India Studies in Business and Economics

Shveta Singh
P.K. Jain
Surendra Singh Yadav

Equity
Markets in
India
Returns, Risk and Price Multiples
India Studies in Business and Economics
The Indian economy is considered to be one of the fastest growing economies of the
world with India amongst the most important G-20 economies. Ever since the
Indian economy made its presence felt on the global platform, the research
community is now even more interested in studying and analyzing what India has to
offer. This series aims to bring forth the latest studies and research about India from
the areas of economics, business, and management science. The titles featured in
this series will present rigorous empirical research, often accompanied by policy
recommendations, evoke and evaluate various aspects of the economy and the
business and management landscape in India, with a special focus on India’s
relationship with the world in terms of business and trade.

More information about this series at http://www.springer.com/series/11234

Shveta Singh P.K. Jain
•

Surendra Singh Yadav

Equity Markets in India

Returns, Risk and Price Multiples

123
Shveta Singh Surendra Singh Yadav
Department of Management Studies Department of Management Studies
Indian Institute of Technology Delhi Indian Institute of Technology Delhi
New Delhi New Delhi
India India

P.K. Jain
Department of Management Studies
Indian Institute of Technology Delhi
New Delhi
India

ISSN 2198-0012 ISSN 2198-0020 (electronic)

India Studies in Business and Economics
ISBN 978-981-10-0867-2 ISBN 978-981-10-0868-9 (eBook)
DOI 10.1007/978-981-10-0868-9

Library of Congress Control Number: 2016935967

© Springer Science+Business Media Singapore 2016

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To
the Almighty
and
our family members
Preface

Great deeds are usually wrought at great risk

—Herodotus

Equity markets constitute the most important segment of stock exchanges. In fact,
status of equity returns is, by and large, reckoned as a barometer of the state of the
economy of a country. Returns earned by equity investors on their funds invested in
equity markets would be a decisive factor in the growth of such markets. What has
been the experience of Indian equity markets constitutes the subject matter of this
book.
It would be useful for equity investors to know the expected returns (on a
rational basis) and actual returns earned on their investments; equally important for
them would be to have an insight into the risk-return trade-off involved in equity
investment and the factors that affect the same.
A study comprising, possibly, the largest sample of the National Stock
Exchange’s (NSE) 500 index companies (representing almost 97 % of the market
capitalisation) has not been undertaken so far, in India. The period of the study is
spread over two decades (1994–2014) tracking returns right from the inception
of the index till the present. This book would, provide a comprehensive view of
equity returns in India.
This book would deepen the investor’s understanding of equity investment and,
thus, help him become a more informed investor. Apart from this, this study would
contribute significantly to the existing body of literature on market returns and
prove to be of some value to academic researchers and market participants
(financial institutions and other intermediaries), regulators and policy makers.

vii
Acknowledgements

At the outset, we would like to thank the Almighty for His blessings to inspire us to
accomplish this academic endeavour. This work has been possible because of the
help, encouragement, cooperation and guidance of many people and we convey our
heartfelt thanks to all of them. Special thanks to the Modi Chair Foundation for
funding the research effort. We are grateful to Prof. Kshitij Gupta, Director, IIT
Delhi and Prof. R.K. Shevgaonkar, ex-Director, IIT Delhi, for their encouragement
and support. We express our gratitude towards Prof. M. Balakrishnan (ex-DDF) and
Prof. Sushil, ex-Dean (Faculty), for their unstinting support. Our thanks are also due
to Prof. S.N. Singh (ex-Dean, IRD), Prof. Sunil Tuli, Dean (IRD), Mr. V.K.
Vashistha, AR (IRD), Mr. R.K. Gupta (ex-AR, IRD Accounts), Mr. Anup Kuksal,
AR (IRD Accounts) and IRD staff for their support for our academic endeavour.
To thank the Head of the Department may seem to be a ritual. But it is not so in
the case of Prof. Kanika T. Bhal, Head, Department of Management Studies
(DMS). She has been supportive throughout. We thank Prof. Ravi Shankar for
engaging in discussions from time to time and all our colleagues in the Department
for their good wishes for this endeavour.
We are grateful to our students, Apurv Manvar, and our research scholars,
Monika Singla, Vandana Bhama and Sadaf Anwar, for their help with the data
collection. We thank our student Nishant Vats for his help with data collation and
processing and our research scholar Harshita for preparing the table of contents and
lists of figures, etc.
Dr. Shveta Singh takes this opportunity to express her deepest gratitude to her
gurus and co-authors, Prof. P.K. Jain and Prof. Surendra Singh Yadav, for their
valuable guidance, inspiration, motivation and untiring efforts in completion of this
project. She also thanks Anil, her husband, for his unwavering support and
encouragement. Professor P.K. Jain acknowledges the patience, understanding,
cooperation and encouragement of his wife, Uma.

ix
x Acknowledgements

Last but not least, we are thankful to all those, not mentioned above, who have
helped in carrying out the study, our family members and loved ones for their
continuous encouragement and support.

Shveta Singh
P.K. Jain
Surendra Singh Yadav
Contents

1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .... . . . . . 1
Section I: Literature Review . . . . . . . . . . . . . . . . . . . . . .... . . . . . 2
Equity Market Studies . . . . . . . . . . . . . . . . . . . . . . . .... . . . . . 2
Factors Affecting Returns . . . . . . . . . . . . . . . . . . . . . .... . . . . . 5
Section II: Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . .... . . . . . 6
Section III: Research Methodology. . . . . . . . . . . . . . . . . .... . . . . . 7
Scope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .... . . . . . 8
NSE 500 Index Background . . . . . . . . . . . . . . . . . . . .... . . . . . 8
Secondary Data and Analysis . . . . . . . . . . . . . . . . . . .... . . . . . 9
Data Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .... . . . . . 11
Section IV: Layout of the Study . . . . . . . . . . . . . . . . . . .... . . . . . 12
Section V: Summary . . . . . . . . . . . . . . . . . . . . . . . . . . .... . . . . . 15
Annexure 1.1: Constituent Companies and Sectors of NSE 500
(as on 11 March 2013) . . . . . . . . . . . . . . . . . . . . . . . . . .... ..... 16
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .... ..... 28

2 Rates of Return on Equity Funds (ROEF)—Corporates’

Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Section I: Literature Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
Risk Factors/Determinants Affecting ROE . . . . . . . . . . . . . . . . . . . 34
Impact of Recent Financial Crisis on India . . . . . . . . . . . . . . . . . . 34
Section II: Scope, Data and Methodology . . . . . . . . . . . . . . . . . . . . . 35
Scope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
NSE 500 Index Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
Secondary Data and Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
Data Sources and Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Section III: Rates of Return from the Company’s
Perspective—ROEF . . . . . . . . . . . . . . . . . . . . . . . . . . . . ........ 38
Section IV: Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . ........ 42
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ........ 43

xi
xii Contents

3 Expected Rates of Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
Section I: Literature Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
Section II: Scope, Data and Methodology . . . . . . . . . . . . . . . . . . . . . 50
Scope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
NSE 500 Index Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Secondary Data and Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
Section III: Expected Rates of Return Based on Capm . . . . . . . . . . . . 52
Section IV: Expected Rates of Return—Cost of Equity . . . . . . . . . . . . 55
Section V: Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61

4 Rates of Return—Investors’ Perspective . . . . . . . . . . . . . . . . . . . . 65

Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
Section I: Literature Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
Factors Affecting Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
Behaviour of Share Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
Section II: Scope, Data and Methodology . . . . . . . . . . . . . . . . . . . . . 70
Scope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
NSE 500 Index Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
Secondary Data and Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
Section III: Portfolio Returns for Varied Holding Periods . . . . . . . . . . 74
Section IV: Overall Characteristics of Returns . . . . . . . . . . . . . . . . . . 79
Periods of High Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
Periods of Low Returns and Losses . . . . . . . . . . . . . . . . . . . . . . . 81
Magnitude of Variations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
Three Phases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
Two Components of Total Return . . . . . . . . . . . . . . . . . . . . . . . . 82
Declining Importance of Dividend . . . . . . . . . . . . . . . . . . . . . . . . 82
Comparison with Debt Instruments. . . . . . . . . . . . . . . . . . . . . . . . 83
Section V: Concluding Observations. . . . . . . . . . . . . . . . . . . . . . . . . 86
Annexure 4.1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
Example of Bonus Share Adjustment . . . . . . . . . . . . . . . . . . . . . . 87
Example for Rights Issue Adjustment . . . . . . . . . . . . . . . . . . . . . . 89
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89

