the relationship between portfolio returns and market multiples: a

Oeconomics of Knowledge, Volume 7, Issue 3, 2015

The Relationship between Portfolio Returns and

Market Multiples: A Case Study of Pakistan

Tahir Akhtar, Research Scholar

COMSATS Institute of Information Technology, Abbottabad, Pakistan

E-mail: tahirakhtar01[at]gmail[dot]com

Dr. Kashif Rashid, Associate Professor

COMSATS Institute of Information Technology, Abbottabad, Pakistan

E-mail: mkrashid[at]ciit[dot]net[dot]pk

Abstract: In this paper we have inspected the relationship between portfolio returns and market multiples for instance price to book ratio (P/B), price to earnings ratio (P/E), price to cash flow ratio (P/CF) and price to sales ratio (P/S) in Pakistan. The study includes the non-financial sector of Pakistan. Simple random sample is used to collect the data of 100 non-financial firms listed at Karachi Stock Exchange (KSE) from 2004 to 2011. The data for the firms are gathered from the websites of Business Recorder, Karachi Stock Exchange, State Bank of Pakistan and the companies’ financial reports. The sorting technique along with regression analyses is used to test the hypotheses for the study. The results of the study showed that among four market multiples P/B and P/S showed a significant positive relationship with portfolio returns. On the contrary, P/CF and P/E showed a significant negative relationship with portfolio returns. The results also proved that market multiples have a higher explanatory power for returns in combination than that of using alone except P/B which showed a greater explanatory power alone. Finally, P/B has higher explanatory power than all the other market multiples i.e., P/S, P/E and P/CF.


Keywords: Price to book ratio (P/B), price to earnings ratio (P/E), price to cash flow ratio (P/CF), valuation and multiples.

JEL: C51, C52, G11 and G15.

Introduction

Numbers of techniques were applied in the past to predict the stock

returns. Among them some of the techniques included to check the stock

market performance and also to predict stock market returns are

technical analysis, fundamental examination, capital market theory,

portfolio study and institutional location. The Asian stock markets were

informational inefficient during the period between 1975 and 1989. The

different technical exchange rules could forecast fluctuations in several

Asian Stock Market indices (Bessembinder and Chan, 1995). Thus the

use of fundamental variables in predicting stock returns is greater in

these markets than the developed markets. According to Penman (1992)

fundamental analysis is the method that is used to evaluate assets by

applying accounting concepts in order to judge the worth of an

investment.

Fundamental variables which are also known as market multiples

such as price to book ratio (P/B), price to sales ratio (P/S), price to

earnings ratio (P/E) and price to cash flow ratio (P/CF) are the measures

used to estimate the stocks of the firm’s i.e., whether the stock is

overpriced, underpriced or equally priced as compared to the industry

(Stowe et al., 2007). These measures help the investors in the selection

of stocks to reduce losses on their investment. The combination of

different stocks in the form of group is known as portfolio. The purpose of

making portfolios is to achieve the results that have better functional

importance and also have less biasness than that of analyzing the stocks

individually (Barbee et al., 2008). Beaver and Mors (1978) inspected the

association among price to earnings ratio, risk and growth of the profit by


categorizing common stock and making different portfolios.

The concept of stock valuation based on price to earnings ratio was

first introduced by Graham and Dodd (1934). Investors, researchers and

market makers rely heavily on market indicators like price to earnings

ratio to investigate the performance of the market (Molodovsky, 1953).

The first extensive study on the association among price to earnings ratio

multiple and subsequent total returns was published by Nicholson

(1960), showing that low price to earnings ratio stocks consistently

provided greater returns than the average stock. Malkiel and Cragg

(1970) were among those who suggested a model for calculating the

predicted price to earnings ratio based on cross-sectional regressions. In

the Japanese Stock Market, cash flow yield and book to market ratio

were found to have significant relationship in forecasting stock return

(Chan et al., 1993).

The relationship between common stock and price to earnings ratio

was also examined by Rahimi (1995). The analysis was performed on the

companies listed at Tehranian Stock Exchange during 1990 to 1994.

