Changes in share price

Literature Review

Study of changes in share price came into view to support that changes in fundamental factors should jointly bring the changes in share prices both in developed and emerging markets. In US and Japanese Market we find that there is a significant relationship between the fundamental factor and the changes in the stock price and the investor price the securities much more on the basis of analysis made available to them however, the actual fundamental variables found to be relevant may vary from different market to market. The link between the fundamental variables and the changes in share price has been extensively studied in the US and Japanese Market but in Pakistan few studies have been attempted to analyze the behavior of the change in share price from one year to another due to fundamental factors.

Factors affecting stock prices volatility have been studied from different points of view. Several researchers examined the relationships between stock prices volatility and selected factors which could be either internal or external. The results show a variety of findings depending on the scope of the research. Some of those factors or variables could be common for all stock markets. However, it is difficult to generalize the results due to the different conditions that surround each stock market environment. Each market has its own uniqueness, for example, its own rules and regulations, policies, country of location, type of investors and their behavior, and other factors that provides the basis of its uniqueness.

Some studies have concluded that company fundamental variables or factors such as earning, dividend, growth and valuation multiple are major factors that affect stock prices volatility. Other indicated that inflation, economic conditions, political conditions, investor behavior, the behavior of the market and liquidity, are the most influencing factors of stock prices volatility.

In general, companies' fundamentals such as earning per share, dividend per share, book values of the shares, growth of the company and other factors that reflect companies' performance are considered as fundamentals in this study. It is well known that the most important internal factors are earning per share and dividend per share. Generally the accounting information is relevant for valuing stocks. Financial analysts pay large sums for such information, analyze it carefully, and make forecasts about future accounting information such as earning, growth of the firms and valuation of stocks in justifying their buy and sell recommendations. We also read in the newspaper that major earnings of the companies and potential growth are accompanied by significant changes in share prices.

Fundamental analyst believe that at any time there is a basic intrinsic value for the aggregate stock market, various industries, or individuals securities and stocks and these valued depends on underlying fundamental factors. Therefore investor should determine the intrinsic value of an investment at a point in time by evaluating the variables that determine the value of stock such as current and future earning of the firm, cash flows, interest rates and risk variables. The investors take the appropriate action based on intrinsic value of stock and purchase the stock if the market value of stock is substantially below the intrinsic value. “Fundamental analysis involves aggregate market analysis, industry analysis, and company analysis and portfolio management”. [Reilly and Keith (2005)]

A basic premise of technical analyst is that movements in stock price in trends that persist. Technicians contend that investor do not analyze information and act on the basis of information immediately. This process takes some time. Therefore they assume that stock price moved to a new equilibrium after the release of new information in gradual manner, which cause trends in stocks price volatility.

“The US Investor is known to price the securities much more on the basis of analysis made widely available by the financial analyst community and the mass media”. [Irfan and Muhammad (2002)]. This study will determine that whether change in share price is primarily due the fundamental factors which will help the potential investor to make the decision to invest in the particular stock on the basis of financial analysis of the company available to them by the investment companies in Pakistan. “It is widely agreed that a set of fundamental variables as suggested by individual theories is no doubt relevant as possible factor affecting share price changes in the short run and the long run” [Ariff and Khan (2000)]. The relation between fundamentals and change in stock price from one year to another has not been extensively investigated in Karachi stock Exchange. This study will examine the relationship between the change in share price and fundamentals in the oil and gas sector of the Karachi stock exchange and the five fundamental variables were taken although there is a long list of such fundamental factors. This paper estimates the fraction of variation in stock price that can be attributed to fundamental factors.

“Investigations of share price changes appear to yield evidence that change in fundamentals variables(s) should jointly bring about changes in share price both in developed market and emerging markets. However, the actual fundamentals factors found to be relevant may vary from market to market” [Irfan and Muhammad (2002)]. For example in the Japanese market the book to market ratio has the most important influence on returns; cash flow yield also has a positive and significant impact on returns [Chan, et al (1993)] while in the Korean market book-marker ratio, sales- price ratio and debt-equity ratio were positively related and negatively related to firm size. [Mukherji, et al (1997)]. Another relevant factor in affecting the change in share price is the dividend payout ratio. The dividend payout ratio of the firm has impact of the firm's future growth.