5 Rates of Return—Disaggregative Analysis . . . . . . . . . . . . . . . . . . . 93

Section I: Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
Age . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
Size . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
Ownership Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
Underlying Sector/Industry Affiliation. . . . . . . . . . . . . . . . . . . . . . 96
Section II: Literature Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
Section III: Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
Contents xiii

Scope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .......... 97
NSE 500 Index Background . . . . . . . . . . . . . . . . . . .......... 98
Secondary Data and Analysis . . . . . . . . . . . . . . . . . .......... 98
Section IV: Returns Based on the Age, Size, Ownership
Structure and Underlying Sector/Industry Affiliation
of Sample Companies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
Age . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
Size . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
Ownership Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
Underlying Sector/Industry Affiliation. . . . . . . . . . . . . . . . . . . . . . 113
Section V: Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124

6 Analysis of Price Multiples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127

Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
Section I: Literature Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
Section II: P/E Ratios in India . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
Interpreting the P/E Ratio: A Word of Caution . . . . . . . . . . . . . . . 130
Earnings Per Share (EPS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
Relationship Between EPS and Prices. . . . . . . . . . . . . . . . . . . . . . 131
P/B Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
Section III: Scope, Data and Methodology . . . . . . . . . . . . . . . . . . . . 131
Scope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
NSE 500 Index Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
Secondary Data and Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
Section IV: Price Multiples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
Section V: Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142

7 Volatility in Stock Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145

Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
Section I: Literature Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
International Studies on Behaviour of Returns . . . . . . . . . . . . . . . . 146
Indian Studies on Behaviour of Returns . . . . . . . . . . . . . . . . . . . . 148
Section II: Scope, Data and Methodology . . . . . . . . . . . . . . . . . . . . . 148
Scope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
NSE 500 Index Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
Secondary Data and Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
Formulation of Hypotheses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
Section III: Index Returns and Their Statistical Treatment . . . . . . . . . . 153
Section IV: Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
Annexure 7.1: Glossary of Terms. . . . . . . . . . . . . . . . . . . . . . . . . . . 156
Annexure 7.2: Ljung-Box Q2 Statistics . . . . . . . . . . . . . . . . . . . . . . . 157
xiv Contents

Annexure 7.3: Lagrange Multiplier Test . . . . . . . . . . . . . . . . . . . . . . 157

Annexure 7.4: Stationarity Test Statistics . . . . . . . . . . . . . . . . . . . . . 158
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158

8 Level of Market Efficiency Using ‘Rational Bubbles’ Approach . . . 161

Section I: Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
Section II: Literature Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
Rational Bubbles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
Share Price Changes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
Section III: Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
Scope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
NSE 500 Index Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
Secondary Data and Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
Section IV: Statistical Models Used to Test the Presence
of ‘Rational Bubbles’ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
Unit Root Test. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
Tests for Cointegration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170
Section V: Results and Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . 172
Unit Root Test. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
Threshold Autoregressive (TAR) Test . . . . . . . . . . . . . . . . . . . . . . 173
Momentum-Threshold Autoregressive (M-TAR) Test . . . . . . . . . . . 173
M-TAR Error Correction Model. . . . . . . . . . . . . . . . . . . . . . . . . . 173
Section VI: Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
Annexure 8.1: Brief Definition of Theories and Terms . . . . . . . . . . . . 175
Annexure 8.2: Augmented Dickey–Fuller (ADF) Test Results . . . . . . . 176
Annexure 8.3: Results of TAR Cointegration Test . . . . . . . . . . . . . . . 176
Annexure 8.4: Estimation Results of M-TAR Error
Correction Model (ECM) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... 176
Annexure 8.5: Summary and Diagnostic Checking
for M-TAR Models (1 and 2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
Annexure 8.6: Granger Causality and Path Asymmetry Test . . . . . . . . 177
Annexure 8.7: Engle–Granger Test Results . . . . . . . . . . . . . . . . . . . . 177
Annexure 8.8: ARDL Bound Test Results. . . . . . . . . . . . . . . . . . . . . 178
Annexure 8.9: Johansen–Juselius Test Results . . . . . . . . . . . . . . . . . . 178
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178

9 Concluding Observations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181

Section I: Returns on Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182
Section II: Analysis of Price Multiples . . . . . . . . . . . . . . . . . . . . . . . 185
Section III: Risk/Volatility in Returns . . . . . . . . . . . . . . . . . . . . . . . . 186
Section IV: Level of Market Efficiency. . . . . . . . . . . . . . . . . . . . . . . 186
Section V: Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189
About the Authors

Shveta Singh is an Associate Professor of Finance at the Department of

Management Studies, Indian Institute of Technology (IIT Delhi), India. She teaches
courses on managerial accounting and financial management, indian financial
system and security analysis and portfolio management. Recently, she has devel-
oped a course on corporate governance and has also received training by the
International Finance Corporation (IFC) in collaboration with the Indian Institute of
Corporate Affairs (IICA), for the same. She has contributed to various consulting
assignments for organizations like the Directorate General of Supplies & Disposals
(DGS&D) and the National Buildings Construction Corporation (NBCC).
Overall, she has more than a decade of professional experience, having spent 3
years in the corporate sector prior to joining academics. She has published research
papers in journals of national and international repute. She has been honoured with
the “Leadership” award which she accepted on behalf of IIT Delhi from the Institute
of Business and Finance Research at the Global Conference on Business and
Finance in USA. She also won the “Best in Session” award at the same conference.
She was also honoured with the “Literati” award for outstanding research by
Emerald Publishing Inc. She also received a mention for the “Most Downloaded
Paper” by the Journal of Advances in Management Research, UK.
P.K. Jain is a Professor of Finance at the Department of Management Studies, IIT,
Delhi. He has earlier served as the Co-ordinator of the Dalmia Research Programme
on Management in Asia and also as the Modi Foundation Chair Professor.
He has a teaching experience of more than 40 years in subjects related to
management accounting, financial management, financial analysis, cost analysis
and cost control. His research is primarily focused in the area of corporate finance.
He has authored/co-authored more than 11 textbooks and 14 research
books/monographs. An empiricist, he investigates applied problems using
real-business data to have the managerial implications of various financial aspects.
He has published more than 160 research papers in the journals of national and
international reputation. Recently, his paper “Capital Budgeting Decisions:
Evidence from India” has been adjudged with the “Literati Award” by Emerald for

xv
xvi About the Authors

Outstanding Excellence in Research. He is on the board of academic institutions

and reviewer of journals like Vision, Abhigyan, Vikalp, Finance India,
Management and Change.
Surendra Singh Yadav is currently a Professor at the Department of Management
Studies, IIT, Delhi. He teaches corporate finance, international finance, international
business, and security analysis & portfolio management. He has been a visiting
professor at University of Paris, Paris School of Management and INSEEC Paris
France, and University of Tampa, USA.
Professor Surendra Singh Yadav has published 14 books. He has contributed
more than 130 papers in research journals and about six dozen papers in
conferences/seminars. He has contributed more than 30 articles in
financial/economic newspapers. He has done several sponsored research and con-
sultancy projects for industry and government. Professor Yadav is the
editor-in-chief of the Journal of Advances in Management Research (JAMR),
published by Emerald, UK, in collaboration with IIT Delhi. He has been on a large
number of expert committees as a member or chairman within the institute as well
as outside. He has travelled to several countries such as France, UK, Switzerland,
Belgium, Italy, Netherlands, Singapore and USA.
Abbreviations

ADF Augmented Dickey–Fuller test

ADR American Depository Receipts
AE Abnormal Earnings
AIC Akaike Information Criteria
ANFN Adaptive Neural-Fuzzy Networks
ANOVA Analysis of Variance
APARCH Asymmetric Power Autoregressive Conditional Heteroskedasticity
ARCH Autoregressive Conditional Heteroskedasticity
ARDL Autoregressive Distributed Lag test
ARIMA Autoregressive Integrated Moving Average
β Beta
BE Brand Equity
BEML Bharat Earth Movers Limited
BRIC Brazil, Russia, India and China
BRICA Brazil, Russia, India, China and Argentina
BSE Bombay Stock Exchange
BV/MV Book Value to Market Value
CAPM Capital Asset Pricing Model
CART Classification and Regression Tree
CEO Chief Executive Officer
CFO Chief Financial Officer
CRISIL Credit Rating Information Services of India Limited
CRSP Centre for Research in Security Prices
CS Customer Satisfaction
DCL Degree of Combined Leverage
DF Dickey Fuller test
DFL Degree of Financial Leverage
DOL Degree of Operating Leverage
Dp Preference Dividend
D/P Dividend Pay-out ratio
DPS Dividend per Share

