PREDICTION OF STOCK RETURN PAKISTAN TOBACCO COMPANY

ON

Hashim Ali
MBA (Finance)

INSTITUTE OF MANAGEMENT SCIENCES Session: 2007 2009

PREDICTION OF STOCK RETURN ON PAKISTAN TOBACCO COMPANY

Research report submitted to the institute of Management Sciences in partial fulfillment of the requirements for the DEGREE OF MASTER OF BUSINESS ADMINISTRATION (FINANCE)

INSTITUTE OF MANAGEMENT SCIENCES

MARCH, 2009

ii

PREDICTION OF STOCK RETURN ON PAKISTAN TOBACCO COMPANY

SUPERVISOR

Signature: Name: Designation: Organization:

__________________________ MISS RABIA NAWAZ Lecturer Institute of Management Sciences

COORDINATOR RESEARCH & DEVELOPMENT DIVISION:

Signature: Name: Designation Organization:

____________________________ SIR. SHAHID ALI Coordinator R & DD Institute of Management Sciences

Chapter 1

INTRODUCTION

PREFACE
Life is like a moving train, which is in action every time, any one who is left behind in this race means he is lost forever with no chance of redoing. Accelerating our steps with the time is todays requirement. Learning the modern and specific skills with keeping pace with the time is the key to success. Well thesis is must in getting MBA degree, so accomplishment of research report is must. I think it is done to unlock whatever we have learnt in our academic years and to unleash our hidden abilities. But I think research needs a lot of time, thinking ability and proper guidance which I think is not available every where. Well I have chosen and worked on this project which is prediction of stock return on Pakistan Tobacco Company is to give an insight and helps them in decision making whether to invest in PTC or not for the year 2008.the major objective and work of this project was done on calculating the predicting ratios i.e. price to earning, book to market and dividend yield and on the basis of these ratios with help of regression model prediction of next year return was done.

Hashim Ali MBA (Finance)

Chapter 1

INTRODUCTION

ACKNOWLEDGEMENTS
All praises are attributed to the sole creator of the universe The Almighty Allah The Compassionate, The Merciful, The Source of all Knowledge and Wisdom. For this research study, I would like to mention the persons without whom it could not have come up into its present shape. First of all, I am really very grateful to my parents. Then a deep measure of gratitude is expressed to my research supervisor Miss Rabbia Nawaz, Lecturer, Institute of Management Sciences, Hayatabad Peshawar. Her guidance, continuous help and encouragement she gave me at all stages of my research study helped me learn through the course of this research dissertation. I am also thankful to Sir Attaullah for his guidance without his support I will not be able to accomplish my report.

Chapter 1

INTRODUCTION

TABLE OF CONTENTS
S. No Title Preface Acknowledgement List of Tables List of Graphs List of Abbreviations Executive Summary CHAPTER 1 INTRODUCTION TO REPORT Background of The Study Purpose of The Study Scope of The Study Methodology of study Scheme of the report CHAPTER 2 LITERATURE REVIEW Literature Review Stock return theoretical background Markowitz Portfolio selection Capital asset pricing Model Arbitrage pricing theory Intemporal Capital asset pricing model Consumption oriented capital asset pricing model Early empirical work Price/ Earning Firm size Long term return reversals Book to market equity Momentum Leverage Turning point Data mining Beta estimation The response The explanation Conclusion CHAPTER 3 PAKISTAN TOBACCO COMPANY Introduction History of Pakistan Tobacco Company British American Tobacco Pakistan Tobacco Company (Akhora Khattak Factory) Pakistan Tobacco company Review PTC Brands Organizational Structure CHAPTER 4 INTRODUCTION TO FINANCIAL RATIOS Stock Predicating Ratios Dividend Yield Title Page No i ii v v vi vii 1 1 1 1 2 3 6 6 7 9 10 11 12 12 12 13 13 13 14 14 15 16 16 17 19 20 22 22 23 24 25 26 30 30 Page No 3

