in the success of this program by
creating awareness and providing free of cost tree saplings from its own
nurseries and also providing technical help to growers for forestation. PTC is
producing up to 1.8 million tree saplings per year. This forestation program
has greatly improved corporate image as an environment friendly organization
in the country.
3.3
PAKISTAN TOBACCO COMPANY REVIEW
After six years of serial losses (1997-2001) Pakistan Tobacco Company
limited managed to swing back to a profit of Rs. 354 million in 2001, the
accounts for six months to end June 2002, released recently, show 2% slip in
the top line to Rs 10.8 billion from Rs 11 billion for the corresponding period
of last year. Pre_tax profit rose sharply by 175% to Rs 417 million from Rs.
152 million and after tax profit showed growth of 92% to Rs. 248 million from
Rs. 129 million. New products introduced during the past two years accounted
for 33% of Pakistan tobacco company sales during the six months under
review, during which the company said to have unparalleled performance in
new product innovation in the cigarette industry. The company has continued
to claim that four out of five top selling brands in Pakistan are those of PTC.
They comprised of gold flake, john players gold leaf, embassy and capstan.
The company has paid last cash dividend in 1995. The board didn’t declare a
24
Chapter – 3
INTRODUCTION TO PTC
dividend for shareholders until 2001 and used all of the profit to wipe out the
huge accumulated deficit of Rs 337 million on balance sheet. But the
important thing is that the shareholders equity is back with an amount of Rs.
2.820 billion at the end of June 2002 with Rs. 2.55 billion being the paid up
capital. The company then gives regular increasing dividends of Rs 25.5
million in 2003, Rs 306.59 million in 2004, Rs 638.736 million in 2005,
Rs1890.6556 million in 2006 and Rs 2018.40 million in 2007 which gives a
positive signal to the investors.
The sales volume of PTC during 2007_2008 grew at a rate of 8% touching
37.2 billion sticks which is ahead of industry growth rate which is estimated at
2%. The market share also increases by 1.7 percentage points, so further
strengthening its position as the market leader in tobacco industry.
The 10 rupees share in PTC had hits its record high at Rs 162 in 1994. The
price then slipped over the years to hit the lowest Rs 8.5 in 2000 but the stock
then recovered to 157 at the end of year 2007.
For PTC it isn’t still a smooth journey.” We reiterate that tax evading sector
remains a major threat to government revenue and to our business”. Director’s
complains in their half term report, adding that steps taken by the government
in the past to check evasion has been encouraging. However recent increase in
activities of tax evading sector was stated to be alarming. So the company is
urging government support in this matter.
3.4
PTC Brands