Abarbanell and Bushee (1997) also found a solid linkage among

accounting evidences and stock prices. While, studying the association

among fundamental analysis and stock return of oil and gas firm, Quirin

et al. (2000) showed a significant association among fundamental

variables and the listed stock returns. The different measures like price to

sales ratio, price to earnings ratio, book to market ratio and price to

dividend ratio were used in the past to analyze the stock market

performance (Bodie et al., 2002).

In both developed and developing markets, the use of market

multiples is vital to market forecasters and potential investors because

they are easy to calculate and understand, use actual data and give

actual results. Significant relationship was found between the market

multiples and stock returns mostly in the developed markets (Basu,

1975, 1977, 1983; Reinganum, 1981; Rosenberg et al., 1985; Fama and


French, 1992, 1988; Chan and Chen, 1991 and Barbee et al., 2008). On

the other hand, thin literature is available on the relationship between

the market multiples and stock return in the developing markets (Rahimi,

1995; Roll, 1995; Sun, 2012 and Fun and Basana, 2012).

In the context of Pakistan, Ateeq et al. (2010) studied 50 companies

to find out the causal relationship between the price to earnings ratio and

the cost of equity by applying panel regression. They proved a weak

negative relationship between price to earnings ratio and cost of equity

while, Afza and Tahir (2012) studied the determinants of price to

earnings ratio of 25 firms in Chemical sector listed at Karachi Stock

Exchange (KSE) for the period between 2005 to 2009 by using Ordinary

Least Square Regression model. Irfan (2009) found no relationship

between price to earnings ratio, market to book ratio and stock return by

analyzing 30 firms of the textile sector from 2001 to 2006.

Several studies have been performed on the stock market returns

because it helps both the investors and the firms to identify what effects

their investment returns and firm’s stock value respectively. An investor

considers two factors in the selection of stocks that is risk and return. In

order to minimize risk and to maximize return, investors use different

market indicators (Vakil et al., 2012). Investors try to maximize returns

on their investment. On the other hand, a business organization always

tries to improve its firm value to attract investors and also to strengthen

its credit worthiness. So, finding the relationship between market

multiples and stock return helps both the firms and investors to achieve

their objectives.

KSE is one of the premier stock exchanges in the emerging markets.

In spite of the rapid growth and increasing interest of international

investors, only few researchers rotated their attention to KSE. Investors,

market participants and financial agents are always in search of making

investment strategies that can outperform the market, especially in

emerging markets like Pakistan. Because of development in size,


structure, turnover and investment, the KSE has emerged with the huge

success with 651 companies listed on it and market capitalization of U.S

$26.48 billion (2010-2011). The changes occur rapidly in the sock prices

on daily basis. The investors need to make strategies which maximize

their returns and reduce loses. As compared to researches of

international markets like the U.S., the U.K., and Japan, limited research

related to the Pakistani market is available on the behavior of stock

returns to the market multiples such as price to earnings ratio (P/E),

price to book ratio (P/B), price to sales ratio (P/S) and price to cash flow

ratio (P/CF). So, this study aims to examine the association between the

portfolio returns and market multiples in Pakistan.

This paper is further structured as follows. Section 2 presents a

review of related academic research. Section 3 summarizes the

mechanism of the hypotheses. Section 4 offered the sample, the data

sources, the portfolios construction and the research model. The main

results of the paper are presented in section 5. Section 6 concludes. .

2. Literature Review

A lot of literature is available on the relationship among stock

returns and several market multiples. The literature is built in a way that

first of all the relationship between stock return and various market

multiples are presented then the role of market multiples in relationship

with stock return in developed and developing markets is discussed. At

the end, the studies conducted by the researchers on international

markets are also discussed.