1.1 1.2 1.3 1.4 1.5 2.1 2.1.1 2.1.2 2.1.3 2.1.4 2.1.5 2.2 2.2.1 2.2.2 2.2.3 2.2.4 2.2.5 2.2.6 2.3 2.4 2.4.1 2.5 2.6 2.7 3.1 3.2 3.2.1 3.2.2 3.3 3.4 3.5 4.1 4.1.1 S. No

Chapter 1

INTRODUCTION

4.1.2 Price to Earning ratio 4.1.3 Book To Market Ratio CHAPTER 5 RATIOS ANALYSIS 5.1 Calculation of Price to Earning Raito 5.2 Calculation of Divided Yield 5.3 Book to Market Ratio Calculation 5.4 Ratios calculation of Pakistan Tobacco Company (Summary) 5.5 Prediction with Regression Model 5.6 Explanation of Model 6.5.1 Calculating return for 2008 5.7 Explanation of Model 5.7.1 Calculating return for 2008 5.8 Explanation of Model 5.8.1 Calculating return for 2008 CHAPTER 6 FINDING, CONCLUSION AND RECOMMENDATIONS 6.1 Finding 6.2 Conclusion 6.3 Recommendations References

30 30 32 33 34 35 36 38 38 40 40 42 42 44 45 46 47

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INTRODUCTION

LIST OF TABLES
S. No 5.1 5.2 5.3 Tables Calculation regression model on the basis of P/E for the next year return Calculation regression model on the basis of B/M for the next year return Calculation regression model on the basis of DY for the next year return Page No 37 39 41

LIST OF GRAPHS
S. No 2.1 2.2 2.3 2.4 5.1 5.2 5.3 5.4 5.5 5.6 Graphs Efficient portfolio Frontier Security Market Line Capital Market Line Risk and Return Calculation of Price to Earning Ratio Calculation of Dividend Yield Book to Market Ratio Calculation Return Calculated on the Basis of P/E Return Calculated on the Basis of B/M Return Calculated on the Basis of DY Page No 7 8 8 14 32 33 35 43 43 43

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INTRODUCTION

LIST OF ABBREVIATIONS
PTC LTC BAT P/E DY B/M CAPM WHO ISO PMI BVPS GNP CBA HRD GDP RRR SMB HML CML SML APT EPS DPS X Pakistan Tobacco company Lakson Tobacco company British American Tobacco Price To Earning Ratio Dividend Yield Book to Market Ratio Capital Asset Pricing Model World Health Organizations International Standard Organization Philip Morris International Book Value Per Share Gross National Product Collaborative Agent Human Resources Department Gross Domestic Product Required Rate of Return Small Mince Big High Mince Low Capital Market Line Security Market Line Arbitrage Pricing Theory Earning Per Share Dividend Per Share Mean(x bar) Summation

Chapter 1

INTRODUCTION

EXECUTIVE SUMMARY
The main objective of this report study is to give an insight and knowledge to investors about Pakistan Tobacco Companys prospect and help them in decision making whether to invest in it or not for the year 2008.the sources of this report from where I gather data and other materials to accomplish my report are from different websites, research papers, finance literatures, newspapers (business pages) reference books (related to finance) and annual reports of Pakistan tobacco company (2003 to 2007). This report gives description about the stock predicting ratios i.e. price to earning ratio, dividend yield and book to market ratio. The objective of this report is to check and find the predictive or forecasting ability of these three ratios (P/E, B/M and DY) and then to predict future stock returns of Pakistan Tobacco Company with the help of fitted regression model. Basically Pakistan tobacco company established in 1902 under the name of British American tobacco company to end war between uks imperial tobacco company and American tobacco company but its operations in Pakistan starts in 1947 as a 1st foreign investment company. 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 Pakistans GDP. This translates in the full time equivalent of 312,500 jobs supporting approximately 1.2 million people.