Benson and hedges

Gold leaf

Gold flake

Capstan

Embassy

Will international
25
Chapter – 3
3.5
INTRODUCTION TO PTC
ORGANIZATIONAL STRUCTURE
(PAKISTAN TOBACCO COMPANY)
Chairman
&
Chief Executive
Secretary
Director
W
Leaf
Leaf Account
Junior
S. Mgr
Senior
And Quality Purchase Sales
Manager
Manager
Control
Mkt.
Mgr
Processing
Manager
Manager
Officer
LC
(B)
LP
-Mgr
Manager
Quality
Manager
Annual report of Pakistan tobacco company
26
Chapter – 3
INTRODUCTION TO PTC
The organizational structure of PTC is functional in nature. Chairman and
Chief Executive are at the top and head (Director’s) of various functional
departments like marketing human resources finance and production directly
report to him. Senior manager at PTC are quite large in number and hence
span the management is some what narrow. In many case authority is
positioned at top level of management but in some cases decentralization can
be seen.
The corporate culture of Pakistan Tobacco Company is a modal for Pakistanis
companies.
Pakistan Tobacco Company has been departmentalization with a functional
approach, into Human Resources, production, finances department and
marketing department. HRD is responsible for hiring competent people,
developing them too efficiently, motivating employees to do their best,
maintain a loyal and committed work force and cordial relation with
collaborative agent (CBA).
Production department is planning and controlling process to make it efficient
for quality induced product. Quality department continuously formulates,
implement and monitor quality and policy of Pakistan Tobacco Company for
full customer satisfaction. Finance department manages the assets and
financial structure of the company for maximizing profits and minimize cost.
The marketing department has the advantages to have the services of a
separate Art and creative department. The purpose of this department is to
develop an actual campaign, which include print, electronic, or any promos.
The department is running as an advertising agency for the company. All the
ideas are generated internally in collaboration with brand managers, marketing
manager, or brand executive and discussed with the Art department in the
form of brainstorming; Marketing is one of the major and stronger areas of
Pakistan Tobacco Company, which plays a significant role in over all strategic
planning of the company.
The marketing department covers last three primary activities of the value
change which are not bound logistics, marketing and sales and services and it
27
Chapter – 3
INTRODUCTION TO PTC
also determines the scope of first two primary activities that are inbound
logistics and operation by quarterly forecasting the demand and potential of
different brands.
The new millennium is an age of uncertainty and risk due to ever changing
environment. Entering into new but related product or services such as food
items or edible oil etc will be surely a good strategy for Pakistan Tobacco
Company to diversify its business to reduce risk. A coordinated and unified
strategy is needed to cope with threats from fake cigarettes mafia and World
Health Organization’s (WHO’s) anti tobacco campaign. Pakistan Tobacco
Company should improve its financial performance through sales basting and
cost control. Bets marketing mix strategy are some of the areas of
improvement for PTC. It is not only the taste, which makes some one smoke a
particular brand, but the brand itself, adverting; pack visual and classconsciousness are also important factors. PTC should conduct a research to
find the exact impact of various elements on brand selection and then give
comparative importance to each element in its strategies.
I assume the PTC can enter a new millennium as a leading company in all
respects, if it implemented my suggestion and recommendation.
28
Chapter – 4
INTRODUCTION TO FINANCIAL RATIOS
CHAPTER – 4
INTRODUCTION TO FINANCIAL RATIOS
Financial ratios plays a very important role in measuring the performance of a
company because the ratio shows relative value, they allow financial analyst to
compare information that could not be compared in its raw form.
Financial statement analysis generally begins with a set of financial ratios
designed to reveal a company’s strength and weaknesses as compared with
other companies in the same industry, and to show whether its financial
position has been improving or deteriorating over time.
Financial managers, business managers, creditors, stockholders, investors,
government officials use financial ratios analysis to determine weather
creditors can get debate and interest or stock holder know about their long
term value of their stock.
A financial ratio is a number that express the value of one financial variable
relative to another
OR
A financial ratio is the result we get when we divide one financial number by
another
OR
An index which relates two accounting number and is obtained by dividing
one number by the other
Financial ratios are used to compare

one ratio to another related ratio

The firm’s performance to magnitude goals.

The past and present performance.