In case of developed market, Basu (1975, 1977) showed that by

adjusting the risk factor, the low price to earnings ratio stocks have

higher return than the average as compared to those of stocks having

highest price to earnings ratio. When previous research was updated by

Basu (1983), he found an inverse relationship between price to earnings


ratio and risk adjusted stock returns even after controlling for the firm

size. Similar results were found by Tseng (1988) and Jaffe et al. (1989),

which showed that the portfolios having low price to earnings ratio have

high risk adjusted return than those of portfolios which have high price to

earnings ratio. Reinganum (1981) extended Basu’s findings and

confirmed that there was a significant negative association between price

to earnings ratios and mean returns in excess of those predicted by the

Capital Asset Pricing Model (CAPM) by analyzing both New York Stock

Exchange (NYSE) and AMEX stocks. The lower price to earnings stock

tends to have a higher return than high price to earnings stock (Bleiberg,

1989 and Russikon, 1991).

Levy and Lerman (1985) integrate transaction costs with price to

earnings to check the impact on stock return. They found that low price

earning stocks have higher return, only when transaction costs are least.

The stocks with low price to earnings and price to book ratio performed

well on the market while studying all non-financial firms from 1963 to

1990 listed on NYSE (Fama and French, 1992). They also proved out that

the relationship between book to market ratio and stock return is strong

than that of earnings to price ratio.

Patari and Leivo (2009) documented an inverse relationship between

stock return and accounting ratios in Finnish Stock Market during 1993 to

2003. Significant negative relationship between price to book ratio, price

to sales ratio, price to earnings ratio and price to cash flow ratio and

stock return was found by using the sample of all the firms listed at NYSE

during the period of 1981 to 2000 (Barbee et al., 2008).

Literature also showed the role of market multiples in predicting the

stock return in developing market. For instance, Rahimi (1995)

investigated the relationship between common stock and price to

earnings ratio of the companies listed at Tehranian Stock Exchange

during 1990 to 1994. He found that there was a negative relationship

between price to earnings ratio and stock return. The stocks with low


price to earnings ratio during 1990 to 1994 got superior returns than

stocks having greater price to earnings ratio. The Indonesian market

shows that high book to market ratio stocks appear to have higher

returns than low book to market ratio stocks, even though the difference

between the two groups is not statistically significant (Roll, 1995).

The association among firm’s fundamental variables and equity

returns was also studied in the Indian markets. The data of a sample of

455 firms listed at Indian Stock Market during the period between June

1997 and June 2007 was studied to investigate the relationship between

four company’s fundamental variables (market capitalization, price to

earnings ratio, book equity to market equity ratio and debt to equity

ratio) and the equity returns. Negative relationship was found for market

capitalization and price to earnings ratio with equity returns. On the other

hand, book equity to market equity ratio and debt to equity ratio were

positively related with equity returns in Indian markets (Tripathi, 2011).

The relationship between market multiples and future stock returns

has also been discovered by many researchers on international markets.

Chan and Chen (1991) did the research on Japanese Stock Market during

1971 to 1988 and found that the stocks with low market multiples have

higher returns especially for low book to price ratio and cash flow to price

ratio.

While studying the Japanese market, it has been found that the

stocks with high book to market ratio and cash flow to price ratio have

high risk-adjusted returns (Chan et al., 1993). They also found that book

to market ratio and cash flow yield have significant relationship in

predicting stock return. In countries like Germany, France, Japan, the

U.K., Switzerland and the U.S., a strong positive association of book to

market ratio with stock returns was found (Capaul et al., 1993). Mukherji

et al. (1997) studied Korean Stock Market where high book to market

ratio and sales to price ratio stocks lead to higher return.


Fama and French (1988) did extensive research in 12 major markets

(the U.S., the U.K., France, Netherlands, Singapore, Belgium, Australia,

Switzerland, Sweden, Hong Kong, Japan and Germany) during the period

between 1975 and 1995 and found a negative association between stock

return and the financial ratios (book to market ratio, earning to price

ratio and cash flow to price ratio). Strong negative relationship was found

between market multiples and portfolio returns for time period from 1963

to 2004 in the U.S., stock market and for 1975 to 2004 in 14 major stock

markets external to the U.S. The findings also support that Capital Asset

Pricing Model (CAPM) can describe the strong relationship between 1926

and 1963 in the U.S., market but not in the period between 1963 and

2004. While, studying 21 international markets, Bauman et al. (1998)

observed high returns for stocks which have low price to earnings ratio,

price to book ratio, price to cash flow ratio and price to dividend ratio.

