Firm Performance and Stock Returns: an Empirical

Study of the Top Performing Stocks Listed on

by Jin Dehuan , Zhenhu Jin

INTRODUCTION

The relationship between a firm's stock price movements and its operating performance has
been a subject of considerable research interest in recent years but the results of the studies
are not conclusive. Lamont(1998), Shiller (1984), Fama and French (1988), and Sivakumar
and Waymire ((1993) find that the firm's operating performance can explain a significant
portion of the stock price movements but Lev (1989) conducts a review of several studies
on the information content of earnings and reports that earnings changes are only weakly
related to contemporaneous stock returns and that the operating performance is not
significantly related to contemporaneous stock returns.

This paper extends this line of research into the Chinese stock market, which has
experienced significant growth since the Shanghai Stock Exchange opened on Dec. 19,
1990. The purpose of the study is to determine whether and to what extent stock prices in
the Chinese stock market are driven by firms' operating performance. This is of particular
interest because the Chinese stock market is widely viewed as a very speculative, policy
driven market. On the macro level, there appears to be a disconnect between the overall
stock market returns and the GDP growth. From 1993 to 2003, the Shanghai Stock
Exchange Composite Index experienced a cumulative increase of 79.53%, from 833.8 to
1497.04 (The annual returns of Shanghai Stock Exchange Index from 1991 to 2000 are
presented in Table 1). But during the same time period, the real GDP increased from 3.46
trillion RMB to 11.66 trillion RMB, a cumulative increase of 236%. Clearly, the stock
market has not been a good indicator of the macro economic development even though the
number oflisted companies in Shanghai Stock Exchange increased from 169 to 559 and the
total trade volume increased from 64 billion shares to 231 billion shares from 1994 to 2000.
In our study, we use a sample that consists of the top 10% performers listed in the Shanghai
Stock Exchange from 1996 to 2000 in terms of annual stock returns. We use several
measures to proxy for the firms' operating performance. These proxies are changes in
earnings per share, changes in sales, profit margin, total asset turnover, returns on equity,
and returns on assets. Simple and multiple regressions are performed to determine, at the
firm level, whether and to what extent these variables are related to stock price changes and
what portion of the stock price movements can be explained by these firm performance
variables. Our results indicate that while firm performance measures had some explanatory
power of the stockprice changes in the first two years during our testing period, the
operating performance measures' explanatory power of the stock price movements generally
declined as the stock prices went up. Our results suggest that the significant
stock price increases from 1998 to 2000 were not driven by firms' operating performance.
Instead, they were driven by several non-performance factors.

The paper proceeds as follows. Section one provides a literature review on stock returns and
firms' operating performance. Section two presents data, the empirical methodology, and
the results. Section three summarizes the study and concludes.

LITERATURE REVIEW

Many studies have been conducted on the relationship between firms' operating
performance and the stock returns but the results have not been conclusive. Lam ont (1998)
studies the relationship between earnings and expected returns. He reports that both
dividends and earnings have the ability to forecast returns and that earnings contain
information because they are correlated with business conditions. He also finds that higher
volatility ofearnings is not noise but related to expected returns. Shiller (1984), and Fama
and French (1988) use regressions of returns on the lagged dividends and earnings yield and
find that they have explanatory power. Sivakumar and Waymire (1993) study
stock price behavior in relations to earning reports by 51 NYSE firms. They find that the
announced earnings are positively related to stock returns. Roll (1988) regresses individual
stock price changes on contemporaneous news events and finds that less than 40% of the
variance of price changes can be explained by the regressions. Fama (1990) finds that two-
thirds of the variance of aggregate stock price changes can be explained by the variables
proxying for corporate cash flows and investors' discount rates. Campbell and Ammer
(1993) contend that the use of contemporaneous regressions to explain
asset price variability is appealing though this approach does not provide much information
on the channels through which macroeconomic news variables affect asset prices. Lev
(1989) conducts a review of several studies on the information content of earnings and
reports that earnings changes are only weakly related to contemporaneous stock returns. Su
(2003) analyzes the dynamic behavior of risks and returns in the Chinese stock market and
finds that the volatility of stock returns to be high in China relative to developed markets
and that returns are positively auto-correlated to greater extent in Chinese stock markets
than in developed markets. He also finds that some of the government policies in regards to
the stock market contribute to the market volatilities. Jin and Li (2003) also study the
causes of high volatility and irrational price movements in the Chinese stock market and
identify poor disclosure and inaccurate financial reports by the listed firms as some of the
causes for high volatility.

DATA, METHODOLOGY, AND RESULTS

Our sample consists of 10% of the firms that were listed in the Shanghai Stock Market from
1996 to 2000. The firms selected were the top 10% performers in terms of annual stock
returns. The total number of listed firms in Shanghai Stock Exchange and our sample size
each year during our study period are provided in Table 2. The average year-
end Price/Earning ratios of the stocks listed on the Shanghai Stock Exchange from 1995 to
2000 are presented in Table 3.

To be included in the sample, a firm must have been listed for more than a year and some
key financial measures are available.