The firm’s performance to similar firm’s
29
Chapter – 4
4.1
INTRODUCTION TO FINANCIAL RATIOS
STOCK PREDICTING RATIOS
There are three ratios which are extensively used in prediction of stock return;
4.1.1
Dividend Yield
The dividend yield indicates the relationship between the dividend per
common share and the market price per common share
Dividend Yield 
Dividends per common share
Market price common share
Total earning from securities have both dividends and price appreciation no
rule of thumb is there for dividends yields. The yield depends on the firm’s
policy and the market price. If the firm’s successfully invest money and do not
distribute it as dividends the price would rise. If it holds the dividends at low
amount to allow for reinvestment of profit the dividend yield is likely to be
low. A low dividend yield satisfies many investors if the company has record
of above average return on common equity, investors that want current income
prefer a high dividend yield
4.1.2
Price to Earning Ratio
This ratio express the relationship between the market price of a share of
common stock and the stock current earning per share or it is simply the
number of times investors value earning as expressed in the stock price.
Price to Earning Ratio 
Market Price Per Share
Earning Per Share
Investors view P/E ratio a gauge of future earning power of firms companies,
with high growth opportunities generally have high ratio and vice versa
4.1.3
Book To Market Ratio
It is a ratio of a firm’s book value of equity to its market value of equity. Book
value of equity is determined by the accountants using historic cost
information. Market value of equity is determine by buyers and sellers of the
stock using current information
30
Chapter – 4
INTRODUCTION TO FINANCIAL RATIOS
It indicates the amount of stockholder equity that relates to each share of
outstanding common stock
Book to market ratio 
Total stockholde r equity - preferred stock Equity
No. of Common Share outstandin g
Book value per share
Market price
Preferred stock equity should be stated at liquidation price if other than book
because preferred shareholder would be paid this value in the event of
liquidation, the market price of securities usually does not approximate the
book value since assets are recorded at historical cost, the market value of the
stock reflect the potential of the firm
When the market value is below book value investor view the company is
lacking potential and vise versa. When investor are pessimistic about the
prospect for stocks, the stock sell below the book value, when investor is
optimistic about stock prospect the stock sell above book value.
31
Chapter – 5
RATIOS ANALYSIS
CHAPTER – 5
STOCK PREDICTIVE RATIOS CALCULATIONS
OF PAKISTAN TOBACCO COMPANY
5.1
CALCULATION OF PRICE TO EARNING RATIO
Calculation of price to earning ratio is done by dividing the market price of
Pakistan tobacco company with the earnings of that year (the market price is
taken from the business recorder www.brecorder.com, and the EPS is taken
from the annual reports of the corresponding years). The whole data is based
on from period 2003 to 2007.
For 2003
27
1.26
= 21.42
For 2004
61
2.6
= 23.46
For 2005
68
5.15
= 13.20
For 2006
71
7.46
= 9.52
For 2007
155
9.4
= 16.49
Graph – 5.1
P/E
25
price to earnings
20
P/E
15
10
5
0
1
2
3
4
5
years
32
Chapter – 5
5.2
RATIOS ANALYSIS
CALCULATION OF DIVIDEND YIELD
Dividend yield is calculated by dividing dividends by market value.
For 2003
0.1
27
= 0.0037
For 2004
1.2
61
= 0.019
For 2005
2.5
68
= 0.036
For 2006
7.4
71
= 0.104
For 2007
7.9
155
= 0.050
Graph – 5.2
DY
0.12
dividened yield
0.1
0.08
0.06
DY
0.04
0.02
0
1
