CHAPTER 3

RESEARCH METHODOLOGY

Introduction

The study under consideration has been conducted to examine the fundamental pricing
of equity shares in India. To achieve the desired objectives, there is need to apply
scientific method of research. Research methodology explains purpose and objectives
of the study, sample size, variables taken and sources of data, hypotheses framed and
statistical tools used for analyzing the fundamental variables. It needs to be deliberated
with all care and concern as any mistake in it may lead to offend the reliability and
validity of the findings. In this chapter an attempt has been made to design and define
the research methodology duly adopted to carry out the research study.

Problem Statement

The broad survey of literature observed that significance of fundamental pricing of

equity stocks have been recognized by the researchers. The role and nature of
fundamental analysis is explored through the study in the Indian stock market. In the
era of globalization, privatization and liberalization, there is an urgent need to have
knowledge of fundamental variables that affect stock prices. A deeper look into the
previous studies indicates that a number of research studies have been undertaken on
pricing of equity shares based on fundamental variables but most of the studies were
related to developed countries namely U.K, U.S.A. In an emerging stock market like
India, investment analyst and market participants are continuously in search for
investment strategies, so there is need to do this type of study in India. Most of previous
studies were based on the limited number of fundamental variables. The present study
considers wide range of company specific fundamental variables. Present study covers
a long time period of twelve years and studies the 200 companies which are part of
BSE-200 index. Present study also analyzes the perception of equity investors about
fundamental pricing of equity shares. So, there is the vital need to study the relationship
between equity share prices and various fundamental variables.

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 Objectives of the Study

The main objective of the study is to examine the relationship between fundamental
variables and equity share prices. To achieve the main objective, the same has been
divided into following sub objectives:

• To identify key fundamental factors according to their relative importance

towards equity share prices.

• To identify key fundamental variables on the basis of size of the company.

• To identify key fundamental variables on the basis of industry groupings.

• To analyze investors perception about fundamental pricing of equity shares.

• To suggest guidelines for investors on the basis of findings to take rational

investment decisions.

Research Hypotheses

To achieve the above objectives, following alternative research hypotheses have been
formulated:

H11: There is significant relationship exist between equity share prices and the
fundamental factors i.e. liquidity, leverage, sales, growth, operating efficiency and
profitability.

H12: Fundamental variables i.e. EPS, DPS, DEQ, ROA, DP, Size, BV and PE have
significant relationship with the market value of equity stocks of automotive, banking,
energy, FMCG, infrastructure, metal and mining, pharmaceutical, technology and
miscellaneous industry.

H13: Market price of equity shares of listed Indian companies is dependent on the
fundamental variables i.e. EPS, DPS, DEQ, ROA, DP, Size, BV and PE.

H14: Fundamental variables significantly differ between demographic and attributes of

investors i.e. gender, stock market experience, education level, occupation groups,
family income groups, average holding period groups, trading frequency groups,
techniques used and various age groups.

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 Scope of the Study

To achieve the objectives of present study, the companies listed on Indian stock market
has been taken as the universe of the study and 200 companies which are constitute of
BSE-200 index as on June, 2013, has been taken as sample companies. The time period
is of twelve years ranging from the year April, 2001 to March, 2012 which comprises
the period of boom, recession, recovery, political turmoil, world economic crisis, high
inflation as well as low inflation period, highest and lowest crude oil prices etc. which
justify the period of study to draw meaningful conclusions from the study which may
be useful for the institutional as well as individual investor to make portfolios.

Database and Sources

The present study is based on primary as well as secondary data to achieve research
objectives. Secondary data is collected from the respective websites of the companies,
publications of Bombay Stock Exchange and Prowess database maintained by Centre
for Monitoring Indian Economy (CMIE). The data related to various fundamental
variables and stock prices are of yearly basis i.e. collected from the financial year April,
2001 to March, 2012 respectively.

The remaining objective of the study is achieved by using primary data. The primary
data is used to know the investor’s perception regarding fundamental pricing. The
primary data is collected through a structured questionnaire that is administrated to the
250 equity investors of Haryana and NCR through email and through courier as well
personal interviews have been taken during the period of 2013-14. The questionnaire is
shown in Appendix- IV.

