The effect of Return on Equity, Earning per share (EPS) and Leverage on the Stock Prices

of the companies in the Pakistan Stock Exchange 100 Index(PSX 100).

1. Introduction
1.1. Background of the Study

Many factors affect the Share Prices in the market along with the bigger forces of demand and
supply. However, analyst and investors mostly tend to resort to the financial statements for the
data regarding share prices. Generally the investors and analyst want to have an in-depth look at
the ratios of the company for the current year and previous years for a one glance view as they
tell about the previous and current situation and performance of the company under
consideration and its position with reference to the other companies which are in the stock
exchange. Choosing the right place to invest your money is a difficult and risky task now a days
because of a large variety of investing options available in the market. One has to critically view
for any risk attached to the investing decision they are going to make.

For this purpose, Earnings per share (EPS), Return on Equity and Leverage ratio form an integral
part of what can cause an effect on the share prices in the stock market.

1.2.Gap analysis

A lot of research has been conducted in order to determine what factors cause the change in
stock prices. In order to check the affect of these variables, researchers have done various
studies on the factors causing the stock prices to increase or decrease. Some researchers found
the positive relation of certain variables with stock prices while others have found the negative
relation with the stock prices. However, a very few researches have been done to check these
three variables (Return on Equity, EPS and Leverage) and their effect on the stock prices in the
Pakistan Stock Exchange. This research will add to the knowledge of the previous researches to
support their view while remaining in the Pakistan Stock Exchange. Therefore, this study is
extended to achieve some measurable performance measurement objectives.

1.3.Problem Statement

Every new investor has the urge to invest in different possible area where some profit can be
derived. However, when the investor wants to invest in the securities of different companies, it is

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a very reliable source of profit generation yet there comes a constraint of lesser knowledge of the
investor. Investors want to know about the financial health of the company so that they receive
higher returns. The variables such as ROE, EPS and Leverage ratio can help the investor identify
about the health and position of the company but does it really has a big impact such that it can
determine the magnitude and direction of stock prices? On the basis of the few variables
explained above, this research manages to explain the relation of such variables on the stock
prices so that the investors in Pakistan can have a firm knowledge about the factors with which
their risk is attached. This research gives rise to some research questions which are explained in
the section below. Therefore, the current research analyzed that, “What is the effect of ROE, EPS
and Leverage ratio on the Stock Prices”.

1.4. Rationale of the Study

A lot of researchers have done work on the factors mentioned above that affect the share prices
one way or the other but the information is distorted. This research will add up to the presently
available knowledge of the behavior of ROE, EPS and Leverage ratio on the movement of stock
prices. This will not only add to the knowledge of the world on the concerned topic but will also
guide the investors as to how to look at the share price fluctuations and can help them in making
a better decision while they make their investments. Therefore, in this study an attempt has been
made to identify the relationship between firm specific factors and the stock price of listed
manufacturing companies. For this purpose, three main firm specific variables i.e. Return on
Equity (ROE), Earning per Share (EPS) and Leverage ratio (Debt to Equity) were selected.

1.5. Study Objective

Our research focuses on the determination of the relationship between the firm’s fundamentals
and their stock prices i.e., whether our selected firm’s fundamentals tend to create negative or a
positive effect on the stock prices on the companies in the KSE. This leads to the development of
the following research objectives:

 To determine the effect of Return on Equity (ROE) on the stock prices of the companies
listed in PSX 100 index.
 To determine the effect of Earnings per share (EPS) on the stock prices of the companies
listed in PSX 100 index.

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  To determine the effect of Leverage ratio (Debt to Equity) on the stock prices of the
companies listed in PSX 100 index.

2. Review of Literature

The literature review in this study will help explain the variables involved and give some support
by providing valid evidences found out by the previous researchers. In past a lot of research is
done on what cause the stock price to move. As there was no enough knowledge available to the
investor, the researchers were keen to know what drives the stock prices. One major factor which
will be analyzed as a key component of affecting the stock prices is Earnings per share. Many
studies have been conducted on the relationship of stock prices and EPS and found that a positive
relation exists between the two.