2
3
4
5
years
33
Chapter – 5
5.3
RATIOS ANALYSIS
BOOK TO MARKET RATIO CALCULATION
Book to Market Ratio (B/M) is calculated by first dividing the total
shareholders equity (minus preferred stock if any) by the total no. of shares
outstanding which gives us the book value per share (BVPS), which is then
divided by the market value to get B/M ratio. Figures of total equity and total
number of shares outstanding are given in millions, which are as follows:
For 2003
For 2004
For 2005
For 2006
For 2007
2,853.090
255.494
= 11.166955 (BVPS)
11.16
27
= 0.413591 (B/M)
3,262.823
255.49
= 12.77064432 (BVPS)
12.77
61
= 0.209355 (B/M)
3639.414
255.494
= 14.24461631 (BVPS)
14.24
68
= 0.20948 (B/M)
4139.187
255.414
= 16.20072096 (BVPS)
16.20
71
= 0.228179 (B/M)
4022.857
255.414
= 15.74540694 (BVPS)
15.74
155
= 0.101583 (B/M)
34
Chapter – 5
RATIOS ANALYSIS
Graph – 5.3
B/M
0.45
0.4
book to market ratio
0.35
0.3
0.25
B/M
0.2
0.15
0.1
0.05
0
1
2
3
4
5
years
5.4
RATIOS CALCULATION OF PAKISTAN TOBACCO
COMPANY (SUMMARY)
Years
Beginning price
Ending Price
Eps
Dividend/share
P/E
DY
2003
22
27
1.26
0.1
21.42857143
0.003703704
2004
27
61
2.6
1.2
23.46153846
0.019672131
2005
61
68
5.15
2.5
13.2038835
0.036764706
2006
68
71
7.46
7.4
9.517426273
0.104225352
2007
71
155
9.4
7.9
16.4893617
0.050967742
Years
Total equity
(mn)
Total No. of
shares (mn)
Book
value/share
Market
value/share
B/M
2003
2,853.090
255.494
11.166955
27
0.413590926
2004
3,262.823
255.494
12.77064432
61
0.209354825
2005
3639.414
255.494
14.24461631
68
0.209479652
2006
4,139.187
255.494
16.20072096
71
0.228179168
2007
4,022.857
255.494
15.74540694
155
0.101583271
35
Chapter – 5
5.5
RATIOS ANALYSIS
PREDICTION WITH REGRESSION MODEL
Here the simple regression technique is used to predict the next year return i.e.
of 2008.
Y=a+bX
Y is the dependent variable, which is
Y = Ending price-Beginning price+Dividend
Beginning price
a = y - bx
X = ΣX/n
Y = ΣY/n
b = nΣXY - ΣXΣY
nΣX2 - (ΣX) 2
Here X is independent variable which consists of three stocks predicting
financial ratios namely price to earning ratio, book to market ratio and
dividend yield.
36
Chapter – 5
RATIOS ANALYSIS
Table – 5.1: Calculations of Regression model on the basis of P/E
for the next year return
X(P/E Ratio)
21.42
23.46
13.20
9.51
16.48
84.06
Y= Ending price-Beginning price + dividend
Beginning price
0.23
1.30
0.15
0.18
1.29
3.17
Σx
Σy
Σx2
Σxy
X
Y
X2
458.38
550.37
174.24
90.44
271.59
1545.03
XY
4.96
30.58
2.05
1.75
21.33
60.68
84.06
3.17
1545.03
60.68
16.82
0.63
Ending price
Beginning price
27
61
68
71
155
Dividends
22
27
61
68
71
nΣxy-ΣxΣy
a=Y-bX
-0.31
37.01
0.1
1.2
2.5
7.4
7.9
nΣx2 - (Σx) 2
659.06
b
0.05
Y =-0.31+(0.05)X
0.88
1.002
0.42
0.22
0.61
37
Chapter – 5
5.6
RATIOS ANALYSIS
EXPLANATION OF MODEL
Y =-0.31+ (0.05) X
The fitted regression line suggest that if there is 0 P/E(X) then the returns will
be in negative zone i.e. -31%(a). If P/E changes by 1 then the total return will
vary by 5 %( b).
For Example
If P/E is 1 then
Y
-0.31+ (0.05) 1
Y =-0.26
Or
Y =-26%
If P/E is 2 then
Y
-0.31+ (0.05)2
Y =-21%
So this example shows that with the change in P/E of 1 the return has
increased by 5%.
5.6.1
Calculating return for 2008
The following steps are executed for the calculation of return of FY 2008 with
the help of fitted regression line:
1) Take the average of P/E for the sample period
2) Put the average P/E in regression line
3) The regression model will calculate the return for the next year
The average P/E=16.82, so put this in fitted regression line will give the
following result:
Y
Y
-0.31+ (0.05) *16.82
= 0.63 or 63%
So the return calculated for FY 2008 with help of fitted regression line on the