Sample Selection and Questionnaire Development

The rationale behind selecting BSE-200 Index as sample base is that these 200
companies account for a substantial share of market capitalization in Indian stock
market and reveal the performance of almost the entire business sector in India. To
achieve the objectives of present study, the sample of 124 companies is selected out of
200 companies listed on BSE 200 indices as on June, 2013. The companies are filtered
on the basis of two criteria: 1) the stock of the companies must be listed at least five
years from 2001 to 2012 on BSE 200 indices. 2) The data of all the variables, of all the
periods for all the companies must be available. These 124 companies has been
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 grouped into 9 major industrial sectors i.e. automotive, banking, energy, FMCG,
infrastructure, metal and mining, pharmaceutical, technology and miscellaneous
industry of India to identify the significant fundamental variables according to industry
basis.

To analyze the perception of investors regarding fundamental pricing of equity shares

in India, a questionnaire has been developed. Convenient random sampling technique is
used as sampling technique. Firstly, a pilot survey of the structured questionnaire was
carried out from investors, financial experts and relevant changes have been made in
questionnaire. Cronbach alpha method has been applied to check the reliability of the
questionnaire. The two hundred fifty respondents are asked to fill the questionnaire,
who understands the fundamental determinants of the investments, out of which 187
have been replied back within the stipulated time for the purpose. Twenty two
questionnaires have been rejected later due to incomplete information given by
respondents or multiplicity of ratings of one question that made them unsuitable for
including in the study. Finally, one hundred sixty five investors are considered to
achieve the objective. The questionnaire contained questions relating to influential level
of fundamental variables. The respondent were asked to choose among the options of
strongly agree to strongly disagree. Questionnaires were uploaded online to get
response from stakeholders and some questionnaires were personally sent to investors.
Collecting data through electronic media was deemed to be quick and easy to use by
the most of people, the data was collected automatically for ease of analysis, the
method was inexpensive and data collection was instant.

Computation of Variables

To achieve the objectives of the study, equity share price is used as dependent variable
and company specific fundamental variables i.e. earning per share, dividend payout,
dividend per share, book value, debt to equity, debt to asset, current ratio, quick ratio,
return on asset, return on net worth, return on average capiital employed, cash flow
from operation, price to earning ratio, price to sales, size of the firm, total asset
turnover, net profit margin and price to book value are taken as independent variables.
A brief explanation and calculation of all variables are given below.

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 Dependent Variable

Market price of equity share is taken as the dependent variables in the study to analyze
the various fundamental variables of the company and to exmaine their affect on the
equity share price. The detail of market price taken in the study is given below:

Market Price of Equity Share

Average price of the share has been taken as market price of the share in the present
study. It is calculated as follows:

MP = High Price + Low Price

2

Where, High Price = Highest market price during the financial year, Low Price =
Lowest market price during the financial year.

Independent Variables

Company specific eighteen fundamental variables are taken as independent varables in

the study. The brief details of these variables are given below:

Book Value per Share

It is an accounting value at which an asset is showed on a balance sheet of a company.

The book value tells us whether a share is under priced or overpriced. Book value per
share is calculated as:

Book value per share = Shareholder Equity – Preference Equity

Number of Equity Shares Outstanding

It can be very useful financial ratio for stakeholders of a company. Book value per
share has also a limitation as a valuation tool as it is based on the historical costs of the
assets of a firm. Ohlson (1995), Berger et al (1996) and Collins et al (1997) found a
significant relation between book value and market value of stocks.

Debt to Equity

Debt to Equity Ratio is a long term solvency ratio that indicates the proportion of
borrowed funds and owner’s capital in financing the assets of a firm. Debt to equity
ratio is also known as “external-internal equity ratio”.

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 Debt to Equity Ratio = Total Debt
Shareholders’ Equity

Both a very high and very low debt to equity ratios is not desirable. The general
proposition is: “other’s money should be in a reasonable proportion to the owner’s
capital and the owner should have sufficient stake in the fortunes of the enterprise”
(Khan and Jain, 2008). Bhandari (1988), Chan (1991), Mukherji et al. (1997), Tripathi
(2009) supported that debt to equity has the positive and significant impact on market
price of equity stocks.