xvii
xviii Abbreviations

DSE Dhaka Stock Exchange

EAT Earnings after Taxes
EBIT Earnings before Interest and Taxes
ECM Error-Correction Model
EGARCH Exponential General Autoregressive Conditional Heteroskedasticity
E/P Earnings-to-Price ratio
EPS Earnings per Share
EW Equal Weighted
E&Y Ernst and Young
FD Fixed Deposit
FDI Foreign Direct Investment
GAAP Generally Accepted Accounting Principles
GARCH General Autoregressive Conditional Heteroskedasticity
GARCH-M General Autoregressive Conditional Heteroscedasticity-Mean
GCC Gulf Cooperation Council
GDP Gross Domestic Product
GSADF Generalized Supremum Augmented Dickey–Fuller test
ICT Internet, Communications Technology
IGARCH Integrated Generalized Autoregressive Conditional
Heteroscedasticity
IISL India Index Services and Products Limited
IMF-FSF International Monetary Fund-Financial Stability Forum
INR Indian Rupee
IPO Initial Public Offering
IRR Internal Rate of Return
IVP Indira Vikas Patra
J–J Johansen–Juselius test
Ke Cost of Equity
KPSS Kwiatkowski–Phillips–Schmidt–Shin statistics
KSE Karachi Stock Exchange
KVP Kisan Vikas Patra
LDA Linear Discriminant Analysis
MPS Market Price per Share
M-TAR Momentum-Threshold Autoregression test
NASDAQ National Association of Securities Dealers Automated Quotations
NSC National Savings Certificates
NSE National Stock Exchange
NYSE New York Stock Exchange
OECD Organization for Economic Cooperation and Development
OLS Ordinary Least Squares
P/B Price-to-Book-Value ratio
P/E Price-to-Earnings ratio
P–P Philips–Perron statistics
PPF Public Provident Fund
PSU Public Sector Undertaking
Abbreviations xix

PwC PricewaterhouseCoopers
QDA Quadratic Discriminant Analysis
QMLI Quasi-Maximum Likelihood Estimation
Q–Q Quantile–Quantile
RBI Reserve Bank of India
Rf Risk-Free Return
Rm Market Return
ROE Return on Equity
ROEF Return on Equity Funds
ROR Rate of Return
S&P Standard & Poor’s
SADF Supremum Augmented Dickey–Fuller test
SEBI Securities and Exchange Board of India
SEC Securities and Exchange Commission
SENSEX Sensitive Index
SG Sales Growth
SIC Schwarz–Bayesian Information Criteria
SPSS Statistical Package for Social Sciences
SV Shareholder Value
TAR Threshold Autoregressive test
TARCH Threshold Autoregressive Conditional Heteroskedasticity
TASE Tel Aviv Stock Exchange
TDS Thomson Datastream
UK United Kingdom
ULIPs Unit Linked Insurance Plans
UNCTAD United Nations Council for Trade and Development
USA United States of America
VaR Value at Risk
V/P Value-to-Price ratio
WTO World Trade Organization
List of Figures

Figure 2.1 Mean values of ROEF for sample companies,

2004–2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 40
Figure 3.1 Mean values of operating leverage of the sample
companies, 2001–2014 . . . . . . . . . . . . . . . . . . . . . . . . . . .. 59
Figure 3.2 Mean values of financial leverage of the sample companies,
2001–2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
Figure 4.1 Rates of return for the fifteen-year holding period . . . . . . . . . 78
Figure 4.2 Rates of return for the ten-year holding period . . . . . . . . . . . 79
Figure 4.3 Rates of return for the five-year holding period . . . . . . . . . . . 80
Figure 4.4 Rates of return for the one-year holding period . . . . . . . . . . . 81
Figure 4.5 Twenty-five years of bank interest rates in India (source
Capitalmind website 2014) . . . . . . . . . . . . . . . . . . . . . . . .. 84
Figure 5.1 Segregation of the sample companies on the basis of age . . .. 94
Figure 5.2 Segregation on the basis of ownership structure of sample
companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 95
Figure 6.1 Mean values of P/E ratio for sample companies,
2001–2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 137
Figure 6.2 Mean values of P/B ratio for sample companies,
2001–2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 141
Figure 7.1 Histogram of the NSE 500 daily returns, 1999–2014 . . . . . .. 153
Figure 7.2 Time Path of the NSE 500 daily closing prices,
1999–2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 154
Figure 7.3 Volatility patterns (deviations) of the NSE 500 index based
on daily closing prices, 1999–2014 . . . . . . . . . . . . . . . . . .. 154
Figure 7.4 Q–Q plot of daily closing prices of the NSE 500 index,
1999–2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 155

xxi
List of Tables

Table 1.1 Sector-wise classification of NSE 500 companies . . . . . . . .. 9

Table 1.2 Sector-wise reclassification of sample companies . . . . . . . . .. 13
Table 2.1 Mean, standard deviation, coefficient of variation,
skewness, kurtosis, median and quartile values related to
return on equity funds (ROEF) of sample companies,
2004–2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 39
Table 2.2 Frequency distribution related to ROEF of sample
companies, 2004–2014 . . . . . . . . . . . . . . . . . . . . . . . . . . .. 41
Table 3.1 Expected returns for the sample companies and their
comparison with market index returns for the period,
2001–2014 (figures are in percentage) . . . . . . . . . . . . . . . .. 53
Table 3.2 Mean, standard deviation, variance, coefficient of variation,
minimum, maximum, skewness, kurtosis and quartile
values of expected and market index returns,
2001–2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 53
Table 3.3 Mean, standard deviation, coefficient of variation,
skewness, kurtosis, median and quartile values of degree of
operating leverage (DOL) and degree of financial leverage
(DFL) of sample companies, 2001–2014 . . . . . . . . . . . . . .. 56
Table 3.4 Frequency distribution pertaining to the degree of operating
leverage (DOL) and degree of financial leverage (DFL) of
sample companies, 2001–2014 (figures are in
percentages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 58
Table 3.5 Assignment of risk premium rate for DOL and DFL . . . . . .. 60
Table 3.6 Cost of equity based on the risk premium approach . . . . . . .. 60
Table 4.1 Rates of return for the fifteen-year holding period
(when equities were purchased at the year’s average price
and then sold 15 years later, at the terminal year’s average
price) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 75

xxiii
xxiv List of Tables

Table 4.2 Rates of return for the ten-year holding period

(when equities were purchased at the year’s average price
and then sold 10 years later, at the terminal year’s average
price) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 75
Table 4.3 Rates of return for the five-year holding period
(when equities were purchased at the year’s average price
and then sold 5 years later, at the terminal year’s average
price) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 76
Table 4.4 Rates of return for the one-year holding period . . . . . . . . . .. 77
Table 4.5 Comparison of different investment avenues—2015 . . . . . . .. 85
Table 5.1 Mean, minimum, maximum, standard deviation, coefficient
of variation, skewness, kurtosis, median and quartile values
related to the age of sample companies . . . . . . . . . . . . . . .. 101
Table 5.2 Mean, minimum, maximum, standard deviation, coefficient
of variation, skewness, kurtosis, median and quartile values
related to the size of sample companies . . . . . . . . . . . . . . .. 102
Table 5.3 Sector-wise reclassification of sample companies . . . . . . . . .. 103
Table 5.4 Weighted annual average returns and statistics of mean,
standard deviation, variation, coefficient of variation,
skewness, kurtosis and quartile values of returns on the
basis of age of sample companies, 2001–2014 . . . . . . . . . .. 106
Table 5.5 Weighted annual average returns and statistics of mean,
standard deviation, variation, coefficient of variation,
skewness, kurtosis and quartile values of returns on the
basis of size of sample companies, 2001−2014 . . . . . . . . . .. 110
Table 5.6 Weighted annual average returns and statistics of mean,
standard deviation, variation, coefficient of variation,
skewness, kurtosis and quartile values of returns on the
basis of ownership structure of sample companies,
2001−2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 114
Table 5.7 Weighted annual average returns and statistics of mean,
standard deviation, variation, coefficient of variation,
skewness, kurtosis and quartile values of returns on the
basis of underlying sector of sample companies,
2001−2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 117
Table 6.1 Interpretation of P/E ratios . . . . . . . . . . . . . . . . . . . . . . . .. 134
Table 6.2 Frequency distribution related to P/E ratio of sample
companies, 2001–2014 . . . . . . . . . . . . . . . . . . . . . . . . . . .. 135
Table 6.3 Mean, standard deviation, coefficient of variation,
skewness, kurtosis, median and quartile values related to
P/E ratio of sample companies 2001–2014 . . . . . . . . . . . . .. 136
Table 6.4 Growth in EPS vis-à-vis P/E multiples for sample
companies, 2001–2014 . . . . . . . . . . . . . . . . . . . . . . . . . . .. 138
List of Tables xxv