3. Hypotheses Development

The most commonly applied earnings based ratio to evaluate stocks

is the price earnings ratio. It helps to predict the fluctuations in future

profitability (Fairfield, 1994). Price to earnings ratio is widely used

indicator to predict future stock return. The ratio shows that how much

an investor is prepared to pay at the present moment from single unit of

earnings. The interpretation of these ratios is always challenging in

nature. The high price earning shows that the stock is overvalued and the

firm is in growing stage with good opportunities; its earnings are risk

free, safe and have more value. As a result of this, investors have a lot of

expectations from the company. They start purchasing stocks of that

company and due to high demand; the price of stock of the firm

increases and resultantly price to earnings ratio will also be improved.

When price to earnings ratio reaches to its peak level, the investors

believe that the firm’s earnings will be increased in the future. After the

execution of earnings and positive report of earnings in the market, the


price to earnings ratio will be reduced.

On the other hand, low price to earnings ratio may indicate low

growth opportunities for the firm with high risk, poor earnings and the

undervaluation of stocks. Low price to earnings ratio stocks as compared

to industry are sometimes preferred by the investors because low price

earnings means that investors are paying less for earnings as compared

to industry. Investors think that the decreasing trend of the price to

earnings ratio is not permanent as it will be increased in the future. Basu

(1975, 1977) suggests a negative relationship between price to earnings

ratio and stock return. So the following hypothesis is stated.

H1: There is a negative relationship between price to earnings ratio (P/E) and portfolio returns.

The alternative measure of the price to earnings ratio is the price to

cash flow ratio. It can be calculated by dividing the current stock price to

cash flow per share. The drawback of accounting earnings is that it may

be an ambiguous and unfair estimate of the economic earnings with

which shareholders are concerned. This drawback will be reduced by the

cash flow per share which helps in reducing manipulation, since the

nature of the cash flow that paths cash rolling into or out of the firm is

less exaggerated by accounting conclusions. Therefore, price to cash flow

ratio is a less biased estimate for evaluating the stocks of the firms. This

ratio is also supposed to be an indicator for the investors to predict the

firm’s future financial strength on the basis of their market opportunities.

There is a negative association between price to cash flow ratio and stock

return (Barbee et al., 2008). So the following hypothesis is presented.

H2: There is a negative relationship between price to cash flow ratio (P/CF) and portfolio returns.


Another alternative measure used to evaluate stock is the price to

sales ratio. It can be obtained by dividing current stock price to sales per

share. Sales revenues are probably least influenced by accounting rules

and conventions as compared to earnings and cash flow. The role of sales

to price in relationship to stock return is discussed by Fisher (1984).

Barbee et al. (2008) have found an inverse relationship between price to

sales ratio and stock return. So the following hypothesis is presented.

H3: There is a negative relationship between price to sales ratio (P/S)

and portfolio returns.

Price to book ratio is another important measure used to evaluate

stock return. It is obtained by dividing stock’s market value per share to

its book value per share. Price to book ratio is a function of the estimated

level of future profitability and there is a strong positive correlation of

price to book ratio with the upcoming return on book value and price to

earnings ratio with growth in earnings (Fairfield, 1994). Higher ratio

shows that investors are expecting that the firm will generate earnings in

the future with the assets the firm is holding. While, low price to book

ratio shows that a firm will not bring the financial value for the investors

which would cover their return on the equity they have required. Graham

and Dodd (1934) showed that price to book ratio is an important

indicator of the expected returns. A series of publications have reported a

significant negative relationship between price to book ratio and stock

returns (Stattman, 1980; Rosenberg et al., 1985; Fama and French,

1992). So the following hypothesis is stated.

H4: There is a negative relationship between price to book ratio (P/B) and stock returns.

The study examines the causal relationship between market

multiples and portfolio return. Additionally, the study checks the multiple


that has greater explanatory power and also testifies the explanatory

power of the combine multiples as compared to the market multiples

alone.

