On the maximization of shareholders' wealth: Evidence based on firm-specific financial characteristics

Stand. J. Mgmt, Vol. 8, No. I, pp 15-33, 1992 Printed in Great Britain

ll281-7527/92 $5.00 + 0.00 @ 1992 Pergamon Press Ltd

ON THE MAXIMIZATION OF SHAREHOLDERS’ WEALTH: EVIDENCE BASED ON FIRM-SPECIFIC FINANCIAL CHARACTERISTICS TEPPO MARTIKAINEN University of Vaasa, Finland (First received January 1YYl; accepted in revisedform

October 1991)

Abstract - This paper focuses on the long-term firm-specific determinants of stock returns. The main goal of the investigation is to show which of the financial characteristics of a firm its management should concentrate on, when maximizing the wealth of the common shareholders. It is found that profitability, financial leverage, operating leverage and growth are important long-term determinants of firm value in the Finnish stock market. However, significant differences are observed between the measures applied to the same presumptive characteristics of the firm. Kev words: variables.

Maximization

of shareholders’

wealth,

stock

returns,

firm-specific

financial

1. INTRODUCTION It is generally accepted that one of the main goals of a firm’s management is to maximize the shareholders’ wealth, i.e. the market value of the firm’s existing common stock. This is achieved essentially by maximizing the future cash flows of a company at a given risk level, which is in turn the result of management decisions affecting certain firm-specific financial characteristics, such as profitability, financial leverage and operating leverage. The main purpose of this study is to discover whether different financial characteristics of firms can be identified as individually significant economic determinants of stock returns. The study was inspired by the reflection that although the connection between profitability/earnings and stock prices has been the subject of much research, little is known about how other financial statement figures are reflected in stock prices. This paper aims to advance our understanding of the risk- and return-generating process operating in capital markets. The risk of and the returns on common stock are dependent on the future cash flow expectations of the firms. These also determine the market value of each firm. Given that the major task of management is to maximize the wealth of stockholders, knowledge about the economic determinants of stock returns is obviously very important. The level of financial ratios naturally depends to some extent on the type of business (for the industry effects on financial ratios, see McLeay and Fieldsend, 1987; Martikainen, 1990). However, it is possible for management to affect firm value to a certain degree by financial ratios and other firm-specific financial variables. For example, the higher the financial leverage and operating leverage of a firm, the higher the expected return on common stock. Similarly, the higher the future growth opportunities of the firm, the higher the expected return on stocks. I.5

This paper investigates the connection between stock returns and various presumptive economic determinants of stock returns measured in terms of firm-specific financial variables. The main interest of the investigation is to find out whether the returns on portfolios ranked by these different determinants are associated with stock returns. The aim, using this kind of approach, is to see whether the chosen financial characteristics do constitute individually important economic determinants of stock returns. It should be noted here that an “association” approach has been adopted. Thus it is assumed that market agents learn about accounting figures and valuation-relevant events throughout the research period (see, for example, Collins and Kothari, 1989). In the context of previous studies the present research can be seen as important on at least two counts. First, there is strong empirical evidence of the connection between profitabi~ity/earnings and stock prices. However. other financial statement figures have received relatively little attention. Secondly, tests of asset pricing theories on thin stock markets have not yielded especially encouraging results when purely stockmarket-based information has been used in the empirical tests (i.e. estimates of systematic risk have been determined on the basis of past stock returns). This may be due partly to the fact that purely market-based risk estimates are apparently highly biased due to infrequent trading. Thus the use of instrumental variables determined with the help of accounting information could be useful here. So far, however, this association has attracted only limited attention in thin stock markets. The remainder of this article is organized as follows. In Section 2 the theoretical background of the study is described and the financial characteristics of the firm which could be regarded as economic determinants of systematic risk and stock returns are identified. It is hoped in this way to demonstrate the financial characteristics of the firm which may be regarded as individually important determinants of stock returns. In Section 3, the data used in the study are introduced. The empirical analysis is presented in the fourth section, and certain conclusions are then drawn. 2. FORM-SPECIFIC

DETERMINANTS

OF STOCK RETURNS

2.1. Theoretical background According to the most famous equilibrium model of finance, the capital asset pricing model (CAPM), the expected return and systematic risk of a stock are linearly related to each other. The traditional equilibria of the CAPM can be written as follows: where

= rff = r,,,, = ri,

pi

=

Wj,) = + + Pi(E(rlnr) - 4, return on the common stock return on the riskfree asset return on the market portfolio (combination example, stocks, bonds and real estate) the beta-coefficient of the stock i.

(1)

of all assets including, for

The beta-coefficient of the above equation is interpreted as a measure of the systematic risk of the security. The beta-coefficient of the stock can be defined by Equation (2)

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Usually in empirical research the beta-coefficient has been estimated Sharpe’s (1964) market model, i.e. with time-series regressions _ ri, = where

Cii

Pirmt +

+

&i*

17

with the help of

(3)

,

= return on security i at time t intercept term, i.e. excess return on security ;; 1 beta-coefficient of security i return on the market portfolio at time t rmt = &it = unsystematic component of the return series rir

i

for firm

i at time

t.