Table 6.5 Frequency distribution related to P/B ratio of sample

companies, 2001–2014 . . . . . . . . . . . . . . . . . . . . . . . . . . .. 139
Table 6.6 Mean, standard deviation, coefficient of variation,
skewness, kurtosis, median and quartile values related to
P/B ratio of sample companies 2001–2014 . . . . . . . . . . . . .. 140
Table 7.1 Mean, standard deviation, variance, kurtosis, skewness and
range in daily returns of the NSE 500, 1999–2014 . . . . . . .. 153
Table 8.1 Descriptive statistics of log (price) and log (dividends). . . . .. 168
Table 8.2 Results of M-TAR cointegration test . . . . . . . . . . . . . . . . .. 173
List of Annexures

Annexure 1.1 Constituent Companies and Sectors of NSE 500

(as on 11 March 2013) . . . . . . . . . . . . . . . . . . . . . . . . . 16
Annexure 4.1 Example of Bonus Share Adjustment . . . . . . . . . . . . . . . 87
Example for Rights Issue Adjustment . . . . . . . . . . . . . . . . . .89
.....
Annexure 7.1 Glossary of Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
Annexure 7.2 Ljung-Box Q2 Statistics . . . . . . . . . . . . . . . . . . . . . . . . . 157
Annexure 7.3 Lagrange Multiplier Test . . . . . . . . . . . . . . . . . . . . . . . . 157
Annexure 7.4 Stationarity Test Statistics . . . . . . . . . . . . . . . . . . . . . . . 158
Annexure 8.1 Brief Definition of Theories and Terms . . . . . . . . . . . . . . 175
Annexure 8.2 Augmented Dickey–Fuller (ADF) Test Results . . . . . . . . . 176
Annexure 8.3 Results of TAR Cointegration Test . . . . . . . . . . . . . . . . . 176
Annexure 8.4 Estimation Results of M-TAR Error Correction Model
(ECM). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 176
Annexure 8.5 Summary and Diagnostic Checking for M-TAR Models
(1 and 2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
Annexure 8.6 Granger Causality and Path Asymmetry Test . . . . . . . . . . 177
Annexure 8.7 Engle–Granger Test Results . . . . . . . . . . . . . . . . . . . . . . 177
Annexure 8.8 ARDL Bound Test Results . . . . . . . . . . . . . . . . . . . . . . 178
Annexure 8.9 Johansen–Juselius Test Results . . . . . . . . . . . . . . . . . . . . 178

xxvii
Chapter 1
Introduction

Equity markets constitute the most important segment of stock exchanges; in fact,
status of equity returns is, by and large, reckoned as a barometer of the state of the
economy of a country. Returns earned by equity investors on their funds invested in
equity markets would be a decisive factor in the growth of such markets. What has
been the experience of Indian equity markets constitutes the subject matter of the
present research monograph.
Therefore, it would be useful for equity investors to know the expected returns
(on a rational basis) and actual returns earned on their equity investments; equally
important would be to have insight related to the risk–return trade-off involved in
equity investment and the parameters that may affect the same.
There is a dearth of recent and systematic data on returns earned from investing
in the Indian equities. Perhaps the first formal exercise to analyse data in this regard
was conducted by Gupta (1981) in his study entitled ‘Rates of Return on Equities:
The Indian Experience’, based on the 16-year period, 1960–1976. He extended his
research endeavour and published a monograph titled ‘Returns on Indian Equity
Shares’, presenting equity returns over the period 1980–1999. More than one and a
half decades have elapsed since its completion, and there appears to be no recent
research effort to study returns on equity shares. This research monograph is an
attempt to fill not only this gap but also go beyond the stated objectives of previous
researches.
Since 2000, the market conditions have undergone substantial changes and
financial markets worldwide have witnessed continual upheavals. Further, to the
best of the knowledge of the authors, even though there have been a large number
of empirical studies on equity returns, they have focused on one or two specific
aspects. Therefore, the broad objective of this research effort titled ‘Equity Markets
in India: Returns, Risk and Price Multiples’ is to present a comprehensive view of
the Indian equity returns for the past two decades (1994–2014). For better expo-
sition, this chapter is divided into five sections. Section “Literature Review” con-
tains the summarized literature review. The objectives of the study undertaken have

© Springer Science+Business Media Singapore 2016 1

S. Singh et al., Equity Markets in India, India Studies
in Business and Economics, DOI 10.1007/978-981-10-0868-9_1
2 1 Introduction

been delineated in section “Objectives”. Section “Research Methodology” contains

the broad research methodology followed, and section “Layout of the Study”
presents the layout of the study. Section “Summary” contains the summary.

Section I: Literature Review

For better comprehension, the literature review has been split between two sub-
themes, viz. equity market studies (both international and Indian) and the factors
affecting equity returns and risk.

Equity Market Studies

Sehgal and Balakrishnan (2002) evaluated the presence of systematic patterns in

stock returns for the Indian stock markets. The results, in general, were in con-
formity with those for the developed capital markets. Bekaert et al. (2002) studied
the effect of liberalization on four variables, viz. the interest rates, net equity capital
flows, returns and the dividend yields for the regions of Latin America and Asia.
Lee and Saltoglu (2002) analysed the predictive performances of a selection of
value-at-risk (VaR) models for the Japanese stock market for the period 1984–2000.
Pandey (2003) compared the performance of the various unconditional volatility
estimators and conditional volatility models using the time series data of the Nifty
index. Jun et al. (2003) studied the behaviour of liquidity in emerging markets for
the period 1992–1999. Batra (2004) studied the time variations in volatility and its
persistence in the Indian stock market during 1979–2003. Azarmi et al. (2005)
examined the empirical association between stock market development and eco-
nomic growth for a period of 10 years around the Indian market ‘liberalization’
event (1991).
Dey (2005) deliberated on the effect of economic growth on the portfolio liq-
uidity of global stock exchanges. Belter et al. (2005) presented a new
dividend-adjusted blue-chip index for the Danish stock market covering the period
1985–2002. Ince and Porter (2006) compared US equity return data from the
Thomson Datastream (TDS) database with similar data from the Centre for
Research in Security Prices (CRSP) database to evaluate the TDS database for use
in studies involving a large number of individual equities in markets outside the
USA. Hamza et al. (2006) examined two alternatives to the capitalization-weighted
index for emerging markets, viz. the gross domestic product (GDP)-weighted and
the equal-weighted (EW) indices. Keasey and McGuinness (2008) analysed three
factors underlying the valuation of initial public offering (IPO) firms within the
Hong Kong stock market, viz. the percentage of equity retained by prelisting share
Section I: Literature Review 3

owners, the decision to disclose prospective earnings’ forecast and the level of IPO
underpricing. Attig et al. (2008) observed that the cost of equity and the agency
costs decreased with the presence (and voting numbers) of large shareholders.
Pan and Sinha (2008) studied the return distributions of several indices from the
Indian stock market. Mariani et al. (2008) conducted an empirical study of the
statistical behaviour of the leading Indian market indices versus the indices of the
similarly developing markets of Taiwan and China as well as compared them also
with developed markets (i.e. the Standard & Poor’s (S&P) 500 index of the USA).
Shapira et al. (2009) analysed the functional role of a market index by comparing
the results of the New York Stock Exchange (NYSE) and the Tel Aviv Stock
Exchange (TASE). Tabaka et al. (2009) recorded the price fluctuations in the
Brazilian stock market and tested whether the Brazilian stock returns exhibited a
power law distribution. Bhar and Nikolova (2009) examined the level of integration
amongst the Brazil, Russia, India and China (BRIC) countries and the rest of the
world. Majumder (2012) studied the BRIC markets and compared them with that of
the USA. On similar lines, Aktan et al. (2009) analysed the market indices of Brazil,
Russia, India, China and Argentina (BRICA) and compared their relationships with
the American market for the period 2002–2009.
Kumar and Deo (2009) studied the multifractal properties of the logarithmic
returns of the Indian financial indices of the Bombay Stock Exchange (BSE) and
the National Stock Exchange (NSE). On similar lines, Liu et al. (2010) analysed the
sources of multifractality over time for the Shenzhen stock market. Zunino et al.
(2010) employed the complexity–entropy causality plane to distinguish amongst the
stages of stock market development. Ansari et al. (2010) identified factors con-
tributing to uncertainties during the recession period using statistical analysis,
econometrical analysis and adaptive neural fuzzy networks (ANFN) on the National
Association of Securities Dealers Automated Quotations (NASDAQ) stock market.
Aityan et al. (2010) analysed the degree of global integration between the stock
markets of different countries and their influence on each other. More specifically,
Paul and Bhajanka (2010) documented the degree of integration of the Indian stock
market with the international stock markets. Soni and Shrivastava (2010) classified
the Indian stock market data using the combination of three supervised machine
learning algorithms, classification and regression tree (CART), linear discriminant
analysis (LDA) and quadratic discriminant analysis (QDA).
Mishra et al. (2010) applied a threshold autoregressive (TAR) model on 11-year
weekly data for two indices and ten common stocks from the NSE. Karmakar
(2010) studied return and volatility spillover effects between large and small stocks
in the NSE. Nyberg and Vaihekoski (2010) developed a new monthly,
value-weighted, total return index for the Finnish stock market that covered the
period from the setting up of the Helsinki Stock Exchange in 1912 till 1970, after
which another index became available. Joshi (2010) undertook the study of stock
market volatility in the emerging markets of India and China, using daily closing
prices, from 2005 to 2009. Bhaduri and Saraogi (2010) analysed the relationship
4 1 Introduction