4. Research Methodology

For examining the relationship between stock returns and market

multiples, simple random sampling is used to collect initial sample of 122

non-financial firms listed at the Karachi Stock Exchange. Because of the

non-availability of the data for some firms, the final sample was reduced

to 100 firms. The data of these firms is collected for the period of eight

years (2004-2011).

4.1 Data Collection

The secondary data used to conduct this study is collected from the

websites of Business Recorder, Karachi Stock Exchange and the State

Bank of Pakistan. The closing stock price of each stock along with the

accounting data used to calculate the market multiples at the end of each

year are collected from 2004 to 2011.

The study is limited to companies that are listed on KSE. The

companies which were delisted during the research period are also

included in the study. Out of 632 firms, 100 firms were selected

randomly for the study for eight years period. Data from all the sectors

were included except banks and other financial institutions since they

have a slightly different way of making financial statements and therefore

would not be comparable to the ratios used in this research.

4.2 Data Analysis

Sorting Technique, Descriptive Statistics, Correlation along with


Univariate and Multiple Regression Analysis is used to test the

relationship between the portfolio return and the market multiples

(Barbee et al., 2008). In the regression analyses, the mean return for

each year is used as a dependent variable, while the mean market

multiples are used as a predictor variable.

4.3 Construction of Portfolios

The stocks were first ranked on the basis of each multiple in a way

that the stocks with higher ratio were at the top and with the least ratio

at the bottom. Then stocks were divided into ten portfolios with each

portfolio containing equal number of stocks. Beaver and Mors (1978)

investigated the relationship between price to earnings ratio, risk and

growth of the profit by classifying common stock and creating different

portfolios. Bird and Whitaker (2003) studied the four key ratios (book to

market ratio, dividend to yield ratio, earnings to yield ratio and sales to

price ratio) to form portfolios by using data from eight European

countries. Price to earnings ratio is one of the best ratios used for ranking

stocks (Rousseau and Rensburg, 2003). Sales to price ratio and book to

market ratio were two of the best elements for ranking stocks (Bird and

Whitaker, 2003; Bird and Casavecchia, 2007).

The portfolios built on the basis of ranking of the each multiple in

each year are named as:

The portfolios formed on the basis of sorting price to earnings

ratio have been stated as P1PE (highest), P2PE, P3PE, P4PE,

P5PE, P6PE, P7PE, P8PE, P9PE and P10PE (lowest).

The portfolios formed on the basis of sorting price to sales

ratio have been stated as P1PS (highest), P2PS, P3PS, P4PS,

P5PS, P6PS, P7PS, P8PS, P9PS and P10PS (lowest).

The portfolios formed on the basis of sorting price to book


ratio have been stated as P1PB (highest), P2PB, P3PB, P4PB,

P5PB, P6PB, P7PB, P8PB, P9PB and P10PB (lowest).

The portfolios formed on the basis of sorting price to cash flow

ratio have been stated as P1PCF (highest), P2CF, P3CF, P4CF,

P5CF, P6CF, P7CF, P8CF, P9CF and P10CF (lowest).

The mean ratio and the mean of annually equally weighted holding

period returns of all the portfolios have been calculated from June 2004

till June 2011 giving a total of 40 annual observations for each year. After

calculating the mean ratio and the mean return of each portfolio, the

univariate regression analysis was applied for each year separately to

check the impact of these market multiples on portfolio returns.

4.4 Research Model

The regression model used by Barbee et al. (2008) is applied to test

the hypothesis that there is a significant relationship between four

independent variables (P/E, P/B, P/S and P/CF) and dependent variable

(portfolio return).

HPR = α + β0 P/E + β1P/B + β2P/S + β3P/CF + ε

Where:

HPR is the holding period return.

HPR = (Pt-Pt-1+D)/Pt-1

α is the constant.

P/E is the price to earnings ratio; and

P/E = Stock price /Earnings per share

P/B is the price to book ratio; and

P/B = Stock price /Book value per share


P/S is the price to sales ratio; and

P/S = Stock price /Sales per share

P/CF is used for the price to cash flow ratio; and

P/CF = Stock price /Cash flow per share

and ε is the error term.