2.1. Stock Prices

One of the most controversial topics in finance is stock returns and the investigation of the
factors that affect stock returns. Even though we do not know the exact factors which predict
specific the movements in stock prices, research has identified a strong inkling of factors which
have a considerable effect on stock prices. For example, Roll (1988) states that it is the firm level
and market level characteristics determine how the stocks move.From an investors’ point of
view, it is vital to study these factors to understand investments and profits.

Early research conducted to understand stock returns was disregarded due to the fact that the
studies used a small sample in their research (Nicholson, 1960). Thus these studies did not
receive the deliberation in the beginning. It was not until the use of technology enables
researchers to conduct studies using considerable large sample sizes that generally accurate
results were achieved.

The earliest contribution in this field was the Capital Asset Pricing Model (CAPM) presented by
Sharpe (1964). This theory states that stock returns are positively correlated with the risk factor.
This relationship was further supported by various researchers like Black (1972); Fama and
Macbeth (1973) who also came up with a positive relationship between the two variables. Banz
(1981) came up with the conclusion that factors other than this also effected stock returns, one of

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which was the size of the firm. The size of the firm, measured by taking market capitalization as
proxy, is inversely related to stock returns i.e. the smaller the size of the firm, the greater its
stock returns.

An interesting phenomena discussed in literature is momentum with regards to stock prices. By

momentum we refer to the rate at which the stock prices rise or fall. Jegadeesh (1990) studied
stock prices and concluded that stocks that have been doing well over the past couple of months
continue to have optimistic growth in future as well; this effect was said to be short term
momentum. Similarly, stocks that performed poorly in the past continue to have lower returns
than usual in future as well.

A considerable number of studies exists which attempts to understand stock returns via financial
ratios. Basu (1977) analyzed stocks with respect to earnings to price ratio. He discovered that
stocks with high earnings to price ratios consequently earned higher stock returns and vice versa.
Similarly, book to market ratio was analyzed by Rosenberg, Reid and Lanstein (1985) and they
concluded that the book to market ratio and stock returns are positively correlated with each
other. Chan, Hamao and Lakonishok (1991) found similar results in the Japanese market and
since then book to market ratio started to receive recognition. Another financial ratio analyzed in
this respect is the debt to equity ratio. It was found that debt to equity ratio sustained a negative
relationship with stock returns (Bhandari, 1988).

2.2. Return on Equity

Sharif, Purohit and Pillai (2015) investigated the determinants of stock price of 41 companies listed on the
Bahrain Stock Exchange. The empirical findings reveal a positive and significant relationship between
return on eqity, book value per stock, ratio dividend paid and number of stock outstanding, ratio stock
price and earning per stock and market capitalization, suggesting that these factors act as active
determinants in shaping the market price of stocks.

Khan et al (2011) analyzed 55 companies that are listed on the Karachi Stock Exchange, in the
period from 2001-2010 for ten years. The results indicate that the dividend, earnings per stock,
return on equity and net profit positively correlate with stock prices.

Another study conducted by Trisno and Soejono (2008) showed that the ratio of ROA and ROE
effects on stock price while the NPM has no effect on stock price. Their study on the effect of the

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profitability ratio (ROA, ROE, NPM) on stock price reveals that not all profitability ratios can be
used as consideration in making stock investment decisions.

Jin Dehuan and Zhenhu Jin (2008) in their journal of Firm performance and Stock Prices: an
empirical study of the top performing stocks listed on Shanghai Stock Exchange studied the
correlation between firm performance (Return on Equity, earning per share, profit margin, return
on asset, changes in sales, and total asset turnover) and stock price. Their study showed that all
the variables are significantly correlated with stock price.

Hartono and Sihotang (2009) had a research about relationship between profitability ratios that
consist of ROA, ROE and Net Profit Margin (NPM) with stock price in 9 publicly listed banking
companies from 2003 until 2007. The result of their research showed only ROE has a significant
influence to the stock price.

Erna Tiningrum (2011) studied a correlation between fundamental factors ROA, ROE, DPR, DE,
EPS, and systematic risk to stock price in 3 publicly listed Manufacture Company from 2006
until 2007. The research shows that only ROE and EPS have significant correlation with stock
price.