between yield spread and stock market returns. Dicle et al. (2010) evaluated the
emerging Indian market for its efficiency and potential to offer diversification
benefits to international investors. Tripathy (2010) studied the expiration day and
week effects for Nifty futures by using the Kruskal–Wallis test for the period
2007–2009. Lao and Singh (2011) deliberated on the herding behaviour in the
Chinese and Indian stock markets.
Ng et al. (2011) studied the impact of the 2003 Securities and Exchange
Commission (SEC) regulation, requiring shareholder approval for all equity-based
executive compensation plans. Kim et al. (2011) analysed whether the chief exec-
utive officer (CEO) and the chief financial officer (CFO) equity incentives were
associated with the firm-specific future stock price crash risk. Cuoco and Kaniel
(2011) reported that the benchmark stocks had lower expected returns, lower Sharpe
ratios and higher volatilities when compared with similar non-benchmark stocks.
John et al. (2011) assessed the impact of geography on agency costs and firm
dividend policies. Guresen et al. (2011) evaluated the effectiveness of applying
neural network models in stock market predictions. Walid et al. (2011) deployed a
Markov-switching exponential general autoregressive conditional heteroscedastic
(EGARCH) model to study the dynamic linkage between stock price volatility and
exchange rate changes for 4 emerging countries’ markets over the period 1994–2009.
Bayar et al. (2011) developed a theory on new project financing and equity
carve-outs under heterogeneous beliefs amongst investors in the equity market.
Alagidede (2011) examined the stock return predictability in Africa’s emerging
equity markets. Mishra et al. (2011a, b) tested the presence of nonlinear dependence
and deterministic chaos in the rates of return of six Indian stock market indices.
Further, Mishra et al. (2011a, b) demonstrated how optimization procedures could
be put into practice in the context of the Bombay Stock Exchange (BSE). Maher
and Parikh (2011) examined the short-term behaviour of three Indian stock market
indices in response to informational shocks. Kumar et al. (2011) analysed the effect
of global competition for order flows on the local market which arose due to the
listing of American Depository Receipts (ADRs) by six Indian firms on the NYSE.
Kenourgios et al. (2011) studied the financial contagion in the BRIC markets and
two developed markets [the USA and the UK], over the past five financial crises.
Durai and Bhaduri (2011) calculated the correlation statistics of the equity market
of India with other countries, using daily price data from 1997 to 2006. Yuksel and
Bayrak (2012) analysed the relationship between the cyclical behaviour of stock
market indices of the manufacturing, service, finance and technology sectors at the
Istanbul Stock Exchange and the GDP of Turkey for the period 1998–2011.
Annaert et al. (2012) introduced a new monthly return index based on the
Brussels stock market data for the period 1832–1914. Raghvan and Sarwono (2012)
studied the development of the corporate bond market in India, identified the factors
which had influenced its development and suggested policy reforms to enhance its
development. Krishnan and Mishra (2012) analysed liquidity patterns to detect any
commonality across liquidity measures, using one-year intraday data at the NSE.
Section I: Literature Review 5

Factors Affecting Returns

Lau et al. (2002) analysed the relationships between stock returns and six parame-
ters, viz. beta, size, the earnings-to-price (E/P) ratio, the cash flow-to-price ratio, the
book-to-market price ratio and sales growth (SG) on the data of the Singapore and
Malaysian stock markets for the period 1988–1996. Trueman et al. (2003) presented
evidence of anomalies in the Internet firms’ stock returns around announcements of
their quarterly earnings. Xing and Howe (2003) applied a bivariate GARCH model
to the weekly stock index returns from the UK; they documented a significant
positive relationship between returns and its variance. Ho et al. (2006) analysed
empirically the pricing effects of beta, firm size and book-to-market price using the
Hong Kong stock market data. On similar lines, Morelli (2007) analysed the role of
beta, size and book-to-market equity as competing risk measurements in explaining
the cross-sectional returns of the UK stock market for the period 1980–2000.
Shivakumar (2007) analysed the relationship amongst aggregate earnings, stock
market returns and the macroeconomy. Marisetty et al. (2008) studied the security
price reactions to announcements of rights issues by listed Indian firms during the
period 1997–2005. Lally and Swidler (2008) deliberated on the relationship
between the market weight of a single stock and the betas of both stock and the
residual portfolio taking the case of Nokia and the Finnish market for the period
1993–2004. Kozaki and Sato (2008) applied the Beck model (developed for tur-
bulent systems that exhibited scaling properties) to stock markets. Rao and Thakur
(2008) assessed the optimal hedge ratio and hedge efficiency by employing the
Box–Jenkins autoregressive, integrated moving average (ARIMA) technique.
Maniar et al. (2009) analysed the effect of expiration day of the index futures and
options on the trading volume, variance and price of the underlying shares.
Similarly, Debasish (2009) deliberated on the effect of futures trading on the
volatility and the operating efficiency of the underlying Indian stock market.
Mahajan and Singh (2009) examined the empirical relationships amongst return,
volume and volatility dynamics by using daily data of the sensitive index (Sensex)
for the period 1996–2006. The findings of Alti and Sulaeman (2011) suggested that
the companies issued new shares when high stock returns coincided with strong
demand from institutional investors. Ferreira and Santa-Clara (2011) analysed data
from 1927 to 2007 in order to forecast the components of stock market returns.
Torres and Tribó (2011) explored the interaction between the shareholder value
(SV) and customer satisfaction (CS), as well as their impact on a firm’s brand equity
(BE) by employing panel data pertaining to 69 firms from 11 nations during the
period 2002–2005. Berkman et al. (2011) conducted research on a sample of major
international political crises to test the link between changes in disaster risk and
subsequent changes (if any) in stock market prices.
Butler et al. (2011) explored the distinction between the composition effect and
the net financing. Khansa and Liginlal (2011) analysed the effects of malicious
attacks on the stock market returns of information security firms. Todorova and
6 1 Introduction

Vogt (2011) analysed stock data to test whether the power law hypothesis held for
the sample stocks. Dichev and Yu (2011) used dollar-weighted returns to assess the
properties of actual investor returns on hedge funds and compared them to the
buy-and-hold fund returns. Hong and Yogo (2012) analysed whether open interest
could be more informative than futures prices in the presence of hedging demand
and limited risk absorption capacity in futures markets. Johnson and So (2012)
studied the information content of the options and equity volumes when the trading
brokers were privately informed and the trade direction was unobserved. Bansal and
Khanna (2012) analysed the differences in the level of underpricing of IPOs that
were priced through the book-building method vis-a-vis those that were priced
through the fixed-price method. Savor (2012) explored how information presence
affected post-event performance of stocks (experiencing large price changes).
Becker et al. (2013) tested the prediction; namely, when corporate payout was
taxed, internal equity (retained earnings) was cheaper than external equity (share
issues). Yalama and Celik (2013) examined whether real or spurious long-term
memory characteristics of volatility were present in stock market data. Li (2013) in
his findings states that there is a nonlinear wealth transfer from shareholders to
creditors causing shareholder loss. Campello and Graham (2013) studied the capital
investment, stock issuance and cash saving behaviour of non-technology-intensive
manufacturers during the 1990’s technology bubble.
From the aforementioned literature review, it is evident that researchers (the
world over) have focused on one or the other aspect of rates of return on equities;
there is not even a single study which has dealt with returns earned on equity funds
by corporate enterprises. This is perhaps the first study which aims at determining
the rates of return earned on equity investments by the corporate enterprises; the
other contribution of the study is to provide update to Gupta’s work on Rates of
Return on Equities; the notable features of the present work, amongst others, would
be to highlight also the risk–return trade-off, from the perspective of equity
investors.