The variables used to calculate the independent variables written

above were obtained as:

Earnings per share = (Net income after tax – preferred dividend)/No

of shares outstanding

Sales per share = Net sales / No of shares outstanding

Cash flow per share = EPS + (Depreciation and amortization/No of

shares outstanding)

Book value per share = as mentioned in the reports which is usually

ten

5. Results of the Study

The results of the Descriptive Statistics, Univariate and Multiple

Regression Analysis, Correlation and the Value and Growth Strategies are

given below.

5.1 Descriptive Statistics

The statistics of sample stocks and 10 yearly portfolios which are

sorted out by four market multiples are presented in Table 1 below.

The digits of sample stocks lie in the range between 1 and 100 in


each year, with a median and mean of 50.5. The mean return of the

sample stocks for the July and June holding periods lies in the range

between -106.76 percent and 79 percent. The mean and median of the

mean returns are 0.31 and 0.11 respectively with the value of 5.17 for

the standard deviation. Price to book ratio has a minimum and a

maximum value of -17.45 and 48.03 respectively with mean of 7.11 and

median value of 3.13. Price to earnings ratio has a minimum and a

maximum value of -1.559 and 5.790 respectively with the mean of 2.139

and the median value of 2.07. Price to sales ratio has a minimum and a

maximum value of -2.026 and 6.063 respectively with the mean of 0.71

and the median value of 0.29. Price to cash flow ratio has a minimum

and a maximum value of -0.63 and 4.74 respectively with the mean of

1.71 and median value of 1.64.

The standard deviation shows that how much data is dispersed from

the mean. Price to book ratio has the highest value of standard deviation

10.83, while all the other multiples have a low standard deviation values

which ranges between 1.18 and 1.48. This shows that the data for price


to sales ratio, price to earnings ratio and price to cash flow ratio is not

widely dispersed from the mean.

5.2 Univariate Regression Analyses (2004-2011)

In the Table 2, the annual cross-sectional univariate regression

statistics for eight years of the study among the portfolios of mean return

and the four median market multiples are shown.

Among four market multiples, price to earnings ratio and price to

cash flow ratio both showed a significant negative relationship with the

stock returns, while price to book ratio and price to sales ratio showed a

significant positive relationship with the stock returns.

The results showed a significant negative relationship of price to

earnings ratio with the stock return in only one year i.e., 2010 while lack

of a positive relationship was found in any of the year. So, the results

lead to the acceptance of H1 that there is a negative relationship

between price to earnings ratio and stock return, which is consistent with

the results of Nicholson (1960), Basu (1975, 1977, 1988) and Bauman et

al. (1998).

Negative relationship of price to cash flow ratio with the stock return

is found only in the year 2010 and an absence of significant positive

relationship in any of the year. So, on the basis of the results of annual

cross-sectional, univariate regression analysis for the eight years period,

the result about the negative relationship between price to cash flow ratio

and the stock return is accepted. The result is consistent with findings of

Fama and French (1992, 1988), Bauman et al. (1998) and Barbee et al.

(2008).


There is a positive relationship between price to sales ratio and stock

returns for the years 2004, 2006 and 2010. Furthermore, a lack of

relationship of price to sales ratio with stock return in any of the year

was found. This contradicts our hypothesis H3 which suggests a negative

relationship between price to sales ratio and stock returns.

Similar to the price to sales ratio, the result also proved that price to

book ratio has a significant positive relationship with returns for the years

2005, 2007 and 2010. So, H4 that there is a negative relationship

between price to book ratio and stock returns is rejected as positive


relationship is found between price to book ratio and stock returns. The

result is consistent with the results of Fama and French (1992), Aby et al.

(2001) and Dechow et al. (2001).

The results also show that price to book ratio has a greater

explanatory power for returns than the other market multiples with a

maximum adjusted R-squared value of 0.15. So after comparing the

median adjusted R-squared values across all the four market multiples

we suggest that some multiples have strongest relationship with portfolio

return than the others or we can say that the hypothesis stating that

there are some multiples having strongest relationship with stock return

than the others is accepted. This result is consistent with the findings of

Barbee et al. (2008).