basis of average P/E is 63%.
38
Chapter – 5
RATIOS ANALYSIS
Table – 5.2: Calculations of Regression model on the basis of B/M for
next year return
X(B/M Ratio)
0.4135911
0.209355
0.20948
0.228179
0.101583
1.162188
Y= Ending price-Beginning price + dividend
Beginning price
0.23
1.30
0.15
0.18
1.29
3.17
Σx
Σy
Σx2
Σxy
X
Y
X2
XY
0.1710575
0.0438295
0.0438818
0.0520656
0.0103191
0.321153
0.095877
0.272936
0.032623
0.042003
0.131485
0.574927
1.16
3.17
0.32
0.57
0.23
0.63
Ending price
Beginning price
27
61
68
71
155
Dividends
22
27
61
68
71
0.1
1.2
2.5
7.4
7.9
-0.81
nΣx2 - (Σx) 2
0.24
nΣxy-ΣxΣy
a=Y-bX
1.38
b
-3.27
Y =1.38+(3.27)X
0.029
0.69
0.69
0.63
1.05
39
Chapter – 5
5.7
Y
RATIOS ANALYSIS
EXPLANATION OF MODEL
=1.38+ (-3.27) X
The fitted regression line suggest that if there is 0 B/M(X), then the returns
will be 1.38 i.e. 138 % (a). If B/M changes by 1 then the total return will vary
by -327 %( b).
For Example
If B/M is 1 then
Y
-3.27)*1
Y =-1.28
Or
Y =-128 %
If B/M is 2 then
Y =1.38+ (-3.27)*2
Y =-516 %
So this example shows that with the change in B/M of 1 the return has
decreased by 327 %.
5.7.1
Calculating return for 2008
The following steps are executed for the calculation of return of FY 2008 with
the help of fitted regression line:
1.
Take the average of B/M for the sample period
2.
Put the average B/M in regression line
3.
The regression model will calculate the return for the next year
The average B/M=0.23, so put this in fitted regression line will give the
following result:
=1.38+ (-3.27) *0.23
= 0.622 or 62.2 %
So the return calculated for FY 2008 with help of fitted regression line on the
basis of average B/M is 62.2 %.
Y
Y
40
Chapter – 5
RATIOS ANALYSIS
Table – 5.3: Calculations of Regression model on the basis of DY ratio
for next year return
X(DY Ratio)
0.0037037
0.0196721
0.0367647
0.1042253
0.0509677
0.215333
Y= Ending price-Beginning price + dividend
Beginning price
0.23
1.30
0.15
0.18
1.29
3.17
Σx
Σy
Σx2
Σxy
X
Y
X2
XY
0.0000137
0.0003869
0.0013516
0.0108629
0.0025977
0.015212
0.000858
0.025646
0.005725
0.019185
0.065970
0.117387
0.21
3.17
0.015
0.117
0.046
0.63
Ending price
Beginning price
27
61
68
71
155
Dividends
22
27
61
68
71
0.1
1.2
2.5
7.4
7.9
nΣxy-ΣxΣy
a=Y-bX
0.76
-0.08
nΣx2 - (ΣX) 2
0.028
b
-2.81
Y =0.76+(2.81)X
0.74
0.70
0.65
0.46
0.61
41
Chapter – 5
5.8
Y
RATIOS ANALYSIS
EXPLANATION OF MODEL
=0.76+ (-2.81) X
The fitted regression line suggest that if there is 0 DY(X) then the returns will
be 0.76 i.e. 76%(a).if DY changes by 1 then the total return will vary by 281%(b).
For Example
If DY is 1 then
Y =0.76+ (-2.81)*1
Y =-2.05
Or
Y =-205%
If B/M is 2 then
Y =0.76+ (-2.81)*2
Y = -486%
So this example shows that with the change in DY of 1 the return has
decreased by 281%.
5.8.1
Calculating return for 2008
The following steps are executed for the calculation of return of FY 2008 with
the help of fitted regression line:
1.
Take the average of DY for the sample period
2.
Put the average DY in regression line
3.
The regression model will calculate the return for the next year
The average DY=0.043, so put this in fitted regression line will give the
following result:
Y
-2.81) *0.043
Y = 0.639 or 63.9%
So the return calculated for FY 2008 with help of fitted regression line on the
basis of average B/M is 63.9%.
42
Chapter – 5
RATIOS ANALYSIS
P/E Ratio
0.7
0.6
return
0.5
0.4
Series1
0.3
0.2
0.1
0
1
2
3
4
5
years
Graph 5.4
B/M ratio
0.7
0.6
return
0.5
0.4
Series1
0.3
0.2
0.1
0
1
2
3
4
5
years
Graph 5.5
DY RETURN
0.7
0.6
0.5
0.4
Series1
0.3
0.2
0.1
0
1
2
3
4
5
Graph 5.6
43
Chapter – 6
FINDING, CONCLUSION AND RECOMMENDATIONS
CHAPTER – 6
FINDING, CONCLUSIONS &
RECOMMENDATIONS
6.1