Section II: Objectives

The objectives of this study are to cover virtually all the major aspects of equity
returns. It is intended to deepen the investor’s understanding of equity investment
and, thus, help him to become a more informed investor. Moreover, apart from the
investor community (both individual and institutional investors), this monograph,
we believe, would contribute significantly to the existing body of literature on
market returns and prove to be of some value to academicians, researchers and
market participants (financial institutions, other intermediaries) regulators and
policy makers. The present study is thus much wider in scope than the one
Section II: Objectives 7

undertaken earlier by Gupta (1981) and another by Gupta and Choudhary (2000).
Given that the objective/focus of management research and education is to improve
and refresh existing perspectives, then this monograph is an important link in the
chain.
Apart from computing actual, expected and market returns, the present study
also aims at conducting a disaggregative analysis (based on underlying aspects such
as age, size, ownership structure and industry affiliation/sector) to understand the
factors affecting returns and risk. Further, to the best of the knowledge of the
authors, a study comprising possibly the largest sample of the NSE 500 index
companies (representing almost 97 % of the market capitalization) has not been
undertaken so far. The period of the study is spread over two decades (1994–2014)
tracking returns right from the inception of the index till the present. This research
would perhaps be the first of its kind in providing a rather comprehensive outlook
towards equity returns in India.
More specifically, in operational terms, the main objectives of the study are as
follows:
1. To compute the rates of returns on equities from the corporates’ perspective [i.e.
rate of return earned on equity funds (ROEF)].
2. To assess the required/expected rate of return [based on ‘beta’ (β) as the risk
measure, computed by employing the capital asset pricing model (CAPM)].
Further, cost of equity (for the investors) has also been measured as a response
to the risk undertaken (based on the operating and financial risk).
3. To ascertain the market rates of return (earned) on equities from the investors’
perspective (by including both the capital gains and the dividend income).
4. To identify the factors affecting returns (by undertaking a disaggregative anal-
ysis of returns focusing on aspects such as age, size, ownership structure and
industry affiliation/sector).
5. To conduct an analysis of price multiples and their relationship with returns
(price-to-earning (P/E) ratio) with a view to assess/have insight on the market
valuation.
6. To examine the volatility in stock returns, with a focus on its behaviour, during
the period of the study.
7. To judge the status of market efficiency, during the period of the study, using the
‘rational bubbles’ methodology.
This monograph is based on the research undertaken to respond to the
above-listed objectives. The analysis is based primarily on the secondary data.

Section III: Research Methodology

The research methodology adopted in the present study to analyse equity returns of
the sample companies has been delineated hereunder.
8 1 Introduction

Scope

The NSE 500 index of the NSE of India comprises of the top 500 companies listed
on the NSE based on their market capitalization. The NSE 500 index represents
about 96.76 % of the free-float market capitalization of the stocks listed on NSE as
on 31 December 2013. The total traded value for the last six months ending
December 2013, of all index constituents, is approximately 97.01 % of the traded
value of all stocks on NSE (source: National Stock Exchange (NSE) Website. http://
www.nseindia.com/products/content/equities/indices/cnx_500.htm). Hence, virtu-
ally, the chosen sample presents a census on equity market returns in India.
The sample is representative in nature as the NSE 500 companies represent all
industry groups (Refer to Annexure 1.1 for the complete list of the NSE 500
companies). The date of sample selection was 11 March 2013. The period of the
study is 1994–2014 (beginning from the inception of the index in 1994 till the
present). This universe was chosen on the assumption that it would be (most likely,
given the above statistics) an accurate representation of the equity returns in India.
Also, selecting the population as large firms with a similar sampling frame of the
previous studies facilitates comparison with these studies.

NSE 500 Index Background

The company Standard & Poor’s (S&P) introduced its first stock-based index in
1923 in the USA. The index has traditionally been market value-weighted; that is,
movements in the prices of stocks with higher market capitalizations (the share
price times the number of shares outstanding) have a greater effect on the index than
companies with smaller market capitalizations. However, the index is now
float-weighted. That is, S&P now calculates the market capitalizations relevant to
the index using only the number of shares (called ‘float’) available for public
trading. This transition was made in two steps, the first on 18 March 2005 and the
second on 16 September 2005 (source: Wikipedia Website. http://en.wikipedia.org/
wiki/S%26P_CNX_500).
Its Indian counterpart, the CNX 500 (hereby referred to as NSE 500), is India’s
first broad-based benchmark of the Indian capital market. The NSE 500 companies
were disaggregated into 72 industry indices, viz. CNX Industry Indices (as on the
date of sample selection). Industry weightages in the index reflect the industry
weightages in the market. For example, if the banking sector has a 5 % weightage in
the universe of stocks traded on NSE, banking stocks in the index would also have a
representation of 5 % in the index (source: National Stock Exchange (NSE) Website.
http://www.nseindia.com/products/content/equities/indices/cnx_500.htm).
Section III: Research Methodology 9

Secondary Data and Analysis

The relevant secondary data were collected from the Bloomberg® database for
twenty-one years (1994–2014). The other secondary data sources used to sub-
stantiate any missing data were the NSEs Website, Capitaline® and AceEquity®
databases and even the constituent companies’ annual reports. More importantly,
the sample data of 500 companies can be considered representative of the universe
as it adequately covers all industry groups (Table 1.1).

Table 1.1 Sector-wise classification of NSE 500 companies

S. No. Sector (CNX Industry Index) Number of Percentage of market
companies capitalization
1 Abrasives 1 0.05
2 Air conditioners 1 0.03
3 Aluminium 2 0.57
4 Auto ancillaries 14 1.10
5 Automobiles—2 and 3 3 1.55
wheelers
6 Automobiles—4 wheelers 6 3.21
7 Banks 36 12.87
8 Bearings 2 0.10
9 Brew/distilleries 3 0.32
10 Cables—power 1 0.01
11 Castings/forgings 2 0.12
12 Cement and cement products 12 2.61
13 Ceramics and sanitary ware 1 0.02
14 Chemicals—inorganic 6 0.36
15 Chemicals—organic 2 0.08
16 Chemicals—speciality 4 0.26
17 Cigarettes 3 3.75
18 Compressors/pumps 4 0.07
19 Computers—hardware 1 0.02
20 Computers—software 29 11.60
21 Construction 47 4.60
22 Consumer durables 4 0.24
23 Cycles 1 0.05
24 Diesel engines 3 0.28
25 Diversified 2 1.65
26 Dyes and pigments 1 0.03
27 Electrical equipment 12 2.24
(continued)
10 1 Introduction

Table 1.1 (continued)

S. No. Sector (CNX Industry Index) Number of Percentage of market
companies capitalization
28 Electrodes 3 0.06
29 Electronics—industrial 2 0.23
30 Engineering 8 2.02
31 Fastners 1 0.02
32 Fertilizers 5 0.28
33 Finance 31 2.88
34 Finance—housing 4 0.30
35 Financial institution 4 0.91
36 Food and food processing 9 0.72
37 Gas 6 1.26
38 Gems jewellery and watches 4 0.52
39 Hotels 4 0.18
40 Leather and leather products 1 0.08
41 Media and entertainment 9 0.81
42 Metals 1 0.91
43 Mining 7 4.96
44 Miscellaneous 8 0.43
45 Oil exploration/production 6 5.89
46 Packaging 6 0.15
47 Paints 4 0.94
48 Paper and paper products 3 0.04
49 Personal care 7 1.65
50 Pesticides and agrochemicals 4 0.16
51 Petrochemicals 3 0.27
52 Pharmaceuticals 33 5.12
53 Plastic and plastic products 8 0.22
54 Power 18 9.76
55 Printing and publishing 3 0.13
56 Refineries 7 2.20
57 Refractories 1 0.01
58 Shipping 8 0.75
59 Solvent extraction 3 0.05
60 Steel and steel products 19 2.72
61 Sugar 5 0.15
62 Tea and coffee 3 0.23
63 Telecommunication— 2 0.03
equipment
64 Telecommunication— 7 3.01
services
65 Textile machinery 1 0.03
(continued)
Section III: Research Methodology 11

Table 1.1 (continued)

S. No. Sector (CNX Industry Index) Number of Percentage of market
companies capitalization
66 Textile products 10 0.26
67 Textiles—cotton 1 0.00
68 Textiles—synthetic 5 0.08
69 Trading 4 0.95
70 Transmission towers 3 0.06
71 Travel and transport 10 0.52
72 Tyres 5 0.22
73 Sector not available 1 0.07
Total 500 100