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 UKs 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 Internet Magazine Newspapers 8

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INTRODUCTION

Books

1.5
1.5.1 1.5.2 1.5.3

SCHEME OF THE REPORT

Chapter No. 1 which includes background, purpose, scope, methodology, and scheme of the report. Chapter No.2 contains Literature review and Theoretical Background of the study Chapter No. 3 contains introduction of the Tobacco Company, history of the Pakistan tobacco company, organizational structure of the Pakistan tobacco company.

The scheme of the report consist of

1.5.4 1.5.5 1.5.6

Chapter No. 4 contains introduction of the financial ratios. Chapter No. 5 contains Ratio Analysis. Chapter No. 6 consists of finding, conclusions and recommendations

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. 3

Chapter 2

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 Famas 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 markets 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 4

Chapter 2

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 cant be used for prediction of one year return but that they are useful for the prediction of four year return.

Chapter 2

LITERATURE REVIEW

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 firms 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 risk model of expected returns still it is not clear why the three-factor model cant 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
2.1.1

STOCK RETURNS THE THEORETICAL BACKGROUND

Markowitiz Portfolio Selection

Chapter 2

LITERATURE REVIEW

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
Efficient Protfolio Frontier 31% 30% 30% 29% 29% 28% 28% 27% 27% 26% 26% 0 0.01

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% 0.02 0.03 0.04 0.05

Portfolio Return

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. 8

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LITERATURE REVIEW

GRAPH 2.2

0.7 0.6 0.5 Return 0.4 0.3 0.2 0.1 0.01 0.02 0.03 0.04 BETA(Risk) 0.05 0.06 Over priced Under priced SML

GRAPH 2.3

0.7 0.6 0.5 Return 0.4 0.3 0.2 0.1 0.01 0.02 0.03 0.04 BETA(Risk) 0.05 0.06 M

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 9

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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

CAPM
E (Rj) = Rf +j [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 j is the beta, is the coefficient for asset j. j 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) doesnt 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 10

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LITERATURE REVIEW

efficient financial market. This assumption is much less restrictive than those 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 assets expected return must be a linear function of its sensitivity to the n common factors APT E(Rj) =Rf+ jll + j2++jnn E(Rj) and Rf are defined as before. Each j coefficient represent the sensitivity of asset j to risk factor k and 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 Mertons

Both the CAPM and the APT are static or single period models. They ignore the multi-period nature of participation in the capital markets. (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 11

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LITERATURE REVIEW

the asset pricing equation. The resulting model is; ICAPM E(Rj) = Rf + j + j2 +...+ jnn 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. 2. They describe the evolution of the investment opportunity set over time. 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 cant 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

12

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LITERATURE REVIEW

returns since they provide high returns during states of the economy where high returns do the least good. Based on this line of reasoning, Breedon derives a consumption based capital asset pricing model of the form: CCAPM E(Rj) = Rf + jc [E(Rm) - Rf] In this model, jc measure the sensitivity of the return of asset j to changes in aggregate consumption, jc 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 13

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LITERATURE REVIEW

the size effect is distinct From the P/E effect, small firms tends to have higher returns, even after 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 14

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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 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 BETA 0.04 0.05 0.06

15

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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 16

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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 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 17

Chapter 2

LITERATURE REVIEW

address one of Kothari, Shanken and Sloans (1995) main criticisms. The results of Dawis in 1994 generally confirmed those of Fama & French (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 CAPMs 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 19811992 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 18

Chapter 2

LITERATURE REVIEW

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 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) 19

Chapter 2

LITERATURE REVIEW

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. 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 everyones satisfaction. Feelings run strong on both sides of argument. There are two crucial points that investors should remember i.e. 1. 2. Factors based on value and size has explained much of the variation in US stock returns for the past three quarters of the century. 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 dont 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 models 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. 20

Chapter 2

LITERATURE REVIEW

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.

