prediction of stock return on pakistan tobacco company

7/30/2019 PREDICTION OF STOCK RETURN ON PAKISTAN TOBACCO COMPANY

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PREDICTION OF STOCK RETURN ON

PAKISTAN TOBACCO COMPANY

Hashim AliMBA (Finance)

INSTITUTE OF MANAGEMENT SCIENCESSession: 2007 2009


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Research

report submitted to the institute of Management

Sciences in partial fulfillment of the requirements for the

DEGREE OF MASTER OF BUSINESS ADMINISTRATION (FINANCE)


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INSTITUTE OF MANAGEMENT SCIENCESMARCH, 2009

ii


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SUPERVISOR

Signature: __________________________

Name: MISS RABIA NAWAZ

Designation: Lecturer

Organization: Institute of Management Sciences

COORDINATOR RESEARCH & DEVELOPMENT DIVISION:

Signature: ____________________________

Name: SIR. SHAHID ALI

Designation Coordinator R & DD

Organization: Institute of Management Sciences


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Chapter 1Chapter 1 INTRODUCTIONINTRODUCTION

PREFACE

Life is like a moving train, which is in action every time, any one who is leftbehind in this race means he is lost forever with no chance of redoing.

Accelerating our steps with the time is todays requirement. Learning the

modern and specific skills with keeping pace with the time is the key to

success.

Well thesis is must in getting MBA degree, so accomplishment of research

report is must. I think it is done to unlock whatever we have learnt in our

academic years and to unleash our hidden abilities. But I think research needs

a lot of time, thinking ability and proper guidance which I think is not

available every where.

Well I have chosen and worked on this project which is prediction of stock

return on Pakistan Tobacco Company is to give an insight and helps them in

decision making whether to invest in PTC or not for the year 2008.the major

objective and work of this project was done on calculating the predicting ratios

i.e. price to earning, book to market and dividend yield and on the basis of

these ratios with help of regression model prediction of next year return was

done.

Hashim Ali

MBA (Finance)

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ACKNOWLEDGEMENTS

All praises are attributed to the sole creator of the universe The AlmightyAllah The Compassionate, The Merciful, The Source of all Knowledge and

Wisdom.

For this research study, I would like to mention the persons without whom it

could not have come up into its present shape.

First of all, I am really very grateful to my parents. Then a deep measure of

gratitude is expressed to my research supervisor Miss Rabbia Nawaz,Lecturer, Institute of Management Sciences, Hayatabad Peshawar. Her

guidance, continuous help and encouragement she gave me at all stages of my

research study helped me learn through the course of this research dissertation.

I am also thankful to Sir Attaullah for his guidance without his support I will

not be able to accomplish my report.

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TABLE OF CONTENTS

S. No Title Page No

Preface iAcknowledgement iiList of Tables vList of Graphs vList of Abbreviations viExecutive Summary viiCHAPTER 1 INTRODUCTION TO REPORT

1.1 Background of The Study 11.2 Purpose of The Study 11.3 Scope of The Study 11.4 Methodology of study 11.5 Scheme of the report 2

CHAPTER 2 LITERATURE REVIEW

Literature Review 32.1 Stock return theoretical background 62.1.1 Markowitz Portfolio selection 62.1.2 Capital asset pricing Model 72.1.3 Arbitrage pricing theory 92.1.4 Intemporal Capital asset pricing model 102.1.5 Consumption oriented capital asset pricing model 112.2 Early empirical work 12

2.2.1 Price/ Earning 122.2.2 Firm size 122.2.3 Long term return reversals 132.2.4 Book to market equity 132.2.5 Momentum 132.2.6 Leverage 14

2.3 Turning point 142.4 Data mining 15

2.4.1 Beta estimation 162.5 The response 162.6 The explanation 17

2.7 Conclusion 19CHAPTER 3 PAKISTAN TOBACCO COMPANY

3.1 Introduction 203.2 History of Pakistan Tobacco Company 22

3.2.1 British American Tobacco 223.2.2 Pakistan Tobacco Company (Akhora Khattak Factory) 23

3.3 Pakistan Tobacco company Review 243.4 PTC Brands 253.5 Organizational Structure 26

CHAPTER 4 INTRODUCTION TO FINANCIAL

RATIOS

4.1 Stock Predicating Ratios 304.1.1 Dividend Yield 30

S. No Title Page No

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4.1.2 Price to Earning ratio 304.1.3 Book To Market Ratio 30

CHAPTER 5

RATIOS ANALYSIS5.1 Calculation of Price to Earning Raito 325.2 Calculation of Divided Yield 335.3 Book to Market Ratio Calculation 345.4 Ratios calculation of Pakistan Tobacco Company (Summary) 355.5 Prediction with Regression Model 365.6 Explanation of Model 38

6.5.1 Calculating return for 2008 385.7 Explanation of Model 40

5.7.1 Calculating return for 2008 405.8 Explanation of Model 42

5.8.1 Calculating return for 2008 42CHAPTER 6 FINDING, CONCLUSION AND

RECOMMENDATIONS

6.1 Finding 446.2 Conclusion 456.3 Recommendations 46

References 47

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LIST OF TABLES

S. No Tables Page No

5.1 Calculation regression model on the basis of P/E for the next yearreturn

37

5.2 Calculation regression model on the basis of B/M for the nextyear return

39

5.3 Calculation regression model on the basis of DY for the next yearreturn

41

LIST OF GRAPHS

S. No Graphs Page No

2.1 Efficient portfolio Frontier 72.2 Security Market Line 82.3 Capital Market Line 82.4 Risk and Return 145.1 Calculation of Price to Earning Ratio 325.2 Calculation of Dividend Yield 335.3 Book to Market Ratio Calculation 355.4 Return Calculated on the Basis of P/E 435.5 Return Calculated on the Basis of B/M 435.6 Return Calculated on the Basis of DY 43

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LIST OF ABBREVIATIONS

PTC Pakistan Tobacco company

LTC Lakson Tobacco company

BAT British American Tobacco

P/E Price To Earning Ratio

DY Dividend Yield

B/M Book to Market Ratio

CAPM Capital Asset Pricing Model

WHO World Health Organizations

ISO International Standard Organization

PMI Philip Morris International

BVPS Book Value Per Share

GNP Gross National Product

CBA Collaborative Agent

HRD Human Resources Department

GDP Gross Domestic Product

RRR Required Rate of Return

SMB Small Mince Big

HML High Mince Low

CML Capital Market Line

SML Security Market Line

APT Arbitrage Pricing Theory

EPS Earning Per Share

DPS Dividend Per Share

X Mean(x bar)

Summation

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EXECUTIVE SUMMARY

The main objective of this report study is to give an insight and knowledge to

investors about Pakistan Tobacco Companys prospect and help them in

decision making whether to invest in it or not for the year 2008.the sources of

this report from where I gather data and other materials to accomplish my

report are from different websites, research papers, finance literatures,

newspapers (business pages) reference books (related to finance) and annual

reports of Pakistan tobacco company (2003 to 2007).

This report gives description about the stock predicting ratios i.e. price to

earning ratio, dividend yield and book to market ratio. The objective of this

report is to check and find the predictive or forecasting ability of these three

ratios (P/E, B/M and DY) and then to predict future stock returns of Pakistan

Tobacco Company with the help of fitted regression model.

Basically Pakistan tobacco company established in 1902 under the name of

British American tobacco company to end war between uks imperial tobacco

company and American tobacco company but its operations in Pakistan starts

in 1947 as a 1st foreign investment company. By contributing some 28 billion

rupees per years to government income, Pakistan Tobacco Company has

become a dependable source of income for government of Pakistan. This

amount is equal to 4.5% of Pakistans GDP. This translates in the full time

equivalent of 312,500 jobs supporting approximately 1.2 million people.

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CHAPTER 1

INTRODUCTION TO REPORT

1.1 BACKGROUND OF THE STUDY

The main idea of the report revolves around the Fama and French, Cambell

and Sheller predicting stock return. Pakistan Tobacco Company is the

cigarette manufacturing company. Basically Pakistan tobacco company

established in 1902 under the name of British American tobacco company to

end war between UKs imperial tobacco company and American tobaccocompany but its operations in Pakistan starts in 1947 as a 1st foreign

investment company.