2.3. Earnings per share

Islam,Khan,Choudhury and Adnan (2014) conducted a research about how earnings per share
effects on share price. The result shows that for every individual investor share price and firm
value is one of the most important factor for the investors .The data have been collected by 22
scheduled banks and 110 firms year data which analyzed that share price does not move as fast
as earning per share (EPS).They also examined that movement of share price depends on both
micro and macro economic factors of the economy. The investors must keep in mind the factors
like Earnings per share if they want to invest in security markets.

Similarly, Glezakos, Mylonakis, and Kafouros (2012) conducted a study to examine the effect of
specific firms fundamental on stock prices which includes book value per share and earnings per
share. Athens stock exchange was the market used to collect the accounting information for
thirty eight companies for the period 1996-2008.The result of this study shows that increase in
number of countries directly effects the share prices and earnings per share (EPS) has a positive

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and significant effect of stock prices. This study helps the people to invest in shares that are less
risky. However, the effect of earnings per share is reducing as compared to the book value per
share.

To study the similar effect in the Indian Stock Market, Bhatt and JK (2012) conducted a study of
impact of EPS and market value of an equity share. This study is based on 50 companies in 5
years. These were the most valuable companies in the year 2010. In this research, they have
attempted a research paper on a study, the impact of (EPS) on the market value of equity share.
The results show that EPS does affect the stock prices in Indian Stock Market.

Khemadivya and Devi (2013) conducted a research of relationship between market price and
EPS with reference to companies in primary and secondary market. Thesis found factors
affecting price of equity share and can be viewed from the micro and macroeconomic
perspectives. The results of this study clearly show that EPS does impact the market prices on
the selected companies in this research.

Another similar research done by Chang, Chen, Su and Chang (2008) was to study the
relationship between stock price and EPS in Taiwani Stock Market. The study has a panel of co
integration methods to inspect the relationship between stock price and EPS. The stock prices
responded to EPS in different levels of growth. The study found that those firms showed a high
growth rate had a higher EPS and vice versa.

Another research on the impact of earning per share on market value of share was conducted in
Pakistan in the growing cement industry of Pakistan (Jatoi, Hammad, Iqbal & Muhammad,
2014). They found different factors affecting the market value of shares. The study was to
determine the relationship between market value of share and earnings per share (EPS). The
correlation and regression for EPS exposed a related variable that influenced the market value of
share in the industry. The increase in MVS and EPS are vice versa.

Al-Tamimi, Alwan, and Rahman (2011) conducted a research in UAE to examine the factors that
are affecting the stock prices of shares it helps to maintain stock market environment more
effectively and efficiently. A sample of research that consists of seventeen listed companies from
the time frame of sixteen years from 1990-2005.The result depicts that there exists a positive and
strong relation between earning per share and stock prices means that earning per share has high

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influence on stock prices. Whereas the coefficients of GDP and supply of money were positive
but insignificant and rate of interest and consumer price were negative but significant.

Menaje (2012) conducted a research Philippines to examine the factors that are affecting the
stock prices of firms. This study is made because there are a lot of studies on it but most of them
are opposite to each other. This study helps the investors to clear their view about these factors
affects on stock prices. A sample of fifty companies was taken that are listed in Philippines stock
exchange for the year 2009.The study basically focuses on the affect of earning per share and
return on asset on the stock prices and earnings per share is found from the income statement,
return on asset is calculated by using ratio evaluation process and financial statement s are only
the key factors most of the researchers have done a lot of work on these factors but it is much
confusing. This result shows that there is a negative relation between return on asset and stock
prices where as there is a positive relation between earnings per share and share prices.

Ohlson and Nauroth (2005) conducted a research to examine the impact of expected EPS and
EPS growth. This research made a model that shows the effect of next year earnings per share,
short term growth in earnings per share, long term growth in earnings per share on the share
prices of the firms. A sample of twenty listed companies was taken from the year ranges from
2000-2010.The result shows that there positive relation of earnings per share one stock prices of
the listed firms and it is highly influencing.