21

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 Pakistans 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
3.2.1

HISTORY OF PAKISTAN TOBACCO COMPANY

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 parents 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 worlds 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 plants 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 didnt 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 isnt still a smooth journey. We reiterate that tax evading sector remains a major threat to government revenue and to our business. Directors 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

INTRODUCTION TO PTC

3.5

ORGANIZATIONAL STRUCTURE (PAKISTAN TOBACCO COMPANY)

Chairman & Chief Executive

Secretary

Director

Leaf Leaf Senior Account Manager Manager Manager Manager (B) LP

W S. Mgr Quality Sales Junior And Purchase Processing Control Mkt. Mgr LC Officer -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 (Directors) 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 Organizations (WHOs) 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 companys 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 firms performance to magnitude goals. The past and present performance. The firms performance to similar firms

29

Chapter 4

INTRODUCTION TO FINANCIAL RATIOS

4.1

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 Dividends per common share Market price common share

Dividend Yield =

Total earning from securities have both dividends and price appreciation no rule of thumb is there for dividends yields. The yield depends on the firms policy and the market price. If the firms 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. Market Price Per Share Earning Per Share

Price to Earning Ratio =

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 firms 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 stockholder equity - preferred stock Equity No. of Common Share outstanding

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 For 2004 For 2005 For 2006 For 2007 27 1.26 61 2.6 68 5.15 71 7.46 155 9.4

= 21.42 = 23.46 = 13.20 = 9.52 = 16.49

Graph 5.1
P /E

25

20

price to earnings

15

P /E

10

0 1 2 3 ye ar s 4 5

32

Chapter 5

RATIOS ANALYSIS

5.2

CALCULATION OF DIVIDEND YIELD

Dividend yield is calculated by dividing dividends by market value. For 2003 For 2004 For 2005 For 2006 For 2007 0.1 27 1.2 61 2.5 68 7.4 71 7.9 155

= 0.0037 = 0.019 = 0.036 = 0.104 = 0.050

Graph 5.2
DY 0.12

0.1

0.08 dividened yield

0.06

DY

0.04

0.02

0 1 2 3 y e a rs 4 5

33

Chapter 5

RATIOS ANALYSIS

5.3

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

2,853.090 255.494 11.16 27

= 11.166955 (BVPS) = 0.413591 (B/M) = 12.77064432 (BVPS) = 0.209355 (B/M) = 14.24461631 (BVPS) = 0.20948 (B/M) = 16.20072096 (BVPS) = 0.228179 (B/M) = 15.74540694 (BVPS) = 0.101583 (B/M)

For 2004

3,262.823 255.49 12.77 61

For 2005

3639.414 255.494 14.24 68

For 2006

4139.187 255.414 16.20 71

For 2007

4022.857 255.414 15.74 155

34

Chapter 5

RATIOS ANALYSIS

Graph 5.3

B /M 0.45 0.4 0.35 0.3 book to market ratio 0.25 B /M 0.2 0.15 0.1 0.05 0 1 2 3 ye a rs 4 5

5.4
Years 2003 2004 2005 2006 2007

RATIOS CALCULATION OF PAKISTAN TOBACCO COMPANY (SUMMARY)

Ending Price 27 61 68 71 155 Eps 1.26 2.6 5.15 7.46 9.4 Dividend/share 0.1 1.2 2.5 7.4 7.9 P/E 21.42857143 23.46153846 13.2038835 9.517426273 16.4893617 DY 0.003703704 0.019672131 0.036764706 0.104225352 0.050967742