Irfan and Muhammad (2002) established the joint linear effect of six fundamental variables over a lengthy period of twenty years to estimate a valid relationship between the share price and the fundamental variables using all listed companies at Karachi Stock Exchange from 1981 to 2000 and the significant joint factors are payout ratio, size of the firm, leverage and dividend yields while earning volatility and assets growth are not significantly explaining the share price changes. Together these four fundamental variables explain one-fourth variation in stock price changes in Karachi stock exchange.

Chan, et al. (1993) consider the four fundamental variables that is book to market ratio, cash flow yield, size of the firm and yield to explain the changes in the Japanese Stock returns and used the monthly data from January 1971 to December 1988 of Tokyo Stock Exchange and the monthly returns including the dividend. The author conducted the analysis of the relation between stock returns and fundamental variables at the portfolio level. The author employ the regression model to adjust for portfolio risk and simultaneously test the significance of the fundamental variables on the stock returns and the finding reveal significant relationship between the stock returns in the Japanese market and the four fundamental factors. The book to market ratio is statistically and economically the most important of the four fundamental factors investigated and the cash flow yield has also a positive and significant impact on the stock returns.

The study was conducted by Mukherji, et al (1997) to examine the relations between the fundamental variables and future stock returns and the data obtained by the author from 1982 to 1993 for all the companies listed in the Korea Stock Exchange. This article examine the six fundamental variables that is beta, debt to equity, earning to price ratio, book to market value, market capitalization and ratio of sales per share to stock price. The author used the spearman rank correlations coefficient methodology of stock returns and fundamental variables and conclude that t the fundamental analysis of stock returns in Korea reveals that annual stock returns during the 1982-93 periods were positively related to book to market and ratio of sales per share to stock price and debt to equity ratio and negatively related to firm size but not significantly related to price earning ratio.

“Studying a market as important as the Japanese Stock market is of interest in its own right. In addition, our results, when placed alongside the evidence accumulated from studies of American data may also be useful in evaluating empirical models of the determinants of stock returns” [Chan, et al (1991)]. The study was conducted by Chan, et al (1991) in view of that related to cross sectional differences in stock returns of Japanese Market to the behavior of the four fundamental variables that is earning yield, size, book to market ratio and cash flow yield and the author used the monthly data on stocks listed on Tokyo stock exchange from January 1971 to December 1988 and employed the seemingly unrelated Regression model to adjust simultaneously for portfolio risk and test the significance of the fundamental factors and finding reveals a significant cross sectional relationship between the fundamental factors and the expected returns in market and the book to market ratio and cash flow yield have the most significant positive impact of the expected stock returns.

The study was conducted by the [Campbell and Robert (1987)] that the dividend price ratio and earning price ratio predict the stock returns measured over the several years. The data set used in this article consists of annual observations on dividends, stock prices and the earning from 1871 to 1987 of the US stock market through a vector autoregressive approach to analyze the stock price movements and predicting the stock returns and conclude that stock returns are highly forecastable in the long horizon.

Zeghal (1984) measure the firm size as the market value of common stocks at the end of each year. Size of a firm does have effect on the valuation of the firm's assets and as the size of the firm increase, their share price movement's decrease. The size of the firm if captured through total capital employed is likely to influence the share prices positively as large firms are better diversified than smaller firm and therefore are less risky. The value of a firm or firm size can be determined in many different ways. The company market capitalization and size do factor in stock price volatility. Large market capitalization would consider be safer then the small capitalization stock. However, the small capitalization firms have greater growth potential and therefore have higher average returns. The study of Fama and Kenneth (1995) about the behavior of share prices, in relation to size of the firm and book-to-market-equity reflects the behavior of earnings. Consistent with rational pricing, high book-to-market-equity indicate persistent poor earnings and low book-to-market-equity signals strong earnings.