However, the above model involves some severe estimation problems. Thus the use of market-model-estimated betas means that the estimates are apparently significantly biased, particularly in thin stock markets (see, for example, Berglund et al., 1989, and the literature cited there). This does not mean, however, that the beta may not be an interesting concept theoretically speaking. In a management perspective the most important issue is to recognize the real determinants of systematic risk. Knowing these determinants, management can concentrate on the main underlying factors of systematic risk in order to maximize the wealth of the common stockholders. This article concentrates on the “real” firm-specific economic determinants of stock returns. These theoretical determinants are an essential factor in management decisions aimed at maximizing the wealth of common stockholders. The theoretical background of the study is shown in Fig. 1. Figure 1 shows four firm-specific economic determinants of common stock systematic risk which are investigated in this paper. Since according to CAPM the systematic risk and expected return on a stock are linearly related to each other, these four systematic risk determinants can be regarded also as determinants of stock returns. In the following empirical analysis the long-term association between the four determinants and stock returns is analysed in the Finnish stock market. Due to the serious estimation problems of systematic risk on a thin security market, the analysis is limited to stock returns only.

financial

operating

pr0ti-

leVerage

leverage

tability

I

systematic risk

1

I

Fig.

growth

1. Theoretical

I

stock returns

background

II I

of the study.

~j~l~?z~~~~i leverage. The capital structure of a firm consists basically of equity funds and debt. The equity represents the basic risk capital of the firm. The essential characteristics of equity are that it is pernlanent, it can be counted on to remain invested in times of adversity and is subject to no mandatory requirements as regards dividends. In contrast to equity, debt has to be repaid. The larger the proportion of debt in a firm’s capital structure, the higher the lender’s risk, i.e. the greater the prob~~bility that the lender will not receive his interest or principals from the firm. Financial leverage is also an import~~nt factor from an investor’s point of view. In a pioneering study Miller and ~odiglialli (1961) showed the theoretical ~~~nne~tion between capital structure and firm valuation. The theoretical connection between financial leverage and systematic risk was shown by Hamada (1972). He demonstrated that the degree of financial leverage of a firm is theoretically directly associated with its common stock systematic risk. The higher the financial leverage of common stock, the higher the systematic risk. Hamada (1972) also found a positive empirical relationship between the estimated beta-coefficient of a stock and the degree of finan~i~~l leverage. Hamada’s theoretical work was taken further by Bowman (1979). The empirical evidence of U.S. data strongly supports financial leverage as a positive ~letermin~~nt of estimated common stock systematic risk and total risk (see, for example, Christie, 1982; Mandelker and Rhee, 1984). In addition Rhandari (198X) reported a positive relationship between the debt to equity ratio and the expected return on a security. In recent years the level of optimal capital structure has been widely discussed in the finance literature (see Copeland and Weston, 1988, pp. 497-533 for a review). This optimal level maximizes the value of the firm and may be due. for example, to bankruptcy or agency costs. The empirical evidence supports the existence of this phenomenon at least to some extent. ~~~eratin~ leverage. The total risk of a company can be tackled in two parts: financial risk and operating risk. In principle any given risk level can be achieved by changing either the ,financial or the asset structure of the firm. In this context the operating leverage can be seen as high in firms which have a large proportion of fixed assets. Operating risk is thus independent of a firm’s capital structure. The fixed costs of a firm therefore form the basis for its operating leverage. If the company’s sales do not cover its fixed costs, it will incur a loss. Once the fixed costs have been covered, further sales increases will result in more than prop~~rti~~nate increases in profitability. Theoretically the most appropriate measure for this category is the ratio relating fixed and variable operating costs. The main problem in using this dimension is that, due to problems in separating variable and fixed costs from financial statements, it is very difficult to calculate measures of operating leverage. On the difficulties in determination of this concept see, for example, McDaniel (1984). Thus, various other measures indicating concepts relating to operating leverage have also been used in the literature. These include the measure of i&our intensiveness and various types of ratio representing the expense structure of the firm. tev (1974) showed that operating leverage has a direct theoretical connection with the systematic risk component of a security. The overall empirical evidence also supports the supposition that operating leverage is an economic determinant of market-based systematic risk (see, for example, Foster, 1986 and the literature cited there, as well as Blann and ~aiachan~iral~, 1988; ~andclker and Rhee, 1984). ~;~~~~~z.Growth is one of the key concepts in stock valuation, The growth dimensio1~

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in dynamic stock valuation models has been included as growth in dividends or earnings. As Gordon (1962) has pointed out, the valuation of stock can be carried out simply by knowing the current dividend rate, the required rate of return of the stockholders and the growth rate of dividends. The problem associated with this kind of valuation is naturally the uncertainty related to the quantification of the variables and inputs into the model. Studies of the connection between corporate growth and stock prices send out rather different signals. However, Fewings (1975) has shown the theoretical connection between growth and common stock systematic risk. This theoretical connection is based on the traditional valuation models presented in Gordon (1961) and Modigliani and Miller (1958). The positive empirical relationship between systematic risk and corporate growth has also been reported by, among others Beaver et al. (1970), and with the help of Finnish data by Martikainen (forthcoming). Profitability. Profitability has been an important factor in previous theoretical and empirical studies in financial accounting literature. The measurement of anticipated profitability requires that the expected rate of return on an investment is compared with the rate of return required by investors in capital markets. In financial ratio analysis the profitability concept is somewhat different. Financial statement data are used to analyse company earnings performance over years or across firms. In this context it is interesting to note that strong empirical evidence indicates this factor as one of the most important determinants of stock prices. The value of a company can be regarded as the present value of its cash flows. Thus, the suitability of profitability figures in the process of evaluating securities depends on how “usefully” accounting earnings-based profitability figures can surrogate future cash flows. In this context it is relevant to emphasize that in an efficient capital market only the unexpected components of an earnings announcement provide new information, since stock prices already reflect any expected level of earnings. The conditions under which annual accounting earnings can be regarded as “useful” in this sense have been considered by Bowman (1979) among others. If accounting earnings do capture economic income, they could be regarded as useful in determining future cash flows and expected returns on stock. In a single-period context, however, it is obviously more realistic to assume that accounting earnings follow a stable random walk (see, for example, Foster, 1986; Kinnunen, 1988 and the literature cited there). The previous empirical evidence indicates that the unexpected part of earnings figures is obviously relatively large, since changes in a company’s annual earnings have been typically reported as following the random walk type of process (see, for example, Kinnunen, 1988 and the literature cited there). Thus assuming that the unexpected component of earnings and profitability figures is large, we can expect a positive relationship between profitability figures and stock returns. Similarly, since a positive relationship between systematic risk and expected returns is assumed according to CAPM it seems reasonable to see whether there is a positive empirical relationship between systematic risk measures and profitability ratios. 2.2. Review of earlier empirical studies comparing the significance of different firmspecific financiul variables Empirical evidence indicates that stock price fluctuations and accounting earnings announcements are closely related to each other. In a pioneering study Ball and Brown

20

T.