Beginning price 22 27 61 68 71

Years 2003 2004 2005 2006 2007

Total equity (mn) 2,853.090 3,262.823 3639.414 4,139.187 4,022.857

Total No. of shares (mn) 255.494 255.494 255.494 255.494 255.494

Book value/share 11.166955 12.77064432 14.24461631 16.20072096 15.74540694

Market value/share 27 61 68 71 155

B/M 0.413590926 0.209354825 0.209479652 0.228179168 0.101583271

35

Chapter 5

RATIOS ANALYSIS

5.5

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/n Y/n nXY - XY nX2 - (X) 2

X = Y = b =

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 x y x2 xy X Y Ending price 27 61 68 71 155 a=Y-bX -0.31 Y =-0.31+(0.05)X 0.88 1.002 0.42 0.22 0.61 nxy-xy 37.01 Beginning price 22 27 61 68 71 Y= Ending price-Beginning price + dividend Beginning price 0.23 1.30 0.15 0.18 1.29 3.17 84.06 3.17 1545.03 60.68 16.82 0.63 Dividends 0.1 1.2 2.5 7.4 7.9 nx2 - (x) 2 659.06 X2 Y 458.38 550.37 174.24 90.44 271.59 1545.03 4.96 30.58 2.05 1.75 21.33 60.68 X

b 0.05

37

Chapter 5

RATIOS ANALYSIS

5.6

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=-0.31+ Y

(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

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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 x y x2 xy X Y Ending price 27 61 68 71 155 a=Y-bX 1.38 Y =1.38+(3.27)X 0.029 0.69 0.69 0.63 1.05 nxy-xy -0.81 Beginning price 22 27 61 68 71 Y= Ending price-Beginning price + dividend Beginning price 0.23 1.30 0.15 0.18 1.29 3.17 1.16 3.17 0.32 0.57 0.23 0.63 Dividends 0.1 1.2 2.5 7.4 7.9 nx2 - (x) 2 0.24 b -3.27 X2 0.1710575 0.0438295 0.0438818 0.0520656 0.0103191 0.321153 XY 0.095877 0.272936 0.032623 0.042003 0.131485 0.574927

39

Chapter 5

RATIOS ANALYSIS

5.7
Y

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=1.38+ (-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. 2. 3. Take the average of B/M for the sample period Put the average B/M in regression line 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 x y x2 xy X Y Ending price 27 61 68 71 155 a=Y-bX 0.76 Y =0.76+(2.81)X 0.74 0.70 0.65 0.46 0.61 nxy-xy -0.08 Beginning price 22 27 61 68 71 Y= Ending price-Beginning price + dividend Beginning price 0.23 1.30 0.15 0.18 1.29 3.17 0.21 3.17 0.015 0.117 0.046 0.63 Dividends 0.1 1.2 2.5 7.4 7. 9 nx2 - (X) 2 0.028 b -2.81 X2 0.0000137 0.0003869 0.0013516 0.0108629 0.0025977 0.015212 XY 0.000858 0.025646 0.005725 0.019185 0.065970 0.117387

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5.8
Y

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. 2. 3. Take the average of DY for the sample period Put the average DY in regression line 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=0.76+ (-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%.

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RATIOS ANALYSIS

P /E R a tio
0 .7 0 .6 0 .5 0 .4 return

S e rie s 1
0 .3 0 .2 0 .1 0 1 2 3 ye ars 4 5

Graph 5.4
B /M ra tio
0 .7 0 .6 0 .5 0 .4 return 0 .3 0 .2 0 .1 0 1 2 3 ye ar s 4 5

S e rie s 1

Graph 5.5
DY RETURN
0 .7 0 .6 0 .5 0 .4 0 .3 0 .2 0 .1 0 1 2 3 4 5

S e rie s 1

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. 2. 3. price to earning ratio book to market ratio 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.

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FINDING, CONCLUSION AND RECOMMENDATIONS

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%.

6.2

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%.

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FINDING, CONCLUSION AND RECOMMENDATIONS

6.3

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.

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REFERENCES

REFERENCES
1. 2. 3. 4. 5. 6. PTC 2003-2007, Annual Reports. F M Theory and Practice, by Eugene F. Brigham and M C. Ehrhadt. Charles P. Jones Investment analysis and Portfolio. Magazine of Gulf Economist Literature Review Mit Sloan School of Mgt (working paper) by Jonathan Lewellen. 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

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