Abarbanell and Brian (1997) Studying the relationship between fundamental factors and future earnings changes allows testing directly the validity of the economic intuition that underlies the original construction of the signals. In examining the links between the fundamental signals and future earning, Abarbanell and Brian (1997) develop the benchmark for assessing how efficiently investor used these fundamental variables in assessing the share price volatility. Based on the relationship between the fundamental signals and future earnings changes, there is an economic justification for the investors and analyst to rely on many, but not all, of the fundamental signals when evaluating future firm performance. In addition, some fundamental signals explain only long-term earnings growth, suggesting the possibility that they indicate both structural shifts and transitory profitability variation. The author showed that macroeconomic variables such as inflation and GDP as well as firm specific variables such as prior earning news and expected earnings growth of the company, state some of the relations between the fundamental signals and future earnings, revisions, and forecast errors.

Niederhoffer and Patrick (1972) in his study demonstrate that stock price are strongly dependent on the earning charges during the period of 1970-71 of the 1253 common stocks firms listed on the New York stock exchange. The common characteristics of the firms registering the best price changes in the stock included a forecast of moderately increase earning and a realized profit gain far in excess of analyst expectations. The worst performing stocks of the companies were characterized by serious earning declines, combines with unusually optimistic forecast. It is evident that an accurate earning forecast is of enormous value in the particular stock selection.

Schwert (1989) analyzes the relationship between stock price volatility with real and nominal macroeconomic volatility, economic activity, financial leverage, and stock trading activity using monthly data from 1857 to 1987. Estimates of the standard deviation of monthly stock returns vary from two to twenty percent per month during that period and find that there is weak evidence that macroeconomic volatility can help to predict stock price volatility while aggregate financial leverage is significantly correlated with volatility and effect stock price volatility.

“Security prices accurately reflect available information, and respond rapidly to new information as soon as it becomes available” Brealey A. Richard et al. () .The semi-strong form of efficient markets hypothesis claim that all publicly available information is incorporated in share prices. Studies showed that public announcements of earnings, dividends, bonus share etc. affect stock prices to immediately change to reflect the new information, therefore on the basis of fundamental analysis to predict the stock price would be ineffective.

Studies showed that dividend yield and payout ratio have impact on the share price volatility. Empirical results are consistent with the expectations that that increases in dividends lead to positive stock returns. Investors seeking high current income cash flows and limited capital growth prefer those firms with high Dividend payout ratio. However investors seeking capital growth may prefer lower dividend payout ratio because capital gains are taxed at a lower rate. High growth firms in early stage of their life generally have low or zero payout ratios, as they progress to towards maturity stage, they tend to pay back more of their earnings to the investors.

Allen and Veronica (1996) in his article performed cross-sectional regression analysis on the sample of 173 Australian listed companies for a period from 1972 to 1985 the relationship between stock price volatility and dividend policy, after controlling for firm size, leverage, growth and earnings volatility no evidence is found that dividend yield is associated with share price volatility. On the other hand, there is evidence of significant positive association between stock price volatility and leverage and earning volatility and a significant negative correlation with the payout ratio. It is also found that a significant positive correlation present between size of the firm and stock price volatility.

One of the important issues in financial economics is whether stock price volatility reflects market fundamentals. This issue has been widely discussed in the context of the variance bounds tests of the simple present value relation. Researchers have shown that share prices are too volatile to be compatible with subsequent dividends. It is important to identify and measure the deviation of share prices from fundamentals and the relative importance of various components of stock prices due to permanent and temporary changes in earnings and dividends, changes in discount factors, and non-fundamental factors. Lee bong-Soo (1998) has found that, although the long-term trend in stock prices volatility is due to the permanent changes in fundamental factors, the short-term stock price volatility is largely due to the discount factor changes reflected in excess stock return changes and partly due to non-fundamental factors. The author find that half of the yearly variation in stock prices is not related to either earning or dividend changes. Interest rates varying with the time do not explain the remaining stock price movements. However, risk premiums in the interest rates due to greater time horizon provide excess stock returns and account for much in the remaining variation of stock prices.