Earning per Share

Earning per share is a profitability ratio of a firm shows that how much of profit after
tax and preference dividend available to the equity shareholders on a per share basis. It
is computed as follows:

Earning per Share = Net profit - Preference Dividend

Number of Outstanding Ordinary Shares

In determining market price of share, earning per share is usually considered as the
most essential indicator from the shareholders point of view. Basu (1983), Ou and
Penman (1989), Mukherji et al. (1997), Sharma (2011) found earning per share as one
of the strongest indicator of equity share prices.

Price to Earning

Price earning ratio measures the amount that investors are ready to pay for each rupee
of income. This ratio compares the market price of the firm with the earning per share.
It is calculated as follows:

Price Earning = Market Price per Share

Earning per share

The price to earning ratio is the important variable mostly used by the investors for
share valuation. Nissim and Penman et al. (2001), Tripathi (2009), Nirmala et al. (2011),
Sahoo and Chatterjee (2011) stated that price to earning is the significant determinant
of the stock returns.

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 Dividend per Share

Dividend per share is the dividend (including interim dividend) paid to the ordinary
shareholders per share. It can be calculated as follows:

Dividend per Share = Total dividend paid to ordinary shareholders

Number of Ordinary Share Outstanding

This ratio helps in valuation of equity share prices. Gordon and Shapiro (1956) showed
the significance of dividends in valuing a firm’s market value at the time of formulation
of the Dividend Discount Model. Nirmala et al. (2011), Sharma (2011) also found
dividend per share has the significant impact on equity share prices.

Return on Asset

Return on asset measures the relationship between net income and assets. This ratio
shows how efficiently the management of a firm used its assets to generate income. It is
measured as follows:

Return on Asset = Net Profit after taxes

Average Total Assets

Return on asset indicates that whether a firm is earning more with less investment or
not. Piotroski (2000), Wu and Xu (2006) and Venkates et al. (2012) also found strong
association between return on asset and price of equity stocks of a firm.

Dividend Payout

This ratio measures the relationship between the income related to equity shareholders
and the dividend paid to equityholders. It indicates that what percentage share of
earnings belonging to shareholders is paid out as dividend to them. It is computed as
follows:

Dividend Payout Ratio = Dividend paid to Ordinary Shareholders

Net Profit after Taxes and Preference Dividend

This ratio can be compared with the trend over the years or an inter firm and intra
industry comparison would through light on its adequacy. Gurgul et al. (2006),
Chukwuma-Agu (2009) stated that dividend payout affects the market value of equity
stocks.

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 Return on Average Capital Employed

Return on average capital employed is an important profitability ratio of the firm that
measures the firm’s ability to generate profit from its capital employed in the business.
Average of opening and closing capital employed for the time period has been taken in
the study. Return on average capital employed (ROACE) is calculated as:

ROACE = Earning before interest and tax

Average capital employed

ROACE is used as a benchmark to measure the ability of the company to generate its
profit by employing the capital. Shobhana and Karpagavall (2011), Dabade (2012)
found ROCE as a fundamental determinant of stock prices.

Return on Net worth

Return on net worth (RONW) measures the profitability of the company in terms of
how much a company is earning profit with the funds invested by the ordinary
shareholders of the company. It is calculated as:

RONW = Net profit after tax and preference dividend

Net Worth

From the equity shareholders point of view, it is the most significant fundamental
variable because it tells that how efficiently a company is using their funds.

Price to Book value

Price to book value measures the relationship between equity share prices and book
value per share of the company. It indicates that how much investor is ready to pay in
form of market price of shares for the firm’s net assets. It is calculated by dividing the
market price of equity shares by the book value per share.

Price to book value = Market price per share

Book value per share

It is significant fundamental variable of the company that helps in predicting market

price of equity shares. According to Fama and French (1992), if price to book value and
size of the firm has taken together, it is one of the best variables to forecast the equity
share prices.

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 Total Asset Turnover

Total asset turnover ratio measures the firm efficiency to generate its sales by use of its
entire asset. It shows how much a firm is able to generate its sales from each rupee of
the firm asset. It is calculated by dividing the net sales by total assets of the firm.

Total Asset Turnover = Net Sales

Total Asset

From the investors’ point of view, it is one of the most important fundamental variables
that affect the equity share prices of the company. Wu and Xu (2006), Martani et al.
(2009) found total asset turnover as a significant fundamental variable.