Data Analysis

The entire set of data has been analysed using Microsoft Excel spreadsheets and the
statistics software SPSS. Well-accepted tools and techniques used in financial
management constitute the basis of the analysis. Specialized financial software like
EViews 8® has been used to assess volatility and the financial statistics software R®
version 2.15.3; package ‘apt’ has been deployed for the ‘rational bubbles’
methodology. For the purpose of the study, key return ratios (say, rates of return
(RoR) on equity funds) and pricing models (say, P/E ratios) have been employed
for understanding investment decisions and returns earned on equity investments.
All the ratios were calculated on a year-to-year basis for the sample companies.
To study the trend and its implications, descriptive statistical values/positional
values, i.e. mean, standard deviation, coefficient of variation, skewness, kurtosis,
median and quartiles, have also been computed for each year. Further, to study
returns over different holding periods, the returns have been computed for holding
periods of 5, 10 and 15 years. Beta (β) values have been taken as the risk measure,
and autoregressive tools have been deployed to estimate market efficiency and
volatility levels.
To do away with the influence of extreme values, they have been excluded from
computing average values. However, where their inclusion has been considered
important, say, for preparation of frequency distribution, extreme values have also
been considered.
The rationale for the study period beginning in 1994 is that the NSE was set up
in the same year. The twenty-one-year period (1994–2014) of the study has been
bifurcated into two subperiods/phases to ascertain whether there has been any
significant change in equity returns of the sample companies over the years. For the
purpose of the analysis, the first nine years, w.e.f. 1 April 1994 to 31 March 2003
(for brevity referred to as 1994–2003), are referred to as phase 1 and the next eleven
years, w.e.f. 1 April 2003 to 31 March 2014 (for brevity referred to as 2003–2014),
as phase 2. It is pertinent to note here that the years 1994–2014 indicate the period
12 1 Introduction

beginning from the Indian financial year, that is, 1 April 1993 and ending on the
closing of the financial year of 31 March 2014. The same holds true for all sub-
sequent notations.
Further, the period of the study is of particular importance because of the
recession (originating due to the American financial crisis) that impacted the world
economy towards the second half of 2008. According to the United Nations
Council on Trade and Development (UNCTAD) investment brief (1 November
2009), the year 2008 marked the end of a growth cycle in global foreign direct
investment (FDI) with worldwide capital flows down by more than 20 %. Due to
the global financial crisis, the capacity of companies to invest was weakened by
reduced access to financial resources, both internally and externally. The propensity
to invest was also affected by the collapsed growth prospects and heightened risks.
Developed countries suffered from a one-third contraction in total FDI inflows in
2008, being at the epicentre of the crisis. In India, total net capital flows reduced
from US$17.3 billion in April–June 2007 to US$13.2 billion in April–June 2008
(source: UNCTAD investment briefs, investment issues analysis branch of
UNCTAD 2009).
Consequently, phase 2 (2003–2014) of the study has been subdivided into two
subphases to ascertain the impact of recession. The five years of 2003–2008 denote
the prerecession phase (phase 3), and the subsequent six years of 2009–2014 denote
the post-recession phase (phase 4) for the purpose of this study (Jain et al. 2013).
The ‘t’ test has been administered to assess whether equity returns differed/
changed during the second phase compared to the first phase, for the sample
companies and amongst its constituent sectors, respectively. For the purpose of the
disaggregative analysis, the 500 companies were regrouped into constituent sectors
to reduce the number of sectors to 10 from 73, primarily for the sake of providing
an adequate/good number of companies in each sector and for the sake of better
statistical analysis (Table 1.2).
It is pertinent to state here that the Gupta (1981) and Gupta and Choudhary
(2000) have conducted studies in the past spanning from 1960 to 1976 and 1980 to
1999, respectively. An effort has been made to link the findings of these studies
with the current one with the aim to establish trends (if any) on equity returns over
the past two decades (to provide a broader perspective).

Section IV: Layout of the Study

Chapter 2 which follows presents the rates of returns on equities from the corpo-
rates’ perspective (based on ROE estimations). Chapter 3 assesses the
required/expected rate of return [based on ‘beta’ (β) as the risk measure, computed
by employing the capital asset pricing model (CAPM)]. It also measures the cost of
equity from the investors’ perspective as a reward for the risk undertaken. Chapter 4
contains the estimations of the market rates of return on equities from the investors’
perspective (by including both the capital gains and the dividend income) for
Section IV: Layout of the Study 13

Table 1.2 Sector-wise reclassification of sample companies

Sectors Number of Percentage of
companies companies
Commodity (metal, metal products, mining, 53 10.60
oil and gas)
Aluminium 2
Castings/forgings 2
Gas 6
Metals 1
Mining 8
Oil exploration/production 6
Refineries 7
Refractories 1
Steel and steel products 19
Sector not available 1
Consumer goods 40 8.00
Air conditioners 1
Brew/distilleries 3
Cigarettes 3
Consumer durables 4
Gems jewellery and watches 4
Leather and leather products 1
Retail 1
Personal care 7
Plastic and plastic products 8
Sugar 5
Tea and coffee 3
Finance 76 15.20
Banks 36
Finance 31
Finance—housing 4
Financial institution 4
Stock broking/trading 1
Health care 36 7.20
Hospitals 3
Pharmaceuticals 33
ICT (Internet, communications and technology) 42 8.40
Computers—hardware 1
Computers—software 29
Telecommunication—equipment 2
Telecommunication—services 7
Transmission towers 3
(continued)
14 1 Introduction

Table 1.2 (continued)

Sectors Number of Percentage of
companies companies
Infrastructure 59 11.80
Cement and cement products 12
Construction 47
Power and electricals 51 10.20
Cables—power 1
Compressors/pumps 4
Electrical equipment 12
Electrodes 3
Electronics—industrial 2
Electrical engineering 8
Fastners 1
Power generation 19
Electricity trading 1
Transport 52 10.40
Auto ancillaries 14
Automobiles—2 and 3 wheelers 3
Automobiles—4 wheelers 6
Bearings 2
Cycles 1
Diesel engines 3
Shipping 8
Travel and transport 10
Tyres 5
Textile and chemicals 50 10.00
Abrasives 1
Chemicals—inorganic 6
Chemicals—organic 2
Chemicals—speciality 4
Dyes and pigments 1
Fertilizers 5
Paints 4
Pesticides and agrochemicals 4
Petrochemicals 3
Solvent extraction 3
Textile machinery 1
Textile products 10
Textiles—cotton 1
Textiles—synthetic 5
Miscellaneous 41 8.20
(continued)
Section IV: Layout of the Study 15

Table 1.2 (continued)

Sectors Number of Percentage of
companies companies
Sanitary ware 1
Diversified 2
Food and food processing 9
Hotels 4
Entertainment 9
Education 1
Packaging 6
Roses 1
Apparel 1
Paper and paper products 3
Printing and publishing 3
Total 500 100

different holding periods. Chapter 5 undertakes a disaggregative analysis of returns

focusing on aspects such as age, size, ownership structure and industry
affiliation/sector. Chapter 6 analyses price multiples and their relationship with
returns. Chapter 7 ascertains the volatility present in the returns, during the period
of the study. Chapter 8 comments on the level of market efficiency using the
‘rational bubbles’ methodology. Concluding the study, Chap. 9 integrates
the observed facts about returns (Chaps. 2, 3 and 4), the disaggregative analysis
(Chap. 5), the price multiples (Chap. 6), volatility and its behaviour (Chap. 7) and
the level of market efficiency (Chap. 8) into a comprehensive perspective of how
the Indian equity market functions. The conceptual framework evolved in the
monograph would be useful to the academia and researchers, not only in India but
also in other developed and developing economies, and would be of value to
regulators such as SEBI, policy makers, practitioners (financial institutions, mutual
funds) and individual and professional investors.

Section V: Summary

The present study aims at having an insight into the equity returns of the 500
companies of the NSE 500 index of the NSE. To the best of the knowledge of the
authors, a study comprising possibly the largest sample representing almost 97 % of
the market capitalization has not been undertaken so far. The period of the study is
spread over the time span of two decades (1994–2014) tracking returns and other
related aspects right from the inception of the index till the present. The study uses
secondary data.
16 1 Introduction

The present study covers virtually all the major aspects of equity returns. It also
conducts a disaggregative analysis (based on underlying factors such as age, size,
ownership structure and industry affiliation/sector) to understand the factors affect-
ing returns and risk. The data analysis is based on well-accepted tools and techniques
in financial management and statistics. This research would perhaps be the first of its
kind in providing a comprehensive outlook towards equity returns in India.