The study of Leledakis and Ian (2001) to examine the relations between the fundamental variables and future stock returns and the data obtained by the author from July 1980 through June 1996 and the monthly returns were taken from the London Share Price data base and all other variables from DataStream International. This article examine the four variables that is Market Value of Equity, book value of equity to market value of equity, sales to price ratio and debt to equity ratio and cross sectional regression were performed to measure the returns premium associated with the company variables. The result indicates that sales to price ratio and debt to equity ratio do not entirely absorb the roles of book value of equity to market value of equity and market value of equity in explaining the cross section of average stock return in the U.K. market and sales to price ratio has significant power beyond the contribution of book value of equity to market value of equity and market value of equity.

The study of Baur et al (1996) tests the broadly held proposition that investor sentiment contributed to the stock market crash of 1987. The 508-point fall in the Dow Jones Industrial Average (DJIA) on Monday, 19 October 1987, is mentioned as evidence that stock markets do not efficiently digest information and reflect these information flows in security prices. Using weekly data during the period of September 1986 to November 1988 and traditional measures of stock fundamentals, changes in fundamentals are found to have a statistically significant influence on the of stock prices movements.

The study was conducted by summers (1986) to examine the power of statistical tests commonly used to assess the efficiency of speculative markets. The evidence found in many studies that the hypothesis of efficiency market cannot be rejected should not lead to conclude that stock prices represents rational assessments of fundamental valuations and it is showed these standard methods have very low power against certain type of market inefficiency. Market valuations of securities can differ substantially and persistently from the rational expectation of the investor of the present value of cash flows.

Many investors prefer to evaluate the value of stocks using the price earning ratio. The reasoning for this approach recalls the concept that the value of any investment is the present value of future cash flows and returns.

The market price to book value ratio has been widely used by analysts and investor as a measure for the stock price relative value. The study of Fama and French (1992) that indicated a significant inverse relationship between the market price to book value ratio and excess rated of return for the stocks. Barbee et al (1996) demonstrated in his study during the1 979-91 period, the sales price ratio and the debt-equity ratio had greater explanatory power for stock returns than the book-market value of equity ratio and the market value of equity. Furthermore, the sales-price ratio confines the role of the debt-equity ratio in explaining stock returns. The book-market value of equity ratio and the market value of equity have not consistent explanatory power for stock returns, and the sales-price ratio which is the only variable that consistently has a significant role in explaining stock returns in the model.

Lee (2006) employed two types of aggregate index data: annual Dow Jones industrial average (DJIA) index data for the sample period includes1920-1999, and annual Standard and Poor's (S&P) 400 industrial index data for the sample period covering 1946-99. The study reveals that the potential investors overreact to non fundamental information but under react initially to fundamental information like dividend payout, book value of company shares and earning with no significant reversal association with fundamental information in the long run.

Docking and Koch (2005) in their study to evaluate investor reaction to dividend increase or decrease shows that dividend change announcements reveal a greater change in stock price when the nature of the news good or bed goes against the grain of the recent market direction during volatile times. First, announcements to increase the dividends tend to reveal a greater increase in stock price when market returns have been normal or down and more volatile. However, this tendency lacks statistical significance. Second, announcements to decrease the dividends reveal a significantly greater decrease in stock price when the market returns have been up and more volatile.

External factors or macroeconomic factors also affect stock price volatility like gross domestic product, consumer prices, money supply, interest rate, and oil prices are the most important external factors. The empirical study undertaken by Ralph and Eriki (2001) on the Nigerian Stock Market examining the relation between the stock prices and inflation provides a strong support for the proposition that inflation provides a significant negative influence on the behavior of the stock prices volatility.

Moreover, the study shows that stock prices are also strongly determine by the level of economic activity measured by GDP, interest rate, money supply, and financial deregulation. On the other hand, the findings of the study reveal that oil price volatility has no significant effect on stock prices.