5.3 Correlations of the Market Multiples and Stock Return

If we look at the Table 3, all the four market multiples show a

significant relationship with stock return. Among them, price to book

ratio and price to sales ratio show a significant positive relationship with

stock returns having the correlation coefficient (r) value of 0.340 and

0.079 respectively. While, price to earnings ratio and price to cash flow

ratio show a significant negative relationship with stock return with the

correlation coefficient (r) value as -0.141 and -0.320 respectively.

In case of the relationship among the independent variables, price to

book ratio is negatively associated with the price to earnings ratio and

price to cash flow ratio with the correlation coefficient (r) value of -0.127

and -0.201 respectively while positively associated with price to sales

ratio with the correlation coefficient (r) value of 0.174. Similarly, price to

earnings ratio is positively associated with the price to sales ratio and

price to cash flow ratio with the correlation coefficient (r) value of 0.102

and 0.200 respectively. Price to sales ratio has a significant positive

association with price to cash flow ratio with the highest correlation


coefficient (r) value of 0.307.

5.4 Results of Value and Growth Strategies

To examine the practical importance of our findings, the results of

different value and growth strategies were calculated in the Table 4.

Firstly the mean returns of the top and bottom quantiles of sample stocks

are calculated for each year for the market multiples sorted from highest

to lowest ratio and then their differences are examined as shown in the

Table 4.

The low multiples stocks i.e., price to earnings ratio and price to

cash flow ratio show an additional mean return of 0.48 and 0.37

respectively which proves that there is a negative relationship between

portfolio returns and market multiples (P/E and P/CF). While, on the

other hand, price to book ratio and price to sales ratio show an adverse

mean return of -1.04 and -1.46 respectively. This shows that the

multiples with lower values have a lower return. Hence, it is proved that

there is a positive relationship between portfolio returns and market

multiples (P/B and P/S).


5.5 Multiple Regressions Results

In Table 5, the results of the annual multiple regressions of the

return against the four market multiples for eight years of the study are

shown. The purpose of multiple regression analyses is to compare the

explanatory power of market multiples in combination than that of using

them alone.

Among four market multiples, price to book ratio shows a significant

positive relationship with stock returns for the years 2005, 2007 and

2010. Price to earnings ratio shows a positive relationship with return in

2004 and 2005. Similarly, price to sales ratio shows a significant positive

relationship with returns for 2006 and 2010, while a negative relationship

was found in 2004. Finally, the result for price to cash flow ratio shows a

negative relationship with the returns in 2010 only.


On comparing the results of multiple and univariate regressions, it is

evident that price to book ratio is consistently significant in three years in

both the models. The median adjusted R-squared of multiple regression

model is 0.019 which shows the greater explanatory power of market

multiples for returns in combination than that of using market multiples

alone except price to book ratio, which has median value of 0.15 in the

univariate analysis.


Conclusions

Due to rapid growth, KSE has attracted the interest of international

investors. Investors, market participants and financial agents are always

in search of making investment strategies that can outperform the

market, especially in Pakistan. The relationship between portfolio returns

and market multiples (price to earnings ratio, price to book ratio, price/

sales and price/cash flow) help both the investors and the business

organizations to know the determinants of their investment returns and

company’s stock value respectively. After sorting the multiples for each

year, the univariate regression analysis was applied for each year

separately to check the impact of these market multiples on portfolio

return. The result showed an inverse relationship between price to cash

flow ratio and price to earnings ratio with stock returns while a positive

relationship was found between price to book ratio and price to sales

ratio. The results also showed that price to book ratio has a greater

explanatory power for returns than the other market multiples. When

multiple regressions were applied for each year separately, it has been

found that market multiples have greater explanatory power in

combination than that of using market multiples alone except for price to

book ratio. These market indicators help the managers in the selection of

stocks. Finally, the investors can get higher return by investing in the

stocks which have high price to book ratio and price to sales ratio and

also the firms can increase the shareholders wealth by using these

market multiples .

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