The study is to predict stock return of Pakistan Tobacco Company in order to

predict FY 2008 returns to give an investor an idea either to invest in Pakistan

Tobacco Company or not for the year 2008. The sample period for this study

is from 2003-2007 for 5 years. Three ratios will be used to predict stock

returns i.e. price to earning ratio, dividend yield and book to market ratio.

1.2 PURPOSE OF THE STUDY

The study is done to predict the stock returns of PTC with the help of Price to

Earning ratio, Dividend yield and Book to Market ratio.

1.3 SCOPE OF THE STUDY

The scope of the study is limited to the prediction of return on PTC shares and

I will give description about the Pakistan Tobacco Company, Tobacco

industry, stock predicting ratios and analysis and findings.

1.4 METHODOLOGY OF STUDY

The data collected based on secondary data.

Secondary data sources

Internet

Magazine

Newspapers

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Books

1.5 SCHEME OF THE REPORT

The scheme of the report consist of

1.5.1 Chapter No. 1 which includes background, purpose, scope,

methodology, and scheme of the report.

1.5.2 Chapter No.2 contains Literature review and Theoretical Background

of the study

1.5.3 Chapter No. 3 contains introduction of the Tobacco Company, history

of the Pakistan tobacco company, organizational structure of the

Pakistan tobacco company.

1.5.4 Chapter No. 4 contains introduction of the financial ratios.

1.5.5 Chapter No. 5 contains Ratio Analysis.

1.5.6 Chapter No. 6 consists of finding, conclusions and recommendations

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Chapter 2Chapter 2 LITERATURE REVIEWLITERATURE REVIEW

CHAPTER 2

LITERATURE REVIEW

Kendall 50 years back observed that stock prices vary time to time. Kendall

tested that price change can be predicted with the help of past returns and later

on predicted some variables, which are price to earning ratio, dividend yield

and book to market value ratios. These three ratios have some common

features i.e. each of them measures price relative to fundamental because in

the above three ratios price comes in denominators, so the ratios should be

positively related to expected return and this is due to the reason that if prices

goes up, expected return will be lower but if prices goes down, expected returnwill go up and all the three ratios should be directly or positively related to

expected returns.

Two theories regarding ratios, one is Mis-pricing theory, which says that the

ratio will be low when stocks are overpriced; they predict low future returns as

prices return to fundamentals. The other theory is of rational pricing which

says that the ratio track time variation in discount variations i.e. the ratio will

be low when discounts are low and high when discounts rate are high, due to

information available about the risk premium prediction of return is possible.

These ratios (D/Y, B/M and P/E) also have similar time series properties, at a

monthly frequency. These ratios have auto-correlation near 1 and most of the

movements are caused by price changes in denominators.

From the last 20 years, we can see that stock returns are predictable. At the

aggregate level, Fama and Schwart (1977) Keim, Stamburgh (1886), Fama

and French (1989), and Kothary and Shaken (1997) show that the interest

rates, the yield between high and low grade debt, aggregate dividend yield and

aggregate book to market predict time variation in expected returns.

Leroy and porter and Sheller (1981) argue that the volatility of stock prices is

too high to be explained by a model constant discount rates, which provides

indirect evidence that expected returns change overtime but Fama and French

(1992) said that the size and book to market together explain much of the cross

sectional variation in average returns.

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Jegadesh and Titamen (1993) showed that the past returns contain additional

information about expected returns.

The interpretation of how to predict is more debatable. The empirical patterns

in return are potentially consistent with either market efficiency or irrational

pricing,

In general term, market efficiency refers prices that fully reflect all available

information.

Fama (1976) distinguishes between the probability distribution of returns

perceived by the market based on whatever information investors view as

relevant and the true distribution of returns conditional on all information. If

the distribution is same we can say that market is informational efficient,

market efficiency implies that investors correctly anticipate any cross sectional

or time variation in true expected returns. While Famas definition ignores

important issues like heterogeneous belief, it provides a useful framework for

thinking about a broad set of asset pricing questions.

B/M value explains cross sectional variation in expected returns. The insight is

that the book value in numerator controls the size of the firm i.e. (the firm

expected cash flows) while M/V which comes in denominator gives us

information about discount rates.

Recent events in the stock market have reawakened interest in an old question:

are P/E ratios of any use in predicting subsequent returns? By mid 1990, years

of large increase in stock prices had lifted the markets average P/E well above20 which is very high by historical standard. Nevertheless prices continued to

raise giving investors the returns of over 20% each year between 1996 and

1999. However with the start of new century came a bursting of this bubble.

Beginning in March 2000, NASDAQ lost 70% of its value in a period of one

year. This decline seems to prove right those who believe that high P/E ratios

lead to lower returns. Still one is left with wonder that what is the historic

relationship between P/E ratios and its subsequent returns?In theory, market prices must ultimately maintain a relationship with earnings;

prices cannot drift away indefinitely from earnings. Whenever stock prices

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rises very rapidly without any sharp increase in earnings, concerns are raised

whether the market is over valued and is ready for correction.

Consider the period between 1994 and 1999; the Dow Jones industrial average

increase by the value of over 200%, while the corporate profit rose during the

same period by less than 60%. As P/E ratios rose to the unprecedented high

level, the monitory authorities warned us of irrational exuberance. So in

theory one would expect that in the long run high P/E ratios cannot be

sustained. If this is true, as prices revert to their equilibrium levels, we would

expect more price decline or modest price increases.

Thus when P/E ratios tend to be high, returns will be low.

A number of studies have examined the predictability of future returns using

different valuation models (ratios) for example (P/E, dividend yield, B/M).

Their findings tend to suggest that future average returns are indeed partially

predictable over longer investment horizons. Fama & French (1989) for

instance, shows the dividend yield at the beginning of the period predicts a

significant portion (R2=25%) of four year returns. However the explanatory

power declines and is not significant over short period of time (R2 less than

5% for subsequent monthly, quarterly or one year returns). Fama and French

conclude that DY and P/E ratios cant be used for prediction of one year return

but that they are useful for the prediction of four year return.

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Fama & French (1995) provide support for the risk hypothesis by showing that

there are size and value factors in earning as well as returns. This

suggests that systematic variation in firms cash flow streams may be

associated with systematic variation in stock returns.

Also Fama & French (1996) show that the three factor model can explain most

of the departure from the CAPM prediction discussed in the recent

financial literature included the two way sorts of the Lakonishok,

Shliefer and vishny (1994). However the three factors model could not

explain the short-term momentum in stock prices. The ability of the

three-factor model to explain most of the observed cross sectional

empirical results supports a multi-factor risk model of expected returns

still it is not clear why the three-factor model cant explain momentum.

Liew and Vassalou (2000) support the risk based story by showing that SMB

and HML are able to predict future GDP growth in some countries

however the relation between these variables and GDP growth is weak

in several countries and is not existence in the US for the 1957-1998

period.

More recently, Campbell & Sheller also find similar results by using these

valuation ratios. For example dividend yield, significantly explained

average returns over longer time period but were poor predictors in the

short run in addition they found out that P/E is good tool for prediction

of stock return than dividend yield

Furthermore Cale, Helwege, and Laster (1996) found that even in adjusting for

share repurchases and changes in accounting rules, the standard

valuation ratios provide some degree of evidence in predicting of

future long-term returns.

2.1 STOCK RETURNS THE THEORETICAL

BACKGROUND2.1.1 Markowitiz Portfolio Selection

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The discussion of stock price behavior starts with Markowitiz (1952-1959).

The Markowitiz model is for single period; in this case investors form a

portfolio at the beginning of the period.

The main theme of investor is to maximize the expected returns {E(R), is the

main value of probability distribution of possible returns}, subject to an

acceptable level of risk (or minimize risk, subject to an acceptable excepted

return). The assumption of both single period and about investors attitude

toward risk allows risk to be measure by variance (which measure the

dispersion of return distribution, it is the sum of squares of a return deviation

from mean divide by n) or standard deviation (which is the statistical measure

of the degree to which an individual value in a probability distribution tends to

vary from mean of distribution) of the portfolios return.