MARTIKAINEN

(1968) found that a substantial part (about SS-90%) of the relevant accounting information (measured in terms of net income and EPS) leaked to investors before the formal release of accounting figures. In the case of “good” news from accounting releases, the average cumulative abnormal return began to rise 12 months before the actual earnings announcements. This can be explained partly by the issue of interim reports and statements, which can provide investors more timely information than the annual reports. The average excess return concerning “good” news, i.e. positive changes in earnings, was about 7.5%. A similar trend was also found with respect to “bad” news. In this case the average negative cumulative excess return was about 10%. Similar results to those of Ball and Brown have been reported by, for example, Brown (1970) and Emanuel (1984). Using Finnish data, Korhonen (1977) and Martikainen et al. (1991) have adopted the same approach as Ball and Brown (1968). Both these studies reported that corporate earnings information conveyed relevant information regarding the pricing process of securities. A great many other studies, using various research methodologies, have also confirmed the importance of corporate earnings information in determining stock returns (see, for example, Foster, 19X6; Lev and Ohlson, 1986 for a review). O’Connor (1973) used a stepwise regression model to find out which financial ratios most efficiently explain cross-sectional variation in abnormal returns. From the 10 selected ratios, five were reported to be statistically significant in connection with these returns: total liabilities to net worth, working capital to sales, cash flow per share, current liabilities to inventories and income to net worth. In our present context, however, the main problem is that these other studies have not been able to report significant generalizations of their results in different samples and in different periods. Yli-Olli and Virtanen (1985, pp. 53-54) found empirical evidence on the connection between average stock prices and financial ratios in the U.S. market for the period 19471975. Correlation coefficients between stock prices and profitability ratios differed with only one exception (value-weighted Times Interest Earned) at the 0.01 level of significance of zero. In their study aggregates of profitability ratios (TIE, ROA, ROE and Earnings to Sales) were defined in terms of value-weighted and equally weighted averages. Ou and Penman (1989) conducted an analysis in which financial statement items were combined into one summarizing measure, in order to predict future stock returns. Using 68 accounting descriptors, they found that financial statements capture fundamentals which are not reflected in prices. Further, Castagna and Matolcsy (1989) offered some Australian evidence on the marginal information content of a number of items reported in published financial statements. They reported that given the information content of accounting income figures the marginal information content of supplementary accounting figures such as sales, extraordinary items, tax reconciliation and other income was zero. On the other hand, given the information content of the supplementary accounting numbers the marginal information content of the accounting income figures seemed not be zero. Martikainen and Yli-Olli (1990) tested the Arbitrage Pricing Theory (APT) using aggregated financial statement information. Starting from earlier theoretical articles, they selected three financial ratios (operating income to sales, net income to sales and equity to invested capital) to represent the aggregated firms’ financial dimensions to measure the common factors in the APT. Their results implied that the financial leverage factor measured by the ratio of equity to capital seemed to be the most important factor

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21

in explaining average returns on the Finnish stock markets in the period 1975-1986. Their results were extended by Martikainen (1991), by applying factor analysis to financial ratios. Of the estimated factors, the leverage factor seemed to be the most important in generating the systematic risk of securities in the Finnish stock market.

3. THE

DATA

The data used in this study consist of all the firms whose ordinary shares were listed on the Helsinki Stock Exchange throughout the period 1975-1986. The data include 28 Finnish firms. The ratios have been collected from the TILPANA data base constructed at the University of Vaasa. The financial statement analyses carried out in the study are based on published financial statement figures adjusted according to the recommendations of the Finnish Credit Analysis Commission. The major adjustments concern depreciations, changes in actuarial deficiencies of pension funds and extraordinary income. The depreciation used in the study is the maximum level of tax-based cumulative depreciations based on the double-declining method allowed in the Finnish law. The depreciation charges allowed on buildings are 9-10% and those on equipment 30% of the undepreciated balance. More detailed information about the adjustments used in income statement and balance sheet items can be found in the Appendix and in Yritystutkimusneuvottelukunta (1983, pp. 10-19). Financial variables representing four financial factors of firms are investigated. Ratios consisting of items from balance sheets as well as income statements were used to measure the financial performance of firms. This approach was chosen because, especially in inflationary conditions, the Finnish valuation principles may lead to a substantial undervaluation of assets and thus to biased values in the financial measures. First of all three profitability ratios - Return on Equity, Return on Assets and Net Income to Sales ratio -were chosen. Equity to Capital, Debt to Sales and Net Interests to Sales have been used to approximate financial leverage. Although the sales-deflated figures are not theoretically as attractive as those deflated by equity and asset figures, they have been chosen because apparently they produce more up-to-date deflators than those based on balance-sheet values. The balance-sheet values are obviously biased, due to the historical nature of valuation assets. The operating leverage ratios used in this paper are the Fixed Costs to Variable Costs ratio and Labour Intensiveness (i.e. personal expenditures/real-term fixed assets). Further, an industry dummy is used to approximate the production technology of the firms. Three growth rates are also included. The compound development in growth over the period has been used for estimating these growth rates. The main problem of this approach is that it is not possible to study the yearly growth rates, as a reasonable calculation of growing requires several observations. Technically this would of course be possible, but rapid structural changes in the Finnish firms (such as mergers and acquisitions) between the chosen subperiods would have made the measures extremely sensitive. Thus, the constant growth assumption for the period as a whole has been adopted in the following analysis. The growth rates included are Growth in Earnings (Net income), Growth in Dividends and Growth in Capital Investments. As regards the stock market data, weekly returns are calculated from the Wednesday

‘1. MARTIKAINEN

22

returns. Returns are determined issues and splits, i.e.

as changes

rir = log, where

ri,

Pi,

(P,,)

= return on stock i in month = stock price index in month

in logarithmic -

log,

(P&l)?

t t for firm

indices

including

dividends,

(4)

i.

The changes in logarithmic price indices can be regarded as good approximations of returns, assuming continuous compounding. For a day with no trade. the true price is proxied by the bid quotation. When several trading prices for the same stock on the same day have occurred, arithmetic averages for these prices have been computed.

4. EMPIRICAL

RESULTS

In this section the individual significance of the selected financial characteristics of firms will be studied. In the first phase, portfolios based on different financial characteristics of the firms are created. This portfolio formulation is based on the ranking of the companies by the financial ratios presented in Section 3. The portfolios created are revised every 3 years. The weekly market-adjusted returns e,,,s (e,,, = r,,, - r,,,,, where r,), = return of the portfolio and r,,,, = return of the market portfolio described in Section 3) for each portfolio are then studied, and a Spearman rank correlation analysis is carried out in order to determine whether there is any connection between the ranking of the portfolios and the cumulative market-adjusted returns on these portfolios on a crosssectional level. If the individual financial ratio category can be regarded as significant, then there should be a correlation between the ranking of the portfolios and the marketadjusted returns. The approach presented in this chapter appears to be a useful one of several counts. First, the normality of the ratios is not a crucial aspect, as the portfolios are based on the values of the ratios when no absolute values for these ratios are being directly used in empirical tests. Secondly, the fact that the use of market-adjusted returns does not depend on the problem of potential miscalculation of the betas. Earlier empirical evidence suggests that the use of market-adjusted returns, mean-adjusted returns or market model residuals all leads to much the same resuhs (see, for example, Liljeblom, 1989). Thirdly, this approach makes it possible to study the potential differences arising from the selection of specific financial ratios in the analysis. 4.1. Profitability Thus in the initial phase, portfolios based on single financial characteristics of firms were constructed. Firstly, portfolios based on the three selected profitability ratios were created, separately for each ratio studied. The first portfolio created consisted of the four most profitable firms, the second of firms ranked from 5 to 8, and so on. The last portfolio, number 7, thus contained four firms with the lowest profitability (firms 25-28). The contents of the portfolios were revised every third year, i.e. at the beginning of 1975, 1978, 1981 and 1984. The market-adjusted returns on these portfolios, and Spearman rank correlations between the ranking of the portfolios and these returns are presented in Table 1. Note that the market-adjusted returns in the table are studied for the same 3year period from which financial ratios (arithmetic averages of the ratios over the 3-year

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Table 1. Average weekly market-adjusted returns for the portfolios created by different profitability ratios. 1975-1986 Net Income Margin Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio

I 2 3 4 5 6 7

Spearman *Statistically **Statistically

period)

are taken.

Return on Equity

0.0038 0.0013 0.0005 0.0023 -0.0012 -0.0003 -0.001 I

0.0036 0.0006 0.0012 0.0001 -0.0003 0.0005 -0.0013

0.0035 0.0010 0.0016 0.0011 -0.0006 -0.0005 -0.0009

-0.79*

-0.86**

-0.86**

significant significant

at the 0.05 level. at the 0.01 level.

The underlying assumption assumed that the market

valuation-relevant 1989). The in Table between the on the portfolios

Return on Assets

1

in the analysis is of “association” agents learn about accounting figures and Collins and Kothari,

that all the chosen profitability

of portfolios consisting of the most profitable

earnings figures and stock that the theoretically returns than indicating

indicate

returns

Margin

ratio

which

of the first and

for the three

can be regarded

returns

portfolios

returns

noticed

were

are fairly the

the firms’ profitability

was not selfevident Finnish

stock

as a

on the portfolio

that the between separately

computed between

returns

simply

portfolios ratios, are presented suggest that the importance

profitability

consisting of the most profitable revised every third year). In addition, similar, regardless

that the between it should be noted

seems to hold very well. In addition

the Net Income

figures

returns

market

in many

respects;

of the

24

~rnula~~ markeradjusted retm%

~~UIativ~ marIcetadjusted return

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WEALTH

Cumulative marketadjusted return

Week Fig. 4. Individual

significance

of Return

on Equity

ratio.

Table 2. Spearman rank correlations between marketadjusted returns and portfolios created by different profitability ratios in four subperiods Net Income Margin 1975-1977 1978-1980 1981-1983 1984-1986 *Statistically **Statistically

-0.77* -0.82* -0.79* -0.11 significant significant

Return on Assets

Return on Equity

-0.68 -0.71 -0.90** -0.07

-0.82* -0.71 -0.86* 0.02

at the 0.05 level. at the 0.01 level.

obviously pressed the stock prices downwards (see, for example, Martikainen et al., 1991). In 1985 and 1986 the interest of investors in Finnish stocks increased both internationally and domestically. This led to a rapid increase in the trading volume of stocks, and simultaneously Finnish stock prices increased enormously. These years thus represent a kind of turning-point in the history of the Finnish stock market, and are therefore, quite exceptional (for an analysis of the intra-year connection between stock prices and financial ratios year by year see Martikainen, 1989). This result is consistent with the results reported by Hietala (1989) and Booth et al. (1992), who identified structural changes in the Finnish stock market around the end of 1985.

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T. MAKTIKAINEN

4.2. Financial leverage Next, portfolios based on the three selected financial leverage ratios were created. The first portfolio now consisted of the firms with the lowest leverage in their capital structure, the second portfolio of the firms ranked from 5 to 8 and so on. The last portfolio (number 7) thus contained firms with the highest level of debt in their capital structure. The market-adjusted returns on these portfolios and the Spearman rank correlations between the ranking of the portfolios and these returns are presented in Table 3. Again, the results based on the different financial ratios but measuring the same a priori dimension of a firm seem to be fairly similar. However. the results are perhaps surprising in the sense that the connection between financial leverage and stock returns is negative, i.e. firms seem not to have enjoyed any substantial benefit from leverage on a cross-sectional level. A possible explanation of this could be that there is an optimal capital structure for firms. This optimal level of debt to equity could be due to bankruptcy or agency costs, which might mean that the weighted average cost of capital started to increase beyond an optimal level of capital structure. The result obtained above thus indicates that on average the indebtedness of Finnish firms has been too high for them to gain significant advantage from financial leverage in this context. Similar conclusions have been reached by, among others, Martikainen (1989) for the period 1974-1986, Yli-Olli and Virtanen (1986) for the period 1977-1981, and Yli-Olli (1981). It should be noted in this context that several factors lie behind the generally high level of debt in the capital structure of Finnish firms. The Finnish taxation has made it more advantageous to take up loans rather than equity capital from owners. In addition to this it has been difficult to acquire equity from Finnish capital markets due to the thinness of the Helsinki Stock Exchange. Another explanation of the negative association observed may be the observed high correlation between financial leverage and profitability/ earnings. In this kind of ex-post analysis, high financial leverage may thus be seen as a consequence of low profitability, which again makes it difficult for less profitable firms to obtain equity. In studying the association between leverage or risk and stock returns there is one crucial aspect that should always be taken into account, namely that in an ex-post

Table 3. Average weekly market-adjusted returns for the portfolios created by different financial leverage ratios, 1975-1986

Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio

1 2 3 4 5 6 7

Spearman *Statistically

Interests Sales

Equity to Capital

Debt to Sales

0.0025 0.0013 0.0025 0.0004 -0.001s 0.0001 -0.0024

0.0023 0.0012 0.0003 0.0028 0.0001 -0.0002 -0.0013

0.0017 0.001s 0.0014 0.0026 -0.0000 -0.0012 -0.0010

-0.79*

-0.79*

-0.75*

significant

at the 0.0.5 level.

to

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analysis the association between risk and return may well be negative. Thus, even where there is always a consistently positive relation between returns and risk ex ante, the situation may be somewhat different ex post. This is because it is impossible to observe the ex-ante expected returns and betas from the data, so that in an ex-post analysis the expected returns and realized returns may differ from each other. In order to demonstrate the changes in the individual importance of the selected financial leverage ratios over time, the cumulative market-adjusted returns for portfolios 1 and 7 are presented graphically in Figs 5-7. These figures strongly support the assumption that investors have preferred firms with less debt in their capital structure to firms with higher indebtedness. Most of the difference in cumulative market-adjusted returns, however, seems to have appeared in the first years of the research period. Again, the Spearman rank correlation coefficients between the ranking of the portfolios and the average market-adjusted returns were computed separately for each subperiod. These correlations are now reported in Table 4. On average the results suggest a strong negative financial leverage effect on stock returns in the first three subperiods. However, in the fourth subperiod the relationship between financial leverage and stock returns is not statistically significant. Some reasons for this phenomenon were discussed in Section 4.1 above. 4.3. Operating leverage Using the same method portfolios were also created based on a basis of operating leverage ratios. The first portfolios in Table 5 consist of the four lowest firms ranked in Cumulative marketadjusted return 3.0 ::: ::: :::

2:: 2:: ::: 1.7

._ W=k Fig. 5. Individual

significance

of Equity

to Capital

ratio.

28

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Cumulative marketadjusted titum

Portfolio 1

Portfolio 7

Week Fig.

6. Individual

significance

of Debt

to Sales

ratio.

Cumulative marketadjusted return

Portfolio 1

Portfolio 7

.^ Week Fig.

7. Individual

significance

of Interests

to Sales

ratio.

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Table 4. Spearman rank correlations between marketadjusted returns and portfolios created by different financial leverage ratios in three subperiods Equity to Capital 1975-1977 1978-1980 1981-1983 1984-1986 *Statistically **Statistically

-0.75* -0.68 -0.71 -0.07 significant significant

Debt to Sales

Interests Sales

to

-0.85* -0.39 -0.86* 0.00

-0.93** -0.79* -0.46 0.29 at the 0.05 level. at the 0.01 level

Table 5. Average weekly market-adjusted returns for the portfolios created by different operating leverage ratios, 1975-1986 Fixed Costs to Variable Costs Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio

1 2 3 4 5 6 7

Spearman **Statistically

Labour Intensiveness

-0.0001 0.0006 0.0011 0.0008 0.0010 0.0011 o.Oc07

0.0023 0.0021 0.0006 -0.0003 0.0010 -0.0000 -0.0006

0.54

-0.82**

significant

at the 0.01 level.

terms of their operating leverage. The results in the case of the two operating leverage ratios are somewhat confusing. The Labour Intensiveness ratio indicates the presence of a negative operating leverage effect in Finnish firms, while the Fixed Costs to Variable Costs measurement suggests the opposite result. It is thus extremely difficult to draw any conclusion about the importance of operating leverage in explaining stock returns in the Finnish stock market. One could assume a priori that the Fixed Costs to Variable Costs measure would be highly unreliable. In the same way, the Labour Intensiveness measurement could be assumed to be a better ratio empirically, but unfortunately the reliability of the ratio is apparently not as high. In order to obtain more information about the characteristics of these two ratios, cumulative market-adjusted returns are also presented graphically, using the same approach as in the other financial ratio categories above. The market-adjusted cumulative returns based on the third measure representing the production technology of the firm, i.e. the industry dummy, are also shown. The industrial movements graph is based in this phase on the two most disparate and clearly defined industrial groups in the sample, namely trade and transport vs industrial companies, as defined by the official classification used by the Helsinki Stock Exchange.

T. MAKTIKAINEN

30

The graphical results suggest that the importance of the Labour Intensiveness ratio has remained relatively stable, indicating on average a negative operating leverage effect on stock returns. On the other hand, the results for the Fixed Costs to Variable Costs ratio are far from clear (see Figs 8 and 9). Figure 10 indicates that the cumulative return behaviour of companies in trade seems to have slightly outperformed the performance of those in industry. However, the difference between the market-adjusted returns of these companies did not differ from zero at a 0.05 level of significance when measured by the t-test. The cumulative difference between the returns of the two groups during the research period was 0.0007 (0.0013-0.0006) and the f-value for testing the null hypothesis of “no difference” between the groups was 0.97. Again, the results were also evaluated separately for each of the four subperiods. The results of this analysis are reported in Table 6. The Labour Intensiveness ratio indicates similar types of results to those presented for the financial leverage ratios. with a negative leverage effect appearing in the three first subperiods. However, the results for the Fixed Costs to Variable Costs ratio seem to be somewhat contradictory. The industry movements were also studied separately for each subperiod. The differences in industry returns are reported in Table 7. The only statistically significant difference was reported in the first subperiod, 1975-1977. Thus, to sum up it can be noted that the empirical results as regards the operating leverage factor are perhaps the most controversial in this study. A priori, a positive relationship between operating leverage and stock returns was expected. However. the

Cumulative marketadjusted return

Fig.

8. Individual

significance

of Fixed

Costs

to Variable

Coat\

ratio.

ON THE MAXIMIZATION

OF SHAREHOLDERS’

WEALTH

31

Cumulative marketadjusted return

Portfolio 1

Partfolio 7

Week Fig.

9. Individual

significance

of Labour

Intensiveness

ratio.

Cumulative marketadjusted return

Trade and transport firms

Industrial fitms

Week Fig.

10. Individual

significance

of industry

differences.

Trade

vs industrial

companies.

32

T.

MARTIKAINEN

Table 6. Spearman rank correlations between market-adjusted returns and portfolios created by different operating leverage ratios in four subperiods

1975-1977 1978-1980 1981-1983 1984-1986 *Statistically

Table

Fixed Costs to Variable Costs

Labour Intensiveness

-0.54 0.76 0.04 0.32

-0.86’ -0.77* -0.50 0.41

significant

7. Average weekly industry portfolios

1975-1977 1978-1980 1981-1983 1984-1986 ***Statistically

at the 0.05

level.

market-adjusted returns in four subperiods

Trade and Transport

Industrial Firms

T

0.0048 0.0004 -0.0003 0.0004

0.0002 0.0002 -0.0002 0.0020

3.11*** 0.09 -0.16 -0.84

significant

at the 0.001

for

level.

Growth The individual importance of the growth rates chosen for explaining stock returns will now be evaluated. As in the previous sections, portfolios based on different growth rates were first created. The first and seventh portfolios represent, respectively the most rapidly and the least rapidly growing firms. The average market-adjusted returns of these portfolios are presented in Table 8. All the Spearman rank correlations tend to be slightly negative, indicating a positive relation between returns and corporate growth. However, the correlations based on growth rates in investments and earnings are not statistically different from zero, at a 0.05 level of significance. The strongest association between growth rates and returns seems to be between the growth rate in dividends and stock returns. Figures 11-13 present the results obtained over time. The most interesting aspect of the figures appears to be that the importance of the variable measuring growth in dividends seemed to have increased in the fourth subperiod, 1984-1986. This finding is in accordance with the results obtained by Martikainen et al. (1991), where a totally

ON THE MAXIMIZATION

OF SHAREHOLDERS’

Table 8. Average weekly market-adjusted the portfolios created by different growth 1986

Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio Portfolio

1 2 3 4 5 6 7

Spearman *Statistically

returns for rates, 197%

Growth in Earnings

Growth in Investments

Growth in Dividends

0.0002 0.0012 0.0016 0.0016 0.0008 0.0008 0.0002

0.0019 -0.0001 0.0012 0.0008 0.0007 -0.0003 0.0008

0.0013 0.0023 0.0006 0.0017 0.0009 -0.0005 -0.0012

-0.39

-0.75*

-0.32 significant

33

WEALTH

at the 0.05 level.

different approach was adopted. The reason for the increase in the relative importance of this growth rate may well be the change in dividend policy in Finnish firms during the 1980s. In that decade dividends obviously fluctuated more than before and changes in dividends were regarded as favourable signals of future success for companies. This effect has become stronger, due to tax reforms which affect dividends and capital gains and to a decrease in the relative importance of stock dividends (Martikainen et al., 1991). To sum up, the expected positive relationship between stock returns and corporate

Portfolio 7

Portfolio 1

500 Fig.

11. Individual

significance

of Growth

rate

coo

in earnings.

Week

T. MARTIKAINEN

Cumulative marketadjusted return

Portfolio

i

Portfolio 7

Fig.

12. Individual

significance

of Growth

rate

in invcstmcnts

Cumulative marketadjusted return

Portfolio 1 b

Portfolio 7

Week Fig.

13. Individual

significance

of Growth

rate

in dividends.

ON THE

MAXIMIZATION

OF SHAREHOLDERS’

WEALTH

3.5

growth measures seems to hold relatively well (especially in the results reported in Table 8). The strongest association between different growth measures and stock returns was reported when the growth rate in dividends was evaluated.

5. CONCLUSIONS In this study, the individual significance of four financial characteristics of firms have been studied in terms of their ability to explain cross-sectiona variations in stock returns. The aim was to discover the firm-specific financial characteristics on which management should concentrate in maximizing the wealth of their common stockholders. Empirical evidence confirms the importance of four categories. Profitability, financial leverage, operating leverage and growth are all regarded as individually important in explaining long-term stock returns on the Finnish stock market. However, some exceptions based on different financial ratios and time periods were also observed. The return behaviour of stocks appeared to be captured most effectively by financial statement items in the three first subperiods, i.e. between 1975 and 1983. The fourth subperiod, 1984-1986, was reported as being quite exceptional manifesting perhaps the most radical structural changes in the Finnish stock markets in recent decades. Turning to the various financial characteristics and financial ratios representing each financial characteristic, we could also report some differences. First, in the long run all the profitability ratios behaved in an expected manner within their categories. In the case of financiat leverage ratios, a negative leverage effect was typically reported. The main differences appeared in the operating leverage and growth dimensions. Operating leverage ratios in particular seemed to measure rather different aspects of the firms’ performance. As well as the analysis based on stock returns which has been reported in this paper, a similar kind of analysis based on portfolio betas was also carried out. However, the results were not as encouraging as those obtained from stock returns. This may well be due to the major estimation problems in measuring the systematic risk of common stock. The results are obtainable from the author on request. There is good reason for treating the results reported here with a certain amount of caution. The financial characteristics analysed here are certainly interrelated. Thus, although they may be individually important, they are not necessarily incrementally important. This point should be considered in any further and more detailed research on this issue. Furthermore, the approach adopted in this paper makes it difficult to distinguish between high risk premiums and abnormal returns. But the approach was because of the serious problems involved in estimating systematic risk on the Finnish stock market (see Section 2.1). It should be noted that the results reported do not necessarily mean that accounting information could be used to earn abnormal returns. In further research more attention should also be paid to practical trading strategies based on the four financial characteristics (see Ou and Penman. 1989, for some evidence regarding a useful trading strategy in this context).

Acknowledgmenfs - I am very grateful to Ray Ball, Tom Berglund, Sten Jtinsson (the Editor), Antti Kanto, Eero Kasanen, Eva Liljeblom, Martti Luoma. Jukka Perttunen, Reijo Ruuhela, Timo Salmi, Ilkka Virtanen, Paavo Yli-Olli, Ralf Ostermark, and three anonymous referees for this journal for their useful comments on the numerous earlier versions of the paper. All remaining errors are naturally entirely mine.

3h

T. MARTIKAINEN

REFERENCES Ball, R. and Brown, P., An empirical evaluation of accounting income numbers, Journal of Accounting Research (1968), No. 2, pp. 159-178. Beaver, W., Kettler, P. and Scholes, M., The association between market-determined and accountingdetermined risk measures, Accounting Review (1970), No. 3, pp. 654-682. Berglund, T., Liljeblom, E. and Loflund, A., Estimating betas on daily data for a small stock market, Journal of Banking and Finance (1989), No. 1, pp. 41-64. Berglund, T., Wahlroos, B. and Grandcll, L., The KOP and the UNITAS indexes for the Helsinki Stock Exchange in the light of a new value weighted index, Finnish Journal of Business Economics (1983), No. 1, pp. 30-41. Bhandari, L. C.. Debt/equity ratio and expected common stock returns: empirical evidence, Journal ofFinance (1988), No. 2, pp. 507-528. Blann, J. and Balachandran, B. V., An empirical test of the statistical association between market risk and financial accounting allocation, Journal of Business Finance and Accounting (198X), No. 1, pp. 101-113. Booth, G. G., Hatem, J., Virtanen, I. and Yli-Olh, P., Stochastic modelling of security returns. Evidence from the Helsinki Stock Exchange, European Journal of Operational Research (forthcoming). Bowman, R. G.. The theoretical relationship between systematic risk and financial (accounting) variables, Journal of Finance (1979). No. 3. pp. 617-630. Brown, P., The impact of annual net profit on the stock market, The Australian Accountant (1970), July, pp. 277-292. Castagna, A. A. and Matolcsy, Z. P.. The marginal information content of selected items in financial statements, Journal of Business Finance and Accounting (1989). No. 3. pp. 317-333. Christie, A. A., The stochastic behaviour of common stock variances: value, leverage and interest rate effects, Journal of Financial Economics (1982). No. 4. pp. 407-432. Collins, D. W. and Kothari, S. P., An analysis of intertemporal and cross-sectional determinants of earnings response coefficients, Journal of Accounting and Economics (1989), pp. 143-181. Copeland, T. E. and Weston, F. .I., Financiul Theory und Corporate Policy (Reading, MA: Addison-Wesley, 1988). Emanuel, D. M., The information content of sign and size of earnings announcements, New Zealand evidence, Accounting and Finance (1984). November, pp. 25-43. Fewings. D. R., The impact of corporate growth on the risk of common stocks. Journal of Finance (1975), No. 2, pp. 525-531. Foster, G., Financitd Statement Anulysis (Englewood Cliffs, NJ: Prentice-Hall Inc, 1986). Gordon, M.J., The Investment, Financing and Valuation of the Corporation (Homewood. IL: Richard D. Irwin Inc. 1962). Hamada, R. S., Portfolio analysis, market equilibrium and corporate finance, Journal of Finance (1969), No. 1, pp. 13-32. Hamada. R. S.. The effect of the firm’s capital structure on the systematic risk of common stock, Journal of Finance (1972), No. 2, pp. 435-452. Hietala, P. T., Asset pricing in a partially segmented market: evidence from the Finnish markets, Journal of Finance (1989), No. 3. pp. 697-718. Kinnunen, J., The time series properties of accrual versus cash-based income variables: empirical evidence from listed Finnish firms. Proceedings of the Helsinki School of Economics, A-58. Korhonen, A., Stock prices, information and the efficiency of the Finnish stock market. Empirical tests, Actu Oeconomicae Hel.singiensis ( 1977). A 23. Lev, B., On the association between operating leverage and risk, Journul of Financial and Quantitative Analysis (1974), No. 4, pp. 627-641. Lev, B. and Ohlson, J. A., Market-based empirical research in accounting: a review, interpretation, and extension, Supplement to Journal of Accounting Research (1982). pp. 249-322. Liljeblom, E., Stock price reactions to financial decisions. Some results on data for the Stockholm Stock Exchange, Publications of the Helsinki Swedish School of Economics 43 (1989). Mandelker, G. N. and Rhee, S. G., The impact of the degrees of operating and financial leverage on systematic risk of common stock, Journal of Financial and Quantitative Analysis (1984). No. 1, pp. 45-57. Martikainen, T., Modelling stock price behaviour by financial ratios, Rivista di matemutica per le scienze economiche e sociale (1989). No. 1. pp. 119-138. Martikainen. T., The individual and incremental significance of the economic determinants of stock returns and systematic risk. Proceedings of the University of Vaasa, Acta Wasaensia 24 (Ph.D. Dissertation, 1990). Martikainen. T., On the significance of the economic determinants of systematic risk. Empirical evidence with Finnish data, Applied Financial Economics (1991), No. 2, pp. 97-104. Martikainen, T., Stock returns and classification pattern of financial ratios. Empirical evidence with Finnish data, Journal of Business Finance and Accounting (forthcoming).