FINDING
PTC should concentrate on effective cost control to bring it to the
minimum and to the level of industry.

Diversification of business scope reduces risk therefore Pakistan
Tobacco Company should diversify its scope by entering new
businesses. A detailed research should be conducted to study of various
possibilities of diversifying the scope of PTC business to reduce the risk
level.

Regression analysis is generally used as an analytical technique for
predicting stock returns.

the general findings of this report are that, Stock returns are predictable
and

Past returns contain additional information about the future returns.

For this I take past data of Pakistan Tobacco Company of the 5 years
i.e. 2003 to 2007 which basis on three financial ratios (P/E, B/M and
DY) and the market prices are taken from KSE website.

In the literature, stock returns are predicted with the help of three
financial ratios i.e.

1.
price to earning ratio
2.
book to market ratio
3.
dividend yield
The return calculated for the share of Pakistan Tobacco Company for
FY 2008 predicted through fitted regression line on the basis of P/E is
found to be 63%.

The return calculated for the share of Pakistan Tobacco Company for
FY 2008 predicted through fitted regression line on the basis of B/M is
62.2% respectively.

The return calculated for the share of Pakistan Tobacco Company for
FY 2008 predicted through fitted regression line on the basis of DY is
63.9%.
44
Chapter – 6
6.2
FINDING, CONCLUSION AND RECOMMENDATIONS
CONCLUSIONS
The main idea of the report revolves around the Fama and French, Cambell
and Sheller predicting stock return. Kendall 50 years back observed that stock
prices vary times to time. Kendall tested that prices change can be predicted
with the help of past returns and later on predicted some variables, which are
price to earning ratio, dividend yield and book to market value ratios. These
three ratios have some common features i.e. each of them measures price
relation to fundamental because in the above 3 ratios price come in
denominator, so the ratios should be positively related to expected return and
this is due to the reason that if the prices goes up expected return will be lower
if prices goes down, expected return will go up and all the three ratios should
be directly or truly expected return.
The study is to predict stock return of Pakistan Tobacco Company in order to
predict FY 2008 returns to give an investor an idea either to invest in Pakistan
Tobacco Company or not for the year 2008. The sample period for this study
is from 2003-2007 for 5 years. Three ratios will be used to predict stock
returns i.e. price to earning ratio, dividend yield and book to market ratio. The
data collected is based on secondary data.
The return calculated for the share of Pakistan Tobacco Company for FY 2008
predicted through fitted regression line on the basis of P/E is found to be 63%.
The return calculated for the share of Pakistan Tobacco Company for FY 2008
predicted through fitted regression line on the basis of B/M is 62.2%
respectively.
The return calculated for the share of Pakistan Tobacco Company for FY 2008
predicted through fitted regression line on the basis of DY is 63.9%.
45
Chapter – 6
6.3
FINDING, CONCLUSION AND RECOMMENDATIONS
RECOMMENDATIONS
It is recommended that investors should invest in shares of Pakistan tobacco
company because the rates offered by all the banks in different schemes is less
than 15% and also the rates on T-bills of different periods is round about 16%.
The rates offered under national savings programs are also less than 20%. So
investing in shares of PTC is a good buy as its returns predicted by the three
financial ratios used in this study for FY 2008 is round about 63%, which is
sufficiently greater than 50%. So it is recommended for investors to buy
shares of PTC, as this will yield a handsome return.
46
REFERENCES
REFERENCES
1.
PTC 2003-2007, Annual Reports.
2.
F M Theory and Practice, by Eugene F. Brigham and M C. Ehrhadt.
3.
Charles P. Jones Investment analysis and Portfolio.
4.
Magazine of Gulf Economist
5.
Literature Review Mit Sloan School of Mgt (working paper) by
Jonathan Lewellen.
6.
Website:

www.fpanet.org.

www.kse.com.pk

www.pakistantobacco.com.pk

www.yespakistan.com

www.pakistanecnomist.com

www.brecorder.com

www.cdc.gov.com

www.ssrn.com

www.businessmonitor.com
47