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Efficient Protfolio Fronti

0.045, 300.036, 30

0.029, 290.0234, 29

0.0196, 280.0176, 280.0174, 28

0.019, 270.022, 27

0.027, 260.034, 26

26%

26%

27%

27%

28%

28%

29%

29%

30%

30%

31%

0 0.01 0.02 0.03 0.04 0.05Portfolio Ris

Portfolio

Return

Efficient Protfolio Fronti


GRAPH 2.1

The figure shows that the investor is trying to go as far North West as possible

As the securities are added to the portfolio the expected return and the

standard deviation change in which the added securities co-vary with other

securities in the portfolio. The investors always wants to further move towards

northwest which is the upper half of the hyperbola as shown in the above

figure, this curve is known as efficient frontier. According to Markowitiz

model investor select the portfolio along the curve according to their tolerance

for risk.

An investor who wants to live with a lot of risk should go for portfolio A,

while a more risk averse investor would be more likely to choose portfolio B

2.1.2 Capital Asset Pricing Model

William Sharpe in 1964, Litner in 1965 and Mossin in 1966 independently

developed capital assets pricing Model (CAPM). This model assumes that

investor use the logic of Markowitiz in forming portfolios. This theory posits a

liner relationship between an assets risk and its required rate of return. This

linear relationship is called Security market line (SML).

SML depicts the relationship between risk (beta) and expected rate of return.

Beta is plotted on the X axis and return is plotted on Y axis. A security having

higher actual return than the RRR will be above SML and considered under-

priced.

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GRAPH 2.2

0.01 0.02 0.03 0.04 0.05 0.06BETA(Risk)

0.7

0.6

0.5

0.4

0.3

0.2

0.1

Return

Under priced

Over priced

SML

GRAPH 2.3

0.01 0.02 0.03 0.04 0.05 0.06BETA(Risk)

0.7

0.6

0.5

0.4

0.3

0.2

0.1

Return

M

The straight line in the figure 2.3 which shows the risk free rate as its

interceptor and is tangent to efficient frontier, is now the northwest boundary

of the investment opportunity set, investor will choose portfolio along this line

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i.e. (capital market line) which shows combination of the risk free asset and

the risk portfolio M. In order for market to be in equilibrium i.e. (quantity

supplied = quantity demanded) the portfolio M must be market portfolio and

the risk free asset and only risk that investor are paid for bearing is the risk

associated with market portfolio, which lead to CAPM equation

CAPM

E (Rj) = Rf +j [E(Rm)-Rf]

E(Rj) and E(Rm) are expected returns to asset j and the market portfolio

respectively, Rf is the risk free rate, and j is the beta, is the coefficient for

asset j. j measure the tendency of asset j to co-vary with the market portfolio

it represent the part of the asset's risks that can't be diversified away and this is

the risk that investor are compensated for bearing.

The CAPM equation says that the expected return of any risk asset is a linear

function of its tendency to co-vary with the market portfolio. So, if the CAPM

is in accurate description of the way asset are priced, this positive linear

relation should be observed when average portfolio returns are compared to

portfolio betas. When beta is included is in explanatory variable, no other

variable should be able to explain cross-sectional differences in average

returns. Beta should be all that maters in a CAPM world

2.1.3 Arbitrage Pricing Theory

The CAPM is a simple model that is based on sound reasoning; some of the

assumption that underlies the model is unrealistic. Some extensions of the

basic CAPM were proposed that relaxed one or more of these assumption

(e.g., black, 1972).

Ross in (1976) doesnt extend an existing theory but he addresses this concern

by developing a completely different model i.e. the arbitrage pricing theory

(APT).

Unlike the CAPM, this is a model of financial market equilibrium, the APT

start with the initiative that arbitrage opportunities should not be present in

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efficient financial market. This assumption is much less restrictive than those

required to derive the CAPM.

The APT starts by assuming that there are n factors which cause asset return to

systematically deviate from their expected values. The theory does not specify

how large the number n is, nor does it identify the factors it simply assumes

that these n factors cause return to vary together. There may be other, firm-

specific reason for returns to differ from their expected values but these firm-

specific deviations are not related across stock. Since the firm-specific

deviations are not related to one another, all return variations are not related to

the n common factors can be diversified away. Based on these assumption

Ross shows that in order to prevent arbitrage, an assets expected return must

be a linear function of its sensitivity to the n common factors

APT

E(Rj) =Rf+ jll + j2++jnn

E(Rj) and Rf are defined as before. Each j coefficient represent the

sensitivity of asset j to risk factor k and represent the risk premium for

factor k. As with CAPM, we have an expression for expected return that is a

linear function of the assets sensitivity to systematic risk. Under the

assumptions of APT, there are n sources of systematic risk, where there is only

one in a CAPM world

2.1.4 Intertemporal Capital Asset Pricing Model

Both the CAPM and the APT are static or single period models. They ignore

the multi-period nature of participation in the capital markets. Mertons(1973) intertemporal capital asset pricing model (ICAPM) was developed to

capture the multi period aspect of financial market equilibrium. The ICAPM

framework recognizes that the investment opportunity set (i.e. might shift over

time, and investors would like to hedge themselves against unfavorable shifts

in the set of available investments). If a particular security tends to have high

returns when bad things happen to the investment opportunity set, investors

would want to hold this security as a hedge. This increased demand would

result in a higher equilibrium price for the security (all else constant). One of

the main insights of the ICAPM is the need to reflect this hedging demand in

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the asset pricing equation.

The resulting model is;

ICAPM

E(Rj) = Rf + j + j2 +...+ jnn

Note that the form of the ICAPM is very similar to that of the APT. There are

slight differences, however. The first factor of the ICAPM is explicitly

identified as being related to the market portfolio. Further, while the APT

gives little guidance as to the number and nature of factors, the factors that

appear in the ICAPM are those that satisfy the following conditions;

1. They describe the evolution of the investment opportunity set over time.

2. Investors care enough about them to hedge their effects.

If there might be a priced factor for unexpected changes in the real interest rate

such a change would certainly shift the investment opportunity set (e.g. the

intercept of the line in the figure 2.3 would move) and the effect would be

pervasive enough that investors would want to protect themselves from the

negative consequences. We still don't know exactly how many factors there

are but the ICAPM at least gives us some guidance.

2.1.5 Consumption-Oriented Capital Asset Pricing Model

The consumption based model of Breedon (1979) provides a logical extension

of the previous work in asset pricing. His model is based on intuition that an

extra dollar of consumption is worth more to a consumer than when the level

of aggregate consumption is low. When things are going smooth people canafford a comfortable way of living so dollar consumption cant make us feel

better off, but in hard times a few dollar consumption on goods is very much

welcomed.

Based on this diminishing marginal utility consumption security that have

higher returns will attract investors when aggregate consumption is low,

hiking their prices and lowering their expected return. In contrast, stocks that

co vary positively with aggregate consumption will require higher expected

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returns since they provide high returns during states of the economy where

high returns do the least good.

Based on this line of reasoning, Breedon derives a consumption based capital

asset pricing model of the form:

CCAPM

E(Rj) = Rf + jc [E(Rm) - Rf]

In this model, jc measure the sensitivity of the return of asset j to changes in

aggregate consumption, jc is referred to as the consumption beta of asset j.

2.2 EARLY EMPIRICAL WORK

Early cross sectional studies of stock return (e.g. Nicholson, 1960) did not

receive much importance due to small samples used to conduct the empirical

tests, but then computed databases become available and research could

construct large samples to produce reliable results consequently for a few

years. After the development of CAPM there was no reliable way to test the

model prediction against variables like book to market or priced to earning.

2.2.1 Price /Earning

Basu (1977) early studied the prediction of CAPM; Basu showed that stocks

with high Earning/Price ratio (or low P/E ratio) earned significantly higher

return than stock with low P/E ratio, his result indicate that difference in beta

could not explain these return differences. In follow up study in1983 by Basu

showed that this P/E effect is not just observed among small cap stocks.