Size of the Firm

Size of the firm is the major fundamental determinant of equity share prices of the
company. Mostly investors want to buy shares of large companies due to their more
liquidity and marketability. From investors point of view mostly investment
opportunities are created by large companies as compared to small companies for
investors. The size of the firm can be measured in many ways, e.g. through turnover,
paid-up-capital, capital employed, total assets, net sales, etc. In the present study, size
of the firm is measured by taking logarithm of total assets.

Size of the firm = logarithm of Total Asset

Srinivasan (2012), Almumani (2014) examined the relation between size of the firm
and stock prices and found significant relation between both of them.

Debt to Total Asset

It is a firm’s financial leverage ratio that shows the relationship between total assets and
liabilities. It indicates the proportion of firm’s assets that is being financed by total
outside liability. It is calculated as:

Debt to total asset = Total outside liability

Total Asset

It is one of the fundamental indicator of equity share prices because market value of the
firm is affected by it. Investors should consider this ratio at the time of making
investment in a particular firm. AI- Deehani (2005), Wu and Xu (2006) found debt to
asset as fundamental determnant of equtiy stock prices.

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 Price to Sales

It is a valuation ratio that helps in valuation of the stocks of the firm. It measures the
relationship between the share prices of the firm with its sales. It indicates the market
price to be found on each unit of a firm’s sales. In the present study, it is calculated as:

Price to sales = Market capitalization

Net Sales

Net Profit Margin

It is a firm’s profitability ratio expressed in a percentage form that measures how much
of each rupee of revenue earned by company is actually converted in to earnings. It is
the proportion of net profit and net sales of the firm. It is calculated as:

Net profit margin = Profit after Interest and Taxes

Net Sales

It is a fundamental indicator that affects the share prices. Every firm has its own pricing
policies and strategies that make them different from other firms.

Current Ratio

It is a firm’s liquidity ratio that measures the ability of the firm to meet its short term
obligation. It shows the relationship of current asset with current liabilities in the firm.
It is calculated as:

Current Ratio = Current Asset

Current Liability

It is also a fundamental indicator that helps the investors while making their investment
decision in a firm. Investors can analyze the liquidity position of a firm by interpreting
this ratio.

Quick Ratio

It measures the firm’s ability to convert its current assets quickly into cash in order to
meet its short term obligation. It is the proportion of quick asset and current liabilities.
It is calculated as:

Quick Ratio = Quick Asset

Current Liability

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 It is more useful as a fundamental indicator when compare among companies within
the same industry or compare over a period of time. Investors usually consider this ratio
to analyze the firm’s short term financial position.

Cash Flow from Operation

Cash flow from operation measures how much a firm generates cash from its day to
day operations. It is the income of the firm that includes the non cash expenses such as
depreciation and excludes the adjustment of investments and financing. It is calculated
as:

Cash Flow from operation = (Earnings before interest & taxes + depreciation) - Income
Taxes

According to International Financial Reporting Standards, cash flow from operation is

the cash generated from operations less tax and interest paid, investment income
received and less dividend paid. Venkates et al. (2012) and Mahmoud and Sakr (2012)
found cash flow from operation as significant fundamental variable.

3.9 Statistical Tools for Analysis

This section explains the statstical techniques that have been employed in the study to
analyze the data. Table 3.1 shows the classification of statistical tools according to each
objective. The research tools employed to achieve the purpose of present study are
explained as follows:

Table 3.1 Classification of Tools

Objectives Statistical Tools Employed

To identify key fundamental variables Factor Analysis, Descriptive Statistics,
according to their relative importance Karl Pearson Correlation and Linear
towards equity share prices. Multiple Regression.
To identify key fundamental variables on Descriptive Analysis, Levin-Lin-Chu
the basis of size of company. Test and Panel data regression.
To identify key fundamental variables on Descriptive Analysis, Levin-Lin-Chu
the basis of industry groupings. Test and Panel Data Regression.
To analyze investors perception about Frequency, Percentage, Mean,
fundamental pricing of equity shares. Independent samples t-test and One- way
ANOVA.