2.4.Leverage (Debt to Capital) Ratio

Ozlen (2014) made a study to determine the effect of different factors on stock prices, it is very
helpful for the investors to know about the factors that changes the share prices of the firms.
Different sectors are taken for this study which includes commerce, chemistry, electric, food,
paper, metal-product, metal-main, stone, textile, communication and transportation. This study
mainly focuses on the effect of Current Ratio, Earnings per share, Net Profit Margin, and Book
Value, Total Asset Turnover Ratio and Debt Ratio on these different sector stock prices. The
conclusion of this study shows that asset turnover ratio has positive effects on Metal Products,
Commerce and Transportation sectors but has negative impact on Textile Sector, Debt ratio has
negative effect on Stone and Metal-Product and the current ratio have significant and negative

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effect on Transportation and Metal-Main sectors where as it has positive effect on Electric and
Textile sectors.

Ghasemi (2012) conducted a research to examine the effect of debt ratio on the stock prices of
the firm. The research was conducted in Iran and the main purpose of this research is to
investigate the relationship between debt ratio and market value of stock. This research is
considered as applied research where as the data collected in it is a descriptive study. The study
is concluded that there is a significant negative relationship between the current ratio and debt
ratio means they are not independent where as there is a insignificant positive relationship
between the debt ratio and ROE that show they are dependent.

Nahoji, Abadi, and Rafat (2014) had a research about stock price and debt ratios in Iran. The
thesis had a data of 144 listed companies in Tehran stock exchange for the time period of 2006 to
2001. The thesis showed the direct relationship between ratio of inventories of sales price and
stock prices. This combined date showed significant and direct relationship between total assets,
stock price and ratio of sum debts.

2.5. Major Conclusions

After studying the previous research papers and studies on the concerned topic, it can be seen
that the variable of our study are well explained and are in line with the previous research
material. Studies regarding the Return on Equity (ROE) show that the profitability ratios show a
positive and significant relationship on the stock prices with a very few exceptions where the
results shows a weak or no significant relationship with the stock prices.

Earnings per share (EPS) is a major factor of determination of the stock prices. Investor’s
decision can greatly rely on this ratio which a general trend of direct relationship between the
two variables. The results from previous studies also support this research paper which
repeatedly says that there is a significant and positive relationship between the said variable and
stock prices.

The third variable of this study is Debt to Asset ratio. The general understating of the ratio says
that there is a negative relationship between the leverage ratio and the stock prices which are
very well justified that as the debt increases, the stock price decreases and vice versa. This is

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another major conclusion of this research which is also supported by the previous research work
showing a negative relationship between the two variables.

2.6. Theoretical Framework

Return on
Equity (ROE)

Earnings per
Share (EPS)
Stock Prices

Leverage Ratio
(Debt to Capital
Ratio)

2.7. Hypotheses

2.7.1 H1: There is a positive significant relationship between ROE and Stock Prices

2.7.2 H10: There is a no significant relationship between ROE and Stock Prices

2.7.3 H2: There is a positive significant relationship between EPS and Stock Prices

2.7.4 H20: There is a no significant relationship between EPS and Stock Prices

2.7.5 H3: There is negative and significant relation between Leverage Ratio and Stock Prices

2.7.6 H30: There is no significant relation between Leverage Ratio and Stock Prices

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 3. Research Methodology
3.1.Sampling Method
3.1.1. Population

The population chosen was the PSX 100 index. Out of these 100 companies in Pakistan Stock
Exchange, only Non-financial companies were chosen as the study does not involves the
financial companies and mining companies due to their regulation differences. So the total
population size consists of 78 companies.

3.1.2. Sample Size

The sample which was chosen was of 20 companies for the years 2006-2015. The data of 10
years is to be analyzed using different techniques.

3.1.3. Sampling Technique

The sampling technique used in the research is the Purposive sampling as we are not taking into
account the financial and mining sector.

Rest of the data was gathered from multiple sources available over the internet. The closing stock
prices were collected from the Pakistan Stock Exchange website. Closing stock prices for the
month of December for the years 2006-2015 were collected from the PSX website. The
remaining information was gathered for the Non-financial sector for the years 2006-2015. This
data included the financial statements for the publically listed non-financial companies for the
period 2006-2015. Also, it contained the key financial indicators which were some of the
important ratios for the respective companies.

3.2. Data Collection Techniques

3.2.1 Secondary Data

All the data which has been collected in the research is secondary data which has been collected
using Internet and different websites (SBP) and some other research based websites.

3.2.1 Primary data

There is no primary data in this research.

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