A later study by Jaffee, Keim and Westerfield in 1989 confirmed this finding

and also showed that P/E effect does not just appear in month of January as

claimed by researchers. The P/E is the direct contradiction of the CAPM; beta

should be all that matters.

2.2.2 Firm Size

Banz (1981) uncovered another apparent contradiction of the CAPM by

showing that the stock of the firms with low market capitalization (the value

of a company as determine by the market price of its issues and outstanding

common stock. It is calculated as the product of market price and sharesoutstanding) have higher average returns than large cap stocks. Basu says that

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the size effect is distinct

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

controlling for P/E proponent of the CAPM are quick to point out the small

firm, tend to have higher betas than large firms, so we could expect to see

higher average returns for small firms. However the beta differences are not

large enough to explain the observed return differences. Once again the

CAPM predictions are violated.

2.2.3 Long Term Return Reversals

Debondt and Thaler (1985) identified "losers as stocks that had poor returns

over the past three to five years. "Winners are those stocks that had high

returns over a similar period. The main result of Debondt and Thaler is that

losses have much higher average returns than winners over the next three to

five years. Chopra, Lakonishok and Ritter in1992 show that beta can't account

for this difference in average returns. This tendency of returns to reverse over

long horizons (i.e. Losers become winners) is yet another contradiction of the

CAPM. Losers would have to have much higher betas than winners in order to

justify the return difference. Chopra, Lakonishok and Ritter in1992 showed

that the beta difference required to save the CAPM is not there.

2.2.4 Book-To-Market Equity

Rosenberg, Reid and Lanstein (1985) provided yet another evidence against

the CAPM by showing that stocks with high ratio of book value of common

equity to market value of common equity (also known as book-to-market

equity, or B/M) have significantly higher return than stocks with low B/M (thereasons might be bad management or risky operations or liquidity problems

facing the company). Since the sample period for this study is fairly short i.e.

from 1973 to 1984, the empirical results did not receive as much attention as

some of the other studies discussed above. However, when Chan, Hamao and

Lakonishok in 1991 found similar return in the Japanese market, B/M began to

receive attention as a variable that could produce dispersion in average returns.

2.2.5 Momentum

Jegadeesh (1990) found that stock return tend to exhibit short-term

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momentum, momentum means that if a stock performs well or worse, it will

continue for some time period to perform well or worse. Research has

uncovered an intermediate (3 to12 months) momentum in U.S. stocks. This

suggests that strong or weak industry performance is followed by strong or

weak performance over a period of time.

2.2.6 Leverage

Bhandari in 1988 found that firms with high leverage i.e. (high debt to equity

ratio) have higher average returns as compared to low leverage firms due to

high riskiness attached with the debt which is another deviation from CAPM

prediction

2.3 TURNING POINT

In 1992, an influential paper was published that pulled together much of the

earlier empirical work.

Fama and French in 1992 brought together size, leverage, P/E, B/M and beta

in a single cross-sectional study. Their results were controversial. First, they

showed that the previously documented positive relation between beta and

average return was an artifact of the negative correlation between firm size

and beta. When this correlation is accounted for, the relation between beta and

return disappears. Below figure show these results,

GRAPH 2.4

0.01 0.02 0.03 0.04 0.05 0.06BETA

0.7

0.6

0.5

0.4

0.3

0.2

0.1

Return

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Figure 2.4 plots beta and average returns for 8 portfolios formed by ranking

stocks on firm size, the positive relation between return and beta is highly

linear as predict by the CAPM. Based on this evidence it appear that the

CAPM nicely explain the higher return that small firms have earned

Given that beta does a poor job of explaining average return, what variable can

do a better job? This is the second main point of the Fama & French study.

They compared the explanatory power of size leverage, P/E, B/M and beta in

cross sectional regression that spend the 1963 to 1990 period that B/M and

size are variables that have the strongest relation to returns.

The explanatory power of the other variables when these two variables are

included in regression, the cross-sectional of average stock returns can be

nicely described by two variables.

The Fama & French (1992) result dealt a severe blow to the view that the

single period CAPM is the way securities are actually priced the model that

has been taught more than any other in business school does not seem to work

2.4 DATA MINING

If an academic paper is judged by the amount of dissolution that it generates,

then Fama & French (1992) was an unparallel success, the reaction was not

timid. One of the first replies was from Black in 1993, who suggested that the

Fama & French results were likely an artifact of data mining. Hundreds ofresearchers in an attempt to write publishable papers spend a great deal of time

looking for relationships between stocks returns and other variables. Only the

successful tests are submitted for publication. The unsuccessful ones never see

the light of the day. A few variables are bound to show a statistical relation to

returns, just by chance, since Fama & French choose there explanatory

variables based on the result of earlier empirical studies, the observed

explanatory power of these variables could be due to a massive data mining

exercise on the part of the authors of these earlier studies. Based on this, Black

contended that some of the statistical tests in Fama & French (1992) were not

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properly specified. He also suggested that, since the relation between returns

and size, B/M, etc were likely an artifact of data mining; they would disappear

if another time period or another data source were analyzed. MacKinlay in

1995 also mentioned data mining as a potential cause of the observed results.

Another criticism of the Fama & French results came from Kothari, Shanken

and Sloan in 1995. Their attack proceeded along two main fronts; survivorship

bias and beta mis-measurement.

2.4.1 Beta Estimation

The other main criticism of Fama & French (1992) put forth by Kothari,

Shanken and Sloan (1995) is related to the estimation of beta. Levhari &Levy

in (1977) showed that beta coefficients estimated with monthly returns are not

the same as betas estimated with annul returns. Since they are different, the

result of empirical study will depend upon which beta estimation convention is

used. Kothari, Shanken and Sloan argue that annual betas are more suitable

than monthly betas since the investment horizon for a typical investor is

probably closer to a year than a month. They show that the relation between

beta and return is stronger when betas are estimated using annual returns.Based on the data mining, selection bias, and beta estimation, criticisms of

Fama & French 1992, many researchers in the early to mid 1990s believed that

the explanatory power of B/M should not be taken seriously. A number of

authors argued that the CAPM was still the best model of expected returns,

claiming that the empirical results contradicting the CAPM are unreliable

2.5 THE RESPONSE

One of the early responses to the criticisms of Fama &French (1992) was

Dawis in 1994, who constructed a database of book values for large US

industrial firms for the 1940-1963 period, a period for which the Computed

coverage is either poor or non existent? This database was constructed to be

free of survivorship bias, and it covers a period that proceeds the period

studied by Fama and French. If the Fama & French results are a result of data

mining, this independent time period should produce different results. A

spurious relation in one period is not likely to carry over to a different period.

Also the beta coefficients in this study were estimated using annual returns to

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address one of Kothari, Shanken and Sloans (1995) main criticisms.

The results of Dawis in 1994 generally confirmed those of Fama & French

(1992), the explanatory power of B/M was observed in the 1940-1963 period

although the magnitude of the return dispersion was somewhat smaller. This is

probably caused by the fact that the database for the pre-Computed period

contain only large firms, in addition the relation between beta average return

was flat betas based on annual returns could not improve the CAPMs

performance during the 1940-1963 period.

Chan, Jaggedness and Lakonish in 1995 provide further evidence that the

Fama & French results were not due to survivorship bias. Examining the

1968-1991 period they found that when the firms on CRSP and computer were

properly matched, there were not enough firms missing from computer to have

a significant effect on the Fama & French results. They also formed a database

of large firms for this period that is free of survivorship bias. Using this data

set they found a reliable B/M effect. Barber and Lyon (1997) presented a

clever way to address the issue of data mining. Noting that empirical results

that are caused by data mining should not carry over to other independent

samples, they formed a sample of financial firms for the 1973-1994 period and

found a reliable B/M effect among these firms. Since financial firms were

purposely excluded from the Fama & French sample, the result of Barber and

Lyon provide independent evidence of the explanatory power of B/M.

Further independent evidence came from Fama & French (1998), who found a

reliable B/M effect in several developed countries for the 1975 -1995period. They also found a reliable value premium in several emerging

markets. Capauls, Rowley and Sharpe in 1993 also found evidence of a

B/M effect in the US and 5 other developed countries for the 1981-

1992 period. This international evidence casts even more doubt on the

data mining criticisms of the US results

2.6 THE EXPLANATION

The results of Fama & French were subjected to a high degree of scrutiny

because of their controversial nature. Based on the papers that supported the

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Fama & French results, most researches reached to the conclusion that the size

and book-to-market effect are real since they have been observed over several

decades in the US and in other countries as well the next topic to be debated is

why? The issue is no longer whether size and B/M are able to produce cross-

sectional dispersion in average returns, the two primary explanations are risk

and inefficiency.

The risk based story starts when Fama & French who shows that factors

related to size and B/m are able to explain a significant amount of the common

regression of the form

F/F 3-factor

Rjt Rft = aj + bj (Rmt Rft) + sj SMBt + hj HMLt + ejt

Where Rjt is the return to portfolio j for month t, Rft is the risk free (T-Bill

return) return for month t and Rmt is the return to CRSP value

weighted index for month t. SMBt is the realization on the

capitalization based factor portfolio that buys small cap stock and sells

large cap stocks. Similarly HMLt is the realization on a factor portfolio

that buys high B/M stocks and sells low B/M stocks. The sj and hj

coefficient measure the sensitivity of the portfolio return to the small

minus big and high minus-low factors respectively. Portfolio of value

stock will have a high value for h, while growth portfolios will have a

negative h.

Large cap portfolios will have a negative effect on SMB(s will be negative)

and small cap portfolios will have a positive value for s.

They observed that historically average returns are high on:

Stocks of small firms

Stocks of firms with high B/M ratio

The above two may be proxies for exposure to systematic risk that is not

captured by CAPM i.e.

Small stocks may be more sensitive to changes in business conditions (macro-economic factors)

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And firms with high B/M ratio are more likely to be in financial distress.

These variables capture sensitivity to macro economic risk factors

Stocks with the above two features will be more risky, and the required rate of

return should be higher on them.

The time series averages of SMB and HML can be interpreted as the average

risk premium for these risk factors.

2.7 CONCLUSION

The issue of whether the value and size factors are caused by risk or

inefficiency may never be resolved to everyones satisfaction. Feelings run

strong on both sides of argument.

There are two crucial points that investors should remember i.e.

1. Factors based on value and size has explained much of the variation in

US stock returns for the past three quarters of the century.

2. Value and size premiums have been observed in several other countries,

with the value premium being observed in nearly every country that has

been observed.

While these observations are being consistent with a risk based story, they

dont prove anything. Nevertheless something very fundamental would have

to change in financial markets in order for these premiums to change.

Furthermore, the returns observed during 1999 in US market shows that

value minus Growth is not a low risk strategy.

The inability of Fama and French three factors model to explain three factor

models is a problem for the models proponents. However the problem may

not be that serious. Consider the following facts:

Pure momentum strategies involves very high turnover. Consequently

transaction costs and taxes can significantly erode the momentum profits.

Most of the returns to winner minus losers momentum portfolio are due to

the poor performance of the losers. So, in order to capture the bulk of the

momentum effect, short positions are necessary. This is not feasible for some

investors. The momentum effect is stronger among small cap stocks, which

tend to be less liquid. Trying to implement a high turnover strategy with small

cap stock is unrealistic.

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These facts suggest that momentum strategies probably do not represent a real

opportunity for investors to earn abnormal profits, at least not to the extent

implied by recent studies.

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Chapter 3Chapter 3 INTRODUCTION TO PTCINTRODUCTION TO PTC

CHAPTER 3

INTRODUCTION TO PAKISTAN TOBACCO

COMPANY3.1 INTRODUCTION

In tobacco industry the market leaders are Pakistan Tobacco Company and

Lakson Tobacco Company. Sales of tobacco decline from 2550.9 million units

in 2003 to 2256 million units in 2008(first half of 2008), mainly due to anti

smoking laws and consumer awareness, while sales increases from $432.1

million to $478.1 million the same period. Tobacco is the only crop sown in

Pakistan where per hectare yield matches with that of US and other European

countries i.e. average yield of 1900 KGS per hectare. It has the largest yield of

any crop in the country and over 1 million people are economically dependent

on this industry. The area under tobacco cultivation increased by 30 per cent

during 1990-91 to 1998-99, from 44,000 hectares to 57,000 hectares. The

production has increased even more significantly during the same period by

145 per cent from 75,000 tonnes to 109,000 tonnes. The value-added sector,

the cigarette production, depicted a far more unproportionate increase of 72per cent from 29.8 billion units to 51.5 billion units during the same period

By contributing some 28 billion rupees per years to government income,

Pakistan Tobacco Company has become a dependable source of income for

government of Pakistan. This amount is equal to 4.5% of Pakistans GDP.

This translates in the full time equivalent of 312,500 jobs supporting

approximately 1.2 million people.

Lakson Tobacco Company is considered market leader in terms of volume and

is being awarded best 25 companies for Karachi stock exchange for three

consecutive years i.e. from 1997 to 1999. According to prestigious

Advertising magazine Age Lakson tobacco spent a good sum amount of $6.4

billion on publicity making it the third largest business advertiser in 1998. In

1990 Lakson Tobacco Company announced an annual profit after tax which

amounted to Rs. 15 million which went down to 14 million in 1991, which

went to Rs. 25 million in 1992, then a total of Rs. 45 million was declared in

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1993 which increased to 65 million in 1994 showing a good growth in profit

after tax in this period.

In case of Pakistan tobacco company, it registered a total turnover of 8060

million in 1991 which went up to 8663 million in 1992,in 1993 the figures

shows a slight decline which stood 8642 million which picked up again

registering figures of 8788 million in 1994 and 10151 in 1995.

So the robust figures from the two major players (Pakistan Tobacco Company

and Lakson Tobacco Company) shows that industry is doing well irrespective

of certain local and international problems facing like inflation and the

increase in prices of wrapping materials in the international markets.

According to independent estimates, the Pakistani government collected

Rs.1705.3 million as tax revenue from tobacco in 2006.

The profit after tax for the whole industry was Rs.1390.1 million in 2002, Rs.

1426.7 million in 2003, then a robust increase of Rs. 2360.3 million in 2004,

Rs. 3165.9 million in 2005 and Rs 3544.1 million in 2006.This increasing

trend in profit after tax for the period shows that the industry is doing well

irrespective of the hike in oil prices, raw materials in the international market

and vulnerable law and order situation in Pakistan.

There were 33 cigarette companies in 1993 (three of which were major

companies, affiliated with multinational companies) operating 35

manufacturing plants. There are many small organizations producing tobacco

products on a very small scale. In 1990 the tobacco contribution to GNP was

0.7%.

During the past 20 years, adult per capita consumption of manufactured

cigarettes has fluctuated between 650 and 700 cigarettes per annum; recorded

tobacco consumption per adult has been about 1200grams. However, two

thirds of population lives in villages where the tobacco consumption is in non

cigarette forms. Therefore it is likely that more tobacco is used for smoking in

bidis and hookah as well as for chewing and snuffing than is smoked ascigarettes

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3.2 HISTORY OF PAKISTAN TOBACCO COMPANY

3.2.1 British American Tobacco

In 1902, the business of British American tobacco was originally established

which result in an end of an intense trade war between British and American

tobacco companies i.e. the imperial tobacco company of the United Kingdom

and American Tobacco Company of the United States agreed to form a joint

venture the British American tobacco limited.

The BAT starts its business in countries like Germany, New Zealand, China,

Canada, Japan, Australia and Denmark, but not the US or UK. By 1910 its

operations had extended to India, Srilanka, West Indies, East Africa, Nigeria,

Malaysia and Java. In 1912 BAT was listed on the London stock exchange and

British investors acquired most of its American parents shares.

BAT held strong market positions around the world and had leadership in

more than 50 markets. Since 1994, the group has increased its global market

share from 10.7% to over 16 %.

BAT has 86 factories in 64 countries. It uses more than 700 million kilos of

tobacco and has 25 leaf growing projects and also 23 leaf processing plants,

with over 300 brands in BAT portfolio with a market share of 16%, make the

cigarette chosen by one in seven of the worlds one billion adult smokers.

BAT differentiated portfolio of brands consist of well established international

brands such as Benson and hedges, 555, luck strike, Kent, Dunhill, gold leaf,

pall mall, viceroy, and john player. Bat is the second largest tobacco group

with annual shipment of more than 800 billion cigarettes.

Pakistan Tobacco Company was incorporated in 1947 immediately after

partition by taking the business from imperial Tobacco Company (India), so

making it the first multinational company of Pakistan and recently completed

60 years of its operations in the country.

The company is the member of the multinational British American tobacco

group, which employs over 200000 persons and operates in 180 countries.

It was incorporated into Pakistan and is listed on three stock exchanges of the

country. It was established on the year when Pakistan came into being i.e.

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1947 and took over the business of imperial tobacco company. It has three

branches namely Karachi, Akhora khattak and Jhelum but Karachi factory has

been closed since 1992 due to heavy losses and some other technical reasons.

The 1st plants setup was in a warehouse in Karachi port with monthly

production of 30 million cigarettes against sales of 60 million, the gap

between supply and demand was then filled up by import.

When Pakistan came into being all tobacco was imported in for production of

cigarettes but in 1952 a development project was initiated in NWFP and the

top quality American tobacco found way to Pakistan.

A factory was established in 1955 at Jhelum and Pakistan Tobacco Company

became a public limited company in the same year. In 1975 a new cigarette

factory was setup at Akhora khattak to meet the increasing demand of

cigarette in the country.

3.2.2 Pakistan Tobacco Company (Akhora khattak factory)

When Pakistan came into being all the tobacco used for production of cigarette

was imported. But in 1952, a development project was initiated in NWFP and

top quality American tobacco found way to Pakistan.

In 1975 a new cigarette factory was setup in Akora Khattak to meet the

increasing demand of cigarette. Recently Akora Khattak factory so many large

numbers of projects such as:

Learning resource centre for the community

Installation of modern high technology such LOGA max machines

Modernization of green leaf thrashing plants

Up gradation of primary and secondary manufacturing departments

Akora Khattak factory has adopted the concept of product stewardship, where

PTC takes the social responsibility as an important aspect of its business and

strives to conserve the natural resources to protect the environment.

Akhora Khattak factory is making effective contribution in a number of areas

that impact the overall economy and the social welfare of the region.

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PTC takes immense pride in its distinguished trade record of being a

responsible corporate citizen of Pakistan. It is part of PTC corporate

philosophy to contribute towards the conservation of environment as it

consider this to be an extremely important area deserving attention of all

inhabitants of the earth. Ideally 25% of total area of a country should consist

of forests.

Pakistan is an arid (with low rainfall) to a semi arid country and the area that

cover the forest is less than 5%, which is a very low ratio and this is very

dangerous. To overcome this, the company has come up with a systematic and

extensive forestation program in the country. This forestation program has

facilitated the plantation of 22 million tree saplings since then with more than

70% survival rate. Leaf department being the owner of this noble cause i.e.

forestation, has played a tremendous role in the success of this program by

creating awareness and providing free of cost tree saplings from its own

nurseries and also providing technical help to growers for forestation. PTC is

producing up to 1.8 million tree saplings per year. This forestation program

has greatly improved corporate image as an environment friendly organizationin the country.

3.3 PAKISTAN TOBACCO COMPANY REVIEW

After six years of serial losses (1997-2001) Pakistan Tobacco Company

limited managed to swing back to a profit of Rs. 354 million in 2001, the

accounts for six months to end June 2002, released recently, show 2% slip in

the top line to Rs 10.8 billion from Rs 11 billion for the corresponding period

of last year. Pre_tax profit rose sharply by 175% to Rs 417 million from Rs.

152 million and after tax profit showed growth of 92% to Rs. 248 million from

Rs. 129 million. New products introduced during the past two years accounted

for 33% of Pakistan tobacco company sales during the six months under

review, during which the company said to have unparalleled performance in

new product innovation in the cigarette industry. The company has continued

to claim that four out of five top selling brands in Pakistan are those of PTC.

They comprised of gold flake, john players gold leaf, embassy and capstan.

The company has paid last cash dividend in 1995. The board didnt declare a

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dividend for shareholders until 2001 and used all of the profit to wipe out the

huge accumulated deficit of Rs 337 million on balance sheet. But the

important thing is that the shareholders equity is back with an amount of Rs.

2.820 billion at the end of June 2002 with Rs. 2.55 billion being the paid up

capital. The company then gives regular increasing dividends of Rs 25.5

million in 2003, Rs 306.59 million in 2004, Rs 638.736 million in 2005,

Rs1890.6556 million in 2006 and Rs 2018.40 million in 2007 which gives a

positive signal to the investors.

The sales volume of PTC during 2007_2008 grew at a rate of 8% touching

37.2 billion sticks which is ahead of industry growth rate which is estimated at

2%. The market share also increases by 1.7 percentage points, so further

strengthening its position as the market leader in tobacco industry.

The 10 rupees share in PTC had hits its record high at Rs 162 in 1994. The

price then slipped over the years to hit the lowest Rs 8.5 in 2000 but the stock

then recovered to 157 at the end of year 2007.

For PTC it isnt still a smooth journey. We reiterate that tax evading sector

remains a major threat to government revenue and to our business. Directors

complains in their half term report, adding that steps taken by the government

in the past to check evasion has been encouraging. However recent increase in

activities of tax evading sector was stated to be alarming. So the company is

urging government support in this matter.

3.4 PTC Brands

Benson and hedges

Gold leaf

Gold flake

Capstan

Embassy

Will international

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3.5 ORGANIZATIONAL STRUCTURE

(PAKISTAN TOBACCO COMPANY)

Annual report of Pakistan tobacco company

LeafManager

LP

AccountManager

WAndLC

Manager

QualityControl

-Mgr

PurchaseOfficer

SalesMkt.

Manager

S. MgrProcessing

JuniorMgr

Quality

SeniorManager

LeafManager

(B)

Chairman

&

Chief Executive

Secretary

Director

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The organizational structure of PTC is functional in nature. Chairman and

Chief Executive are at the top and head (Directors) of various functional

departments like marketing human resources finance and production directly

report to him. Senior manager at PTC are quite large in number and hence

span the management is some what narrow. In many case authority is

positioned at top level of management but in some cases decentralization can

be seen.

The corporate culture of Pakistan Tobacco Company is a modal for Pakistanis

companies.

Pakistan Tobacco Company has been departmentalization with a functional

approach, into Human Resources, production, finances department and

marketing department. HRD is responsible for hiring competent people,

developing them too efficiently, motivating employees to do their best,

maintain a loyal and committed work force and cordial relation with

collaborative agent (CBA).

Production department is planning and controlling process to make it efficient

for quality induced product. Quality department continuously formulates,

implement and monitor quality and policy of Pakistan Tobacco Company for

full customer satisfaction. Finance department manages the assets and

financial structure of the company for maximizing profits and minimize cost.

The marketing department has the advantages to have the services of a

separate Art and creative department. The purpose of this department is to

develop an actual campaign, which include print, electronic, or any promos.

The department is running as an advertising agency for the company. All the

ideas are generated internally in collaboration with brand managers, marketing

manager, or brand executive and discussed with the Art department in the

form of brainstorming; Marketing is one of the major and stronger areas of

Pakistan Tobacco Company, which plays a significant role in over all strategic

planning of the company.

The marketing department covers last three primary activities of the value

change which are not bound logistics, marketing and sales and services and it

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also determines the scope of first two primary activities that are inbound

logistics and operation by quarterly forecasting the demand and potential of

different brands.

The new millennium is an age of uncertainty and risk due to ever changing

environment. Entering into new but related product or services such as food

items or edible oil etc will be surely a good strategy for Pakistan Tobacco

Company to diversify its business to reduce risk. A coordinated and unified

strategy is needed to cope with threats from fake cigarettes mafia and World

Health Organizations (WHOs) anti tobacco campaign. Pakistan Tobacco

Company should improve its financial performance through sales basting and

cost control. Bets marketing mix strategy are some of the areas of

improvement for PTC. It is not only the taste, which makes some one smoke a

particular brand, but the brand itself, adverting; pack visual and class-

consciousness are also important factors. PTC should conduct a research to

find the exact impact of various elements on brand selection and then give

comparative importance to each element in its strategies.

I assume the PTC can enter a new millennium as a leading company in all

respects, if it implemented my suggestion and recommendation.

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Chapter 4Chapter 4 INTRODUCTION TO FINANCIAL RATIOSINTRODUCTION TO FINANCIAL RATIOS

CHAPTER 4

INTRODUCTION TO FINANCIAL RATIOS

Financial ratios plays a very important role in measuring the performance of a

company because the ratio shows relative value, they allow financial analyst to

compare information that could not be compared in its raw form.

Financial statement analysis generally begins with a set of financial ratios

designed to reveal a companys strength and weaknesses as compared with

other companies in the same industry, and to show whether its financial

position has been improving or deteriorating over time.

Financial managers, business managers, creditors, stockholders, investors,

government officials use financial ratios analysis to determine weather

creditors can get debate and interest or stock holder know about their long

term value of their stock.

A financial ratio is a number that express the value of one financial variable

relative to anotherOR

A financial ratio is the result we get when we divide one financial number by

another

OR

An index which relates two accounting number and is obtained by dividing

one number by the other

Financial ratios are used to compare

one ratio to another related ratio

The firms performance to magnitude goals.

The past and present performance.

The firms performance to similar firms

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4.1 STOCK PREDICTING RATIOS

There are three ratios which are extensively used in prediction of stock return;

4.1.1 Dividend Yield

The dividend yield indicates the relationship between the dividend per

common share and the market price per common share

sharecommonpriceMarket

sharecommonperDividendsYieldDividend =

Total earning from securities have both dividends and price appreciation norule of thumb is there for dividends yields. The yield depends on the firms

policy and the market price. If the firms successfully invest money and do not

distribute it as dividends the price would rise. If it holds the dividends at low

amount to allow for reinvestment of profit the dividend yield is likely to be

low. A low dividend yield satisfies many investors if the company has record

of above average return on common equity, investors that want current income

prefer a high dividend yield

4.1.2 Price to Earning Ratio

This ratio express the relationship between the market price of a share of

common stock and the stock current earning per share or it is simply the

number of times investors value earning as expressed in the stock price.

SharePerEarning

SharePerPriceMarketRatioEarningtoPrice =

Investors view P/E ratio a gauge of future earning power of firms companies,

with high growth opportunities generally have high ratio and vice versa

4.1.3 Book To Market Ratio

It is a ratio of a firms book value of equity to its market value of equity. Book

value of equity is determined by the accountants using historic cost

information. Market value of equity is determine by buyers and sellers of thestock using current information

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It indicates the amount of stockholder equity that relates to each share of

outstanding common stock

goutstandinShareCommonofNo.

Equitystockpreferred-equityrstockholdeTotalratiomarketBook to =

priceMarket

shareperBook value

Preferred stock equity should be stated at liquidation price if other than book

because preferred shareholder would be paid this value in the event of

liquidation, the market price of securities usually does not approximate the

book value since assets are recorded at historical cost, the market value of the

stock reflect the potential of the firm

When the market value is below book value investor view the company is

lacking potential and vise versa. When investor are pessimistic about the

prospect for stocks, the stock sell below the book value, when investor is

optimistic about stock prospect the stock sell above book value.

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Chapter 5Chapter 5 RATIOS ANALYSISRATIOS ANALYSIS

CHAPTER 5

STOCK PREDICTIVE RATIOS CALCULATIONSOF PAKISTAN TOBACCO COMPANY

5.1 CALCULATION OF PRICE TO EARNING RATIO

Calculation of price to earning ratio is done by dividing the market price of

Pakistan tobacco company with the earnings of that year (the market price is

taken from the business recorder www.brecorder.com, and the EPS is taken

from the annual reports of the corresponding years). The whole data is based

on from period 2003 to 2007.

For 2003 27= 21.42

1.26

For 2004 61= 23.46

2.6

For 2005 68= 13.20

5.15

For 2006 71 = 9.527.46

For 2007 155= 16.49

9.4

Graph 5.1

P /E

0

5

10

15

20

25

1 2 3 4 5

years

pricetoearnings

P /E

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5.2 CALCULATION OF DIVIDEND YIELD

Dividend yield is calculated by dividing dividends by market value.

For 2003 0.1= 0.0037

27

For 2004 1.2= 0.019

61

For 2005 2.5= 0.036

68

For 2006 7.4= 0.104

71For 2007 7.9

= 0.050155

Graph 5.2

D Y

0

0 . 0 2

0 . 0 4

0 . 0 6

0 . 0 8

0 . 1

0 . 1 2

1 2 3 4 5

y e a r

dividened

yield

D Y

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5.3 BOOK TO MARKET RATIO CALCULATION

Book to Market Ratio (B/M) is calculated by first dividing the total

shareholders equity (minus preferred stock if any) by the total no. of sharesoutstanding which gives us the book value per share (BVPS), which is then

divided by the market value to get B/M ratio. Figures of total equity and total

number of shares outstanding are given in millions, which are as follows:

For 2003 2,853.090= 11.166955 (BVPS)

255.494

11.16 = 0.413591 (B/M)27

For 2004 3,262.823= 12.77064432 (BVPS)

255.49

12.77= 0.209355 (B/M)

61

For 2005 3639.414= 14.24461631 (BVPS)

255.494

14.24= 0.20948 (B/M)

68

For 2006 4139.187= 16.20072096 (BVPS)

255.414

16.20= 0.228179 (B/M)

71

For 2007 4022.857= 15.74540694 (BVPS)

255.414

15.74= 0.101583 (B/M)

155

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Graph 5.3

B/ M

0

0.05

0. 1

0.15

0. 2

0.25

0. 3

0.35

0. 4

0.45

1 2 3 4 5

year

booktomarketratio

B/ M

5.4 RATIOS CALCULATION OF PAKISTAN TOBACCO

COMPANY (SUMMARY)

Years Beginning price Ending Price Eps Dividend/share P/E DY

2003 22 27 1.26 0.1 21.42857143 0.003703704

2004 27 61 2.6 1.2 23.46153846 0.019672131

2005 61 68 5.15 2.5 13.2038835 0.036764706

2006 68 71 7.46 7.4 9.517426273 0.104225352

2007 71 155 9.4 7.9 16.4893617 0.050967742

Years

Total equity

(mn)

Total No. of

shares (mn)

Book

value/share

Market

value/share B/M

2003 2,853.090 255.494 11.166955 27 0.413590926

2004 3,262.823 255.494 12.77064432 61 0.209354825

2005 3639.414 255.494 14.24461631 68 0.209479652

2006 4,139.187 255.494 16.20072096 71 0.228179168

2007 4,022.857 255.494 15.74540694 155 0.101583271

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5.5 PREDICTION WITH REGRESSION MODEL

Here the simple regression technique is used to predict the next year return i.e.of 2008.

Y=a+bXY is the dependent variable, which is

Y = Ending price-Beginning price+DividendBeginning price

a = y - bx

X = X/n

Y = Y/n

b = nXY - XYnX2 - (X) 2

Here X is independent variable which consists of three stocks predicting

financial ratios namely price to earning ratio, book to market ratio and

dividend yield.

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Table 5.1: Calculations of Regression model on the basis of P/E

for the next year return

X(P/E Ratio) Y= Ending price-Beginning price + dividendBeginning price

X2 XY

21.42 0.23 458.38 4.96

23.46 1.30 550.37 30.58

13.20 0.15 174.24 2.05

9.51 0.18 90.44 1.75

16.48 1.29 271.59 21.33

84.06 3.17 1545.03 60.68

x 84.06

y 3.17

x2 1545.03

xy 60.68

X 16.82

Y 0.63

Ending price Beginning price Dividends

27 22 0.1

61 27 1.2

68 61 2.5

71 68 7.4

155 71 7.9

a=Y-bX nxy-xy nx2 - (x) 2 b

-0.31 37.01 659.06 0.05

Y =-0.31+(0.05)X0.88

1.002

0.42

0.22

0.61

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5.6 EXPLANATION OF MODEL

Y =-0.31+ (0.05) X

The fitted regression line suggest that if there is 0 P/E(X) then the returns will

be in negative zone i.e. -31%(a). If P/E changes by 1 then the total return will

vary by 5 %( b).

For ExampleIf P/E is 1 thenY=-0.31+ (0.05) 1Y =-0.26OrY =-26%

If P/E is 2 thenY=-0.31+ (0.05)2Y =-21%So this example shows that with the change in P/E of 1 the return hasincreased by 5%.

5.6.1 Calculating return for 2008

The following steps are executed for the calculation of return of FY 2008 with

the help of fitted regression line:

1) Take the average of P/E for the sample period

2) Put the average P/E in regression line

3) The regression model will calculate the return for the next year

The average P/E=16.82, so put this in fitted regression line will give the

following result:

Y=-0.31+ (0.05) *16.82

Y = 0.63 or 63%

So the return calculated for FY 2008 with help of fitted regression line on the

basis of average P/E is 63%.

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Table 5.2: Calculations of Regression model on the basis of B/M for

next year return

X(B/M Ratio) Y= Ending price-Beginning price + dividend

Beginning price

X2 XY

0.4135911 0.23 0.1710575 0.095877

0.209355 1.30 0.0438295 0.272936

0.20948 0.15 0.0438818 0.032623

0.228179 0.18 0.0520656 0.042003

0.101583 1.29 0.0103191 0.131485

1.162188 3.17 0.321153 0.574927

x 1.16

y 3.17

x2 0.32

xy 0.57

X 0.23Y 0.63


27 22 0.1

61 27 1.2

68 61 2.5

71 68 7.4

155 71 7.9

a=Y-bX nxy-xy nx2 - (x) 2 b

1.38 -0.81 0.24 -3.27

Y =1.38+(3.27)X

0.029

0.69

0.69

0.63

1.05

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Y =1.38+ (-3.27) X

The fitted regression line suggest that if there is 0 B/M(X), then the returnswill be 1.38 i.e. 138 % (a). If B/M changes by 1 then the total return will vary

by -327 %( b).

For ExampleIf B/M is 1 thenY=1.38+ (-3.27)*1Y =-1.28OrY =-128 %If B/M is 2 thenY =1.38+ (-3.27)*2Y =-516 %So this example shows that with the change in B/M of 1 the return hasdecreased by 327 %.




1. Take the average of B/M for the sample period

2. Put the average B/M in regression line

3. The regression model will calculate the return for the next year

The average B/M=0.23, so put this in fitted regression line will give the

following result:

Y =1.38+ (-3.27) *0.23Y = 0.622 or 62.2 %

So the return calculated for FY 2008 with help of fitted regression line on thebasis of average B/M is 62.2 %.

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Table 5.3: Calculations of Regression model on the basis of DY ratio

for next year return

X(DY Ratio) Y= Ending price-Beginning price + dividendBeginning price X2 XY

0.0037037 0.23 0.0000137 0.000858

0.0196721 1.30 0.0003869 0.025646

0.0367647 0.15 0.0013516 0.005725

0.1042253 0.18 0.0108629 0.019185

0.0509677 1.29 0.0025977 0.065970

0.215333 3.17 0.015212 0.117387

x 0.21

y 3.17

x2 0.015

xy 0.117

X 0.046Y 0.63


27 22 0.1

61 27 1.2

68 61 2.5

71 68 7.4

155 71 7.9

a=Y-bX nxy-xy nx2 - (X) 2 b

0.76 -0.08 0.028 -2.81

Y =0.76+(2.81)X

0.74

0.70

0.65

0.46

0.61

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Y =0.76+ (-2.81) X

The fitted regression line suggest that if there is 0 DY(X) then the returns will

be 0.76 i.e. 76%(a).if DY changes by 1 then the total return will vary by

-281%(b).

For ExampleIf DY is 1 thenY =0.76+ (-2.81)*1Y =-2.05OrY =-205%If B/M is 2 thenY =0.76+ (-2.81)*2Y = -486%So this example shows that with the change in DY of 1 the return hasdecreased by 281%.




1. Take the average of DY for the sample period

2. Put the average DY in regression line

3. The regression model will calculate the return for the next year

The average DY=0.043, so put this in fitted regression line will give thefollowing result:Y=0.76+ (-2.81) *0.043Y = 0.639 or 63.9%So the return calculated for FY 2008 with help of fitted regression line on the

basis of average B/M is 63.9%.

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P /E R a

0

0 .1

0 .2

0 .3

0 .4

0 .5

0 .6

0 .7

1 2 3 4 5

y e a r

return S e r i e s

Graph 5.4

B /M r a ti

0

0. 1

0. 2

0. 3

0. 4

0. 5

0. 6

0. 7

1 2 3 4 5

y e a r

return

S er i es

Graph 5.5

D Y R E T U

0

0. 1

0. 2

0. 3

0. 4

0. 5

0. 6

0. 7

1 2 3 4 5

S e r i e s

Graph 5.6

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Chapter 6Chapter 6 FINDING, CONCLUSION AND RECOMMENDATIONSFINDING, CONCLUSION AND RECOMMENDATIONS

CHAPTER 6

FINDING, CONCLUSIONS &

RECOMMENDATIONS6.1 FINDING

PTC should concentrate on effective cost control to bring it to the

minimum and to the level of industry.

Diversification of business scope reduces risk therefore Pakistan

Tobacco Company should diversify its scope by entering new

businesses. A detailed research should be conducted to study of various

possibilities of diversifying the scope of PTC business to reduce the

risk level.

Regression analysis is generally used as an analytical technique for

predicting stock returns.

the general findings of this report are that, Stock returns are predictable

and

Past returns contain additional information about the future returns.

For this I take past data of Pakistan Tobacco Company of the 5 years

i.e. 2003 to 2007 which basis on three financial ratios (P/E, B/M and

DY) and the market prices are taken from KSE website.

In the literature, stock returns are predicted with the help of three

financial ratios i.e.

1. price to earning ratio

2. book to market ratio

3. dividend yield

The return calculated for the share of Pakistan Tobacco Company for

FY 2008 predicted through fitted regression line on the basis of P/E is

found to be 63%.


FY 2008 predicted through fitted regression line on the basis of B/M is

62.2% respectively.

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FY 2008 predicted through fitted regression line on the basis of DY is

63.9%.

6.2 CONCLUSIONS

The main idea of the report revolves around the Fama and French, Cambell

and Sheller predicting stock return. Kendall 50 years back observed that stock

prices vary times to time. Kendall tested that prices change can be predicted

with the help of past returns and later on predicted some variables, which are

price to earning ratio, dividend yield and book to market value ratios. These

three ratios have some common features i.e. each of them measures price

relation to fundamental because in the above 3 ratios price come in

denominator, so the ratios should be positively related to expected return and

this is due to the reason that if the prices goes up expected return will be lower

if prices goes down, expected return will go up and all the three ratios should

be directly or truly expected return.

The study is to predict stock return of Pakistan Tobacco Company in order to

predict FY 2008 returns to give an investor an idea either to invest in Pakistan

Tobacco Company or not for the year 2008. The sample period for this study

is from 2003-2007 for 5 years. Three ratios will be used to predict stock

returns i.e. price to earning ratio, dividend yield and book to market ratio. The

data collected is based on secondary data.

The return calculated for the share of Pakistan Tobacco Company for FY 2008

predicted through fitted regression line on the basis of P/E is found to be 63%.


predicted through fitted regression line on the basis of B/M is 62.2%

respectively.


predicted through fitted regression line on the basis of DY is 63.9%.

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6.3 RECOMMENDATIONS

It is recommended that investors should invest in shares of Pakistan tobacco

company because the rates offered by all the banks

prediction of stock return on pakistan tobacco company

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