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 Brief detail of each of the staatistical tooll is as shown
n as follows:

Descrip
ptive Statisttics

Desripptive statisttics helps in

i describinng, showing
g and summ
marizing thhe data in
meaniinigful way in the form of mean, m
median, standdard deviatioon, skewnesss, kurtosis
and minimum-ma
m aximum vallues of the variables. In the pressent study descriptive
statisttics is used to
t describe all the variaables with thhe help of sooftwares SP
PSS 16 and
Micro
osoft Excel 2013.

Karl Pearson cofficient

c off Correlatioon

It meaasures the linnear correlattion betweenn two variabbles. In the ppresent study
y, it is used
to meaasure the rellatioship am
mong all funddamental varriables takenn under study
y and with
the eqquity share prrices. It provvides us the ddegree of relationship beetween two variables:
v

Wheree,

n= Nu
umber of pairrs of variables

Σxiyi = sum of the products off paired variaables

Σxi = sum of x varriable

Σyi = sum of y varriable

Σx2i = sum of squaared x variabbles

Σy2i = sum of squaared y variabbles

On
ne- Way ANOVA

The one-way
o anaalysis of variance (ANO
OVA) is a sttatistical toool used to ex
xamine the
hypoth
heses wheth
her there are any significcant differen
nces betweenn the meanss of two or
more independentt levels (usinng the F disstribution). It
I can be appplied on datta where a
depenndent variablle is metric and
a an indeppendent variiable known as factor haaving more
than two
t levels of
o treatment is categoriccal. In the prresent studyy, one way ANOVA
A is
used to
t determinee whether fun
ndamental variables takeen under study significan
ntly differs
betweeen demograaphic and in
nvestors relaated attributtes i.e. stockk market exxperience,

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 education level, occupation groups, family income groups, average holding period
groups, trading frequency groups, techniques used and various age groups or not.

Independent-Samples t-test

Independent samples t-test is a statistical test used to compare the means between two
independent groups of independent variable on the same continuous, dependent
variable. In the present study, this test is used to examine the hypotheses that
fundamental variables taken under study do not significantly differ between male and
female investors.

Frequency and Percentage Analysis

The frequencies procedure provides statistics and graphical displays that are useful for
describing many types of variables and percentage analysis is used to form a
contingency table from the frequency distribution and represent the collected data for
better understanding. In the present study, investors demographic and investment
related attributes are shown in the form of frequency and percentages.

Factor Analysis

It is a multivariate statistical technique applied to identify essential variables that

explain the pattern of correlations within a set of observed variables. Under it, whole
set of interdependent relationships is scanned. It is mainly employed to reduce data to
classify a small number of factors that explain most of the variance that is observed in a
much larger number of apparent variables. In the present study, factor analysis using
principal component analysis (PCA) has been applied in the study to extract the key
fundamental factors of equity share prices.

Multiple Regression Analysis

Multiple regression models are the statistical analysis which is used to examine the
relationship between dependent variable with two or more independent variables. The
value of adjusted r square is used to see how much variance in dependent variable is
explained by combination of independent variables. The value of F- test signifies
whether model is fit or not and t-test value helps in identifying significant independent
variables at 1 percent, 5 percent and 10 percent level of significance. In the present
study, a linear multiple regression models have been employed to identify the

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 significant fundamental factors of the market price of equity shares. The common
equation of multiple linear regression models is:

Y = b0+b1X1+b2X2+b3X3+………+bnXn

Where, Y = dependent variable,

b0 = constant

X1, X2, X3……..Xn = independent variables,

b1, b2, b3………..bn = regression coefficient of independent factors (the

partial change in market price per share due to one percentage change in independent
factor while other things remain constant).

Levin-Lin-Chu Test

In the Leviin- Lin Chu test has been employed to test the statonarity of panel data.
Levin, Lin, and Chu (2002) proposed a panel unit root test for the null hypothesis of
unit root against a homogeneous stationary hypothesis. In step one, the ADF
regressions are implemented for each individual i, and then the orthogonalized residuals
are generated and normalized. That is, the following model is estimated:

The two orthogonalized residuals are generated by the following two auxiliary
regressions:

The residuals are saved at and , respectively. To remove heteroscedasticity,

the residuals and are normalized by the regression standard error from the
ADF regression. The standard error and normalized residual is denoted as

After that, the ratios of long-run to short-run standard deviations of are estimated.
The ratios and the long-run variances as denoted as and , respectively. The