Annexure 1.1: Constituent Companies and Sectors of NSE

500 (as on 11 March 2013)

Company name Industry

3M India Ltd. Trading
ABB Ltd. Electrical equipment
ABG Shipyard Ltd. Shipping
ACC Ltd. Cement and cement products
AIA Engineering Ltd. Electrical equipment
Aarti Industries Ltd. Chemicals—speciality
Aban Offshore Ltd. Oil exploration/production
Adani Enterprises Ltd. Trading
Adani Ports and Special Economic Zone Ltd. Shipping
Adani Power Ltd. Power
Aditya Birla Nuvo Ltd. Finance
Advanta India Ltd. Food and food processing
Agro Tech Foods Ltd. Solvent extraction
AkzoNobel India Ltd. Paints
Allahabad Bank Banks
Allcargo Logistics Ltd. Travel and transport
Alok Industries Ltd. Textile products
Alstom India Ltd. Electrical equipment
Alstom T&D India Ltd. Electrical equipment
Amara Raja Batteries Ltd. Auto ancillaries
Ambuja Cements Ltd. Cement and cement products
Amtek Auto Ltd. Auto ancillaries
Amtek India Ltd. Auto ancillaries
Anant Raj Industries Ltd. Construction
Andhra Bank Banks
Ansal Properties & Infrastructure Ltd. Construction
Apollo Hospitals Enterprises Ltd. Miscellaneous
Apollo Tyres Ltd. Tyres
Aptech Ltd. Computers—software
(continued)
Annexure 1.1: Constituent Companies and Sectors of NSE 500 … 17

(continued)
Company name Industry
Arshiya International Ltd. Travel and transport
Arvind Ltd. Textile products
Asahi India Glass Ltd. Auto ancillaries
Ashok Leyland Ltd. Automobiles—4 wheelers
Asian Paints Ltd. Paints
Astra Zenca Pharma India Ltd. Pharmaceuticals
Atul Ltd. Chemicals—speciality
Aurobindo Pharma Ltd. Pharmaceuticals
Autoline Industries Ltd. Auto ancillaries
Automotive Axles Ltd. Auto ancillaries
Axis Bank Ltd. Banks
BASF India Ltd. Chemicals—speciality
BEML Ltd. Engineering
BF Utilities Ltd. Construction
BGR Energy Systems Ltd. Engineering
BOC India Ltd. Gas
Bajaj Auto Ltd. Automobiles—2 and 3 wheelers
Bajaj Electricals Ltd. Consumer durables
Bajaj Finance Ltd. Finance
Bajaj Finserv Ltd. Finance
Bajaj Hindusthan Ltd. Sugar
Bajaj Holdings & Investment Ltd. Finance
Balkrishna Industries Ltd. Tyres
Ballarpur Industries Ltd. Paper and paper products
Balmer Lawrie & Co. Ltd. Travel and transport
Balrampur Chini Mills Ltd. Sugar
Banco Products (India) Ltd. Auto ancillaries
Bank of Baroda Banks
Bank of India Banks
Bannari Amman Sugars Ltd. Sugar
Bata India Ltd. Leather and leather products
Berger Paints India Ltd. Paints
Bhansali Engineering Polymers Ltd. Petrochemicals
Bharat Electronics Ltd. Electronics—industrial
Bharat Forge Ltd. Castings/forgings
Bharat Heavy Electricals Ltd. Electrical equipment
Bharat Petroleum Corporation Ltd. Refineries
Bharti Airtel Ltd. Telecommunication—services
Bhushan Steel Ltd. Steel and steel products
Biocon Ltd. Pharmaceuticals
(continued)
18 1 Introduction

(continued)
Company name Industry
Birla Corporation Ltd. Cement and cement products
Blue Dart Express Ltd. Travel and transport
Blue Star Ltd. Air conditioners
Bombay Burmah Trading Corporation Ltd. Food and food processing
Bombay Dyeing & Manufacturing Co. Ltd. Textiles—synthetic
Bombay Rayon Fashions Ltd. Textile products
Bosch Ltd. Auto ancillaries
Brigade Enterprises Ltd. Construction
Britannia Industries Ltd. Food and food processing
CESC Ltd. Power
CMC Ltd. Computers—software
CORE Education & Technologies Ltd. Computers—software
CRISIL Ltd. Finance
Cadila Healthcare Ltd. Pharmaceuticals
Cairn India Ltd. Oil exploration/production
Can Fin Homes Ltd. Finance—housing
Canara Bank Banks
Carborundum Universal Ltd. Abrasives
Castrol (India) Ltd. Petrochemicals
Central Bank of India Banks
Century Enka Ltd. Textiles—synthetic
Century Plyboards (India) Ltd. Construction
Century Textile & Industries Ltd. Cement and cement products
Chambal Fertilizers & Chemicals Ltd. Fertilizers
Chennai Petroleum Corporation Ltd. Refineries
Cholamandalam Investment and Finance Company Ltd. Finance
Cipla Ltd. Pharmaceuticals
City Union Bank Ltd. Banks
Clariant Chemicals (India) Ltd. Dyes and pigments
Coal India Ltd. Mining
Colgate Palmolive (India) Ltd. Personal care
Container Corporation of India Ltd. Travel and transport
Coromandel International Ltd. Fertilizers
Corporation Bank Banks
Cox & Kings Ltd. Travel and transport
Crompton Greaves Ltd. Electrical equipment
Cummins India Ltd. Diesel engines
D B Realty Ltd. Construction
DCM Shriram Consolidated Ltd. Diversified
DCW Ltd. Chemicals—inorganic
(continued)
Annexure 1.1: Constituent Companies and Sectors of NSE 500 … 19

(continued)
Company name Industry
DLF Ltd. Construction
Dabur India Ltd. Personal care
Deccan Chronicle Holdings Ltd. Printing and publishing
Deepak Fertilisers & Petrochemicals Corp. Ltd. Chemicals—inorganic
Delta Corp Ltd. Construction
Dena Bank Banks
Development Credit Bank Ltd. Banks
Dewan Housing Finance Corporation Ltd. Finance—housing
Dhanlaxmi Bank Ltd. Banks
Dish TV India Ltd. Media and entertainment
Dishman Pharmaceuticals & Chemicals Ltd. Pharmaceuticals
Divi’s Laboratories Ltd. Pharmaceuticals
Dr. Reddy’s Laboratories Ltd. Pharmaceuticals
Dredging Corporation of India Ltd. Shipping
Dynamatic Technologies Ltd. Compressors/pumps
E.I.D. Parry (India) Ltd. Sugar
EIH Ltd. Hotels
ESAB India Ltd. Electrodes
Edelweiss Financial Services Ltd. Finance
Educomp Solutions Ltd. Computers—software
Eicher Motors Ltd. Automobiles—4 wheelers
Elder Pharmaceuticals Ltd. Pharmaceuticals
Electrosteel Castings Ltd. Castings/forgings
Elgi Equipments Ltd. Compressors/pumps
Emami Ltd. Personal care
Engineers India Ltd. Engineering
Entertainment Network India Ltd. Media and entertainment
Era Infra Engineering Ltd. Construction
Eros Intl Media Ltd. Media and entertainment
Escorts Ltd. Automobiles—4 wheelers
Essar Oil Ltd. Refineries
Essel Propack Ltd. Packaging
Exide Industries Ltd. Auto ancillaries
FDC Ltd. Pharmaceuticals
Fag Bearings India Ltd. Bearings
Federal Bank Ltd. Banks
Federal-Mogul Goetze (India) Ltd. Auto ancillaries
Financial Technologies (India) Ltd. Computers—software
Finolex Cables Ltd. Cables—power
Finolex Industries Ltd. Plastic and plastic products
(continued)
20 1 Introduction

(continued)
Company name Industry
Firstsource Solutions Ltd. Computers—software
FlexiTuff International Ltd. Packaging
Fortis Healthcare Ltd. Miscellaneous
Fresenius Kabi Oncology Ltd. Pharmaceuticals
Future Capital Holdings Ltd. Finance
Future Ventures India Ltd. Finance
GAIL (India) Ltd. Gas
GHCL Ltd. Chemicals—inorganic
GMR Infrastructure Ltd. Construction
GTL Ltd. Telecommunication—services
GVK Power & Infrastructures Ltd. Power
Gammon India Ltd. Construction
Gammon Infrastructure Projects Ltd. Construction
Gateway Distriparks Ltd. Travel and transport
Gati Ltd. Travel and transport
Geojit BNP Paribas Financial Services Ltd. Finance
Geometric Ltd. Computers—software
Gillette India Ltd. Personal care
Gitanjali Gems Ltd. Gems jewellery and watches
GlaxoSmithKline Consumer Healthcare Ltd. Food and food processing
GlaxoSmithKline Pharmaceuticals Ltