The information content of accounting earnings, book values, losses and firm size vis-à-vis stocks: empirical evidence from an emerging stock market

Abstract

The Karachi Stock Exchange (KSE) has consistently outperformed better known emerging markets like Brazil, India and China over the past decade. However, some economists, notably Khwja and Mian (2005), claim that trade-based manipulation as opposed to firm fundamentals is the real cause behind this remarkable growth. To uncover the relationship between stock prices and firm fundamentals, we measure the degree of association between firm-specific accounting information embedded in annual financial statements and stock prices, commonly known as the value relevance of financial statements. Based on a data-set of 100 firms listed on the KSE from 1999 to 2011, we find that accounting information is an important determinant of stock returns. In addition, consistent with prior research, we also find that the explanatory power of accounting information shifts from earnings to book values in case of negative earnings and firm size is inversely related to stock returns. However, time-series regressions reveal a gradual decline in the value relevance of accounting information. Our findings are robust to different econometric specifications and methods.

Keywords:

• value relevance
• emerging markets
• earnings
• KSE

JEL Classification:

• M41
• G12
• G15

Notes

¹ The Karachi Stock exchange (KSE) was declared the world’s top performing stock market by Bloomberg Businessweek magazine in its edition on 10 April 2003 and continued to be amongst the top performing markets for several years. The KSE was also included in the list of top five stock markets by CNNMoney 2012. KSE was also covered by The Economist, June 2013.

² Wash trades are illegal trading practices, whereby an investor simultaneously buys and sells shares in a given company through two different brokers. Wash trades artificially enhance the trade activity in a stock, giving the impression of active trading without any change in beneficial ownership. It is a violation of the Securities and Exchange Ordinance in Pakistan.

³ Rahman and Hassan (2012) analysed the following emerging stock markets: China, India, Indonesia, Korea, Malaysia, Pakistan Philippines, Taiwan and Thailand.

⁴ The period from 2002 to 2005 witnessed a high number of IPOs, spurred by the government’s privatization scheme of nationalized industries.

⁵ The criterion for illiquid stocks: no variation in stock prices for 3 or more months in a given financial year.

⁶ An event study has limited scope in Pakistan because accurate data on the exact dates of financial disclosures are generally not available.

⁷ The clean surplus assumption states that dividends reduce BVPS but do not affect current EPS.

⁸ We excluded dividend yield from buy and hold stock returns since reliable data on dividends over the sample period were available for less than 30% of the firms in the data-set, and no meaningful differences were observed between estimates based on this subset of the data and the final results.

⁹ Nonetheless, like all return model, this specification also suffers from attenuation bias.

¹⁰ First, trade-based manipulation is an exercise of market power, and so, it becomes less pervasive as the market opens up. Second, in capital markets, collusion between brokers in equilibrium requires very strong disincentives to inhibit cheating or defection.