ON THE MAXIMIZATION

OF SHAREHOLDERS’

31

WEALTH

Martikainen, T., Rothovius, T. and Yli-Olli, P., On the informational characteristics of earnings and cash dividends in the Finnish stock market. Proceedings of the University of Vaasa, Acta Wasaensia 27 (1991). Martikainen, T. and Yli-Olli, P., A test of the arbitrage pricing theory using accounting information, Economics Letters (1990), No. 1, pp. 55-59. McDaniel, W. R., Operating leverage and operating risk, Journal of Business Finance and Accounting (1984), No. 1, pp. 113-125. McLeay, S. and Fieldsend, S., Sector and size effects in ratio analysis. An indirect test of ratio proportionality, Accounting and Business Research (1987), No. 66, pp. 133-140. Miller, M. H. and Modigliani, F., Dividend policy, growth and the valuation of shares, Journal of Business (1961). No. 4, pp. 411433. Modigliani, F. and Miller, M., The cost of capital, corporation finance and the theory of investment, American Economic Review (1958), pp. 261-297. O’Connor, M., The usefulness of financial ratios to investors, Accounting Review (1973), pp. 33%352. Ou, J. A. and Penman, S. H., Financial statement analysis and the prediction of stock returns, Journal of Accounting and Economics (1989), pp. 295-329. Sharpe, W. F., Capital asset prices: a theory of market equilibrium under conditions of risk, Journal ofFinnnce (1964), No. 3, pp. 425-442. Yli-Olli, P., Leverage, the cost of capital and the value of the firm: empirical evidence on Finnish industrial firms, Finnish Journal of Business Economics (1981), No. 4, pp. 435-446. Yli-Olli, P. and Virtanen, I., Modelling a financial ratio system on the economy-wide level. Proceedings of the University of Vaasa, Acta Wasaensia 21 (1985). Yli-Olli, P. and Virtanen, I., On the stability of the classification of financial ratios. An application of factor and transformation analysis. Proceedings of the University of Vaasa. Research Papers 117 (1986). Yritystutkimusneuvottelukunta (1983) Yritystutkimuksen analyysimenetelmat, Jyvlskyll (The Credit Analysis Commission: Financial ratio analysis).

APPENDIX Adjustments

INCOME

made

to financial statements according to the recommendations Finnish Credit Analysis Commission

STATEMENT

Original

item and adjustments

Variable

expenses

Adjusted

item for analysis

Net sales + any decrease in the inventory reserve not included in “change in inventories” or - any increase in the inventory reserve not included in “change in inventories” Fixed

by the

./. variable

expenses

expenses

+ any increase of the pension

in the acturial fund or - any decrease in the acturial of the pension fund

deficiency

deficiency .I. fixed

expenses

Operating profit Depreciation + any underdepreciation or - any overdepreciation

./. depreciation

purposes

38

T.

MARTIKAINEN

Trading profit Other income _ non-business _ non-business

and expenses income expenses

k other .I. interest

income

and expcnscs

expenses

Profit (loss) before taxes and other items Direct taxes + direct taxes for the year against equity capital

charged ./. direct

taxes

Profit (loss) after taxes and before other items

BALANCE Original Financial

SHEET

item

Adjustments

assets + inventory reserve insofar as not included in the value of inventories

Inventories

Fixed

Adjusted

item

Financial

assets

Inventories

Fixed

assets

assets

Total assets

Total assets

Short-term

liabilities

Short-term

liabilities

Long-term

liabilities

Long-term

liabilities

+ inventory reserve insofar as not included in the reserves

Reserves

Shareholders’

equity

Total liabilities and shareholders’ equity

Reserves

Shareholders’

equity

Total liabilities and shareholders’ equity