Chaudhuri and Smiles (2004) examine the long run relationship between stock prices movements and changes in real macroeconomic activity in the Australian stock market in the period from 1960 to 1998. The real macroeconomic factors include real GDP, real money, real private consumption, and real oil price. The results of their study reveal that long run relationships between stock prices and real macroeconomic activity. The study also finds that the foreign stock markets such as the American and New Zealand market significantly affect the Australian stock return movement.

In order to evaluate the informational efficiency of the Malaysian stock market, Ibrahim (1999) investigates the dynamic interaction between stock prices movements and seven macroeconomic variables covering the period from 1977 to 1996. The author employs cointegration and the Granger causality test. The macroeconomic variables comprise the industrial production, consumer prices, M1, M2, credit aggregates, foreign reserves and exchange rates. The outcomes strongly suggest that informational inefficiency of the Malaysian market. In other words, there is cointegration between the stock prices and these macroeconomic factors. The study demonstrates that stock price volatility anticipate variation in the industrial production, money supply, and the exchange rate while they react to the deviations from long run path of consumer prices, credit aggregates, and foreign reserves.

In a related study Ackert and William (2001) examines the relationship between stock price and cash dividends and showed that the observed relationship between aggregate stock price and dividends may be explained by how managers choose dividend payout using the model of Standard and Poor's stock price and dividend index series for the 1900-1998 time period. The model recognizes that the cash dividends might not properly represent intrinsic value of stocks therefore estimation of the model does not require measurement of fundamentals. The estimates provide support for the dividend management model and indicate that the nonlinear relationship between stock prices movements and dividends may be explained by managerial behavior. Ayers et al (2002) investigated the effect of an increase in the individual share-holder income tax rate on share values and the authors regress cumulative daily abnormal stock returns surrounding the passage of the Revenue Reconciliation Act of 1993 on firm dividend yield, tax status of the investor as represented by level of institutional ownership, the interaction of these two variables, and control variables. Consistent with the author expectations, found that the higher the firm's dividend yield, the more negative the firm's stock price reaction to the increase in the individual income tax rate (dividend tax rate) endorse in the Revenue Reconciliation Act of 1993. The results indicate that both the dividend policy of the firm and the tax status of the investor influence the extent to which dividend taxes are reflected in stock values.

In a related study Loderer et al (1991) the price elasticity of demand for the common stock of an individual corporation. Te author investigate the changes in the price of common stock experienced by firms that announce a common stock offering. According to the results the issue announcement by a firm causes a price decline that cannot be explicate by a simultaneous release of adverse information about firm value or about future cash. . Consistent with the notion of finite price elasticity, we find that the announcement of primary stock offerings by regulated firms declines their stock prices and little if any evidence that this decline is the result of adverse information about future cash flows. The author Attempts to associate offer announcement effects directly to possible determinants of price volatility are inconclusive.

Karachi stock exchange is a significant growing capital market of the region, among the developing countries. Karachi Stock Exchange is the leading and most liquid exchange in Pakistan over the decade and was declared the “Best Performing Stock Market of the World for the year 2002. The Karachi Stock Exchange operates the KSE-100 Index. It is a highly-diversified index of 100 largest capitalization companies' stocks from all the segment of Pakistan economy. The principal objective of the KSE100 index is to have a benchmark by which the share price performance of the companies listed in the stock exchange can be compared to over a period of time. In particular, the KSE 100 is designed to give the investors with a meaning of how the Pakistan equity market is performing. Thus, the KSE100 is parallel to other indicators that pursue various segments of the Pakistan economic activity such as the gross national product, consumer price index, etc. Karachi stock exchange known as high risk return market where investors take the high risk premium. The objective of this research is to investigate and study the effect of fundamental variables on the changes in share price jointly and individually as well in the Pakistani market and to investigate that fundamental factors are significantly related to changes in the share price as evidence in US and Japanese market


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