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 long-

  65
 run variances are estimated by the HAC (heteroscedasticity- and autocorrelation-
consistent) estimators and the ratios are estimated by . And then, the panel
test statistics are calculated.Levin, Lin, and Chu (2002) propose the following
adjusted t statistic:

Panel Data Regression

Panel data includes cross-sectional data (data collected on several units at one point in
time) as well as time series data (data collected on one unit over several time periods)
has been used in the study. Panel data regression is employed to examine the
relationship between equity share prices and fundamental variables. The market value
of equity stock (MP) is taken as the dependent variable while price-earnings, book
value, earnings per stock, dividend payout, dividend per share, debt to equity, size of
the firm and return on asset are taken as the independent variables. Fixed Effect and
Random Effect regression Model is used and R2 and Adjusted R2 values were measured.
Finally, a Hausman specification test has been performed to compare the fixed and
random effect model. The significance of the regression co-efficient pertaining to
various independent variables has been examined by applying t-test at 1%, 5 % and
10 % level of significance. The following regression model has been developed for the
purpose:

MP it = ait + b1 PE it + b2 BV it + b3 EPS it + b4 DP it + b5 DPS it + b6 DEQ it + b7 SIZE it

+ b8 ROA it + eit.

Where, αit = constant term, PE= Price earning, BV = Book value, DP = Dividend
payout, DPS = Dividend per share, DEQ = debt to equity, Size = Size of the firm,
ROA= Return on asset and eit = error term, i = individual firm, t = time, b1, b2,
b3………..b8 = regression coefficient of independent factors (the partial change in
market price per share due to one percentage change in independent factor while other
things remain constant).

Relevance of the Study

The outcome of the present study will help in better understanding the pricing
techniques and fundamental variables related to pricing of equity shares. The study

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 would benefit the society in various ways. It helps the individual as well as institutional
investors in gaining knowledge regarding various fundamental variables that affects the
stock prices and investors can earn extra normal profits by making profitable
investment strategies. Now investors need not take their investment decisions on
speculative basis, they can predict stock prices with the help of these fundamental
variables in simpler way and can take their rational investment decisions in equity
market. The study would also beneficial for corporate management in making their
financial and business related policies. Management of a firm can enhance company
earnings and financial position by increasing the market price of the shares. The results
of the study may also be useful for the stock market authority as they can avoid any
unexpected calamity in the stock market and can control investment strategies and can
also evaluate the extent to which the stock market may need to be rehabilitated. The
study would also beneficial for the government in formulation of better economic
policies and good economic policies help in enhancing the financial performance of the
whole economy. The study will give theoretical as well as practical knowledge and
experience to the researcher and academicians regarding the significant fundamental
variables and their affect on equity share prices that would open new areas in future
research.

Limitations of the Study

Any research study will be constrained in scope by some natural restrictions due to the
choice of the research design, sampling procedure, statistical tools and present study is
no exception of it. This study has considered only those companies as sample size;
those were part of BSE- 200 index. Out of 200 companies, only 124 companies have
been selected as final sample due to non availability of data. The findings of this study
could only be generalized to companies alike to those that were included in this study.
The analysis of study is based on only twelve years data and to make generalizations of
dependence, data should be over about 20-30 years. This research study is confined to
limited number of company specific fundamental variables only though there is more
such type of variable, economy and industry related variables associated with the study.
The objective based on primary data is restricted to the opinions of the equity investors
on sample basis in Haryana and NCR only and hence this cannot be taken to reveal the
view of all equity investors all over the country. The research study is also affected by
the different opinions of investors at different times because of their psychological

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 personality. In addition to it sample size of respondents is also small, due to busy
schedule of investors they could not respond to the questionnaire even after repeated
reminders.

Organization of the Study

The study is divided into following eight chapters:

Chapter I: Introduction

Chapter II: Review of Literature

Chapter III: Research Methodology

Chapter IV: Pricing of Equity Shares: Key Fundamental Factors

Chapter V: Pricing of Equity Shares: Fundamental Determinants of Company

Chapter VI: Pricing of Equity Shares: Fundamental Variables of Industries

Chapter VII: Pricing of Equity Shares: Investor’s Perception

Chapter VIII: Pricing of Equity Shares: Summary and Conclusion

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