We use the following measures as proxies for firms' operating performance:

Total Asset Turnover Ratio (TAT) = Sales / Total Assets

Change in Earnings per Share (CES) = (Current Year Earnings per Share / Previous Year
Earnings per Share ) - 1

Profit Margin (PM) = Net Income / Total Sales

Return on Assets (RA) = Net Income / Total Assets

Return on Equity (RE) = Net Income / Shareholders' Equity

Change in Sales (CS) = (Current Year Total Sales / Previous Year Total Sales) - 1

We use simple and multiple regressions to test whether the above variables can,
individually, or collectively, explain the annual stock returns of the sample firms in
each of the five years from 1996 to 2000. To ensure the multinomial normality of the
independent variables and to avoid possible multicollinearity, all the variables are tested for
univariate and multivariate normality. The results indicate that no variables need to be
transformed to ensure normality. The sample firms were the best performing stocks in our
testing periods in terms of annual stock returns. In our regression analyses, the annual
returns of the individual firms are used as dependent variables and the firm performance
measures listed above are used as independent variables. We are not only interested in
which variables are statistically significant but also in the R-squared, which provides some
information on the explanatory power of the regression models.

Results from simple regressions indicate that return on equity (RE) had significant
explanatory power in four of the five year testing period but the explanatory power dropped
from 0.4009 in 1996 to 0.0985 in 1999. Our results also indicate that changes in earnings
per share (CES) was significant in three of the five year testing period, 1996, 1997, and
1999. Interestingly, the explanatory power of the variable also declined over the years, from
0.4830 in 1996 to 0.1336 in 1999. Other variables, such as profitmargin (PM), return on
assets (RA), changes in sales (CS), and total asset turnover (TAT), were significant either in
one or two of the five year testing period. These results are presented in Table 4.

Results from multiple regressions are presented in Table 5 and they indicate that different
variables had significant explanatory powers in each of the four years in our testing periods.
In 1996, the variable, changes in earnings, (CES), was statistically significant. In 1997, two
variables, changes in sales (CS) and return on equity (RE) were significant. In 1998, Return
on equity (RE) was again the variable that was statistically significant. In both 1999 and
2000, profit margin (PM) was the only variable that was statistically significant.

It is interesting to note that the R-squared of the multiple regressions followed the similar
pattern of the simple regressions. In 1996, the R-squared of our multiple regression was
0.4830 but in 2000, it was only 0.0770. In other words, the explanatory power of the
performance measures in our regression models decreased during our testing period from
1996 to 2000 while the market index moved up, from 917 to 2073. The correlation
coefficient of the R-squared and the year end indices were -0.6728(figure 1). When the
market index was at 917 in 1996, the performance measures were able to explain
approximately 50% of the price movements. When the stock market took off and the index
soared to 2073 in 2000, the explanatory power of these variables dropped to less than 10%.
This suggests that the significant increase in market valuation from 1996 to 2000 was not
based on the operating performance of the firms listed on the exchange. Rather, the increase
in market valuation was based on factors that were not related to the operating
performance of the firms listed on the exchange. This interpretation is, in part, supported by
the dramatic increase in the average price to earning ratios from 1995 to 2000. During the
five years, the price to earning ratio increased from 16.32 to 59.14, an increase of 262.37%.
This dramatic increase in priceearning ratio clearly shows that earnings did not increase
while prices soared. At the same time, the declining R-squareds from 1995 to 2000 in our
regression models indicate that the important performance measures in our models had less
and less explanatory power of the stock price movements. Obviously, stock prices were not
driven by earning increases or other performance factors. Rather, they were driven by other
factors. We believe the disconnect between the stock price and firm performance may be
due to the following reasons. Starting from 1996, the benchmark one-year CD rate was cut
repeatedly and a lot of savers moved their money into the stock market from their bank
accounts. In 1998, scores of open-ended funds were launched and regulatory changes
allowed state-owned enterprises to invest in the secondary market. All these result in a
significant flow of funds into the stock market. At the same time, because the market was
only established in 1991, there were only limited number listed companies. The severe
imbalance between the supply and demand for stocks caused the stock price to go up
significantly. In addition, the unique ownership structure of the listed companies and the
trade restrictions may also have contributed to the disconnect. During our testing period,
about 60% of the outstanding shares of the listed companies were owned by the state and
these shares were not allowed to be traded. In addition, investors were not allowed to sell
stocks short even if they believe that the stock price will go down. These institutional
restrictions are not conducive to an efficient market in which market prices reflect the
intrinsic value of the stock. One limitation of the study is that it only covers from 1996 to
2000. The Chinese stock market has undergone significant changes but the result of the
study provides important insight on the relationship between firms' operating performance
and their stock performance.

CONCLUSION

Using a sample that consists of the best performing 10% of the stocks listed on Shanghai
Stock Exchange from 1996 to 2000, we study the relationshipbetween firms' operating
performance and their stock returns. We find that while firm performance measures had
 some explanatory power of the stockprice changes in the first two years during our testing
period, these firm performance measures' explanatory power of the stock price movements
generally declined as the stock prices went up. Our results indicate that the significant
stock price increases from 1998 to 2000 were not driven by firms' operating performance.
Rather, the stock price increases were due to other macro economic factors and market
imperfections.

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Publication Information: Article Title: Firm Performance and Stock Returns: an Empirical Study of the Top Performing
Stocks Listed on Shanghai Stock Exchange. Contributors: Jin Dehuan - author, Zhenhu Jin - author. Journal Title: Academy
of Accounting and Financial Studies Journal. Volume: 12. Issue: 1. Publication Year: 2008. Page Number: 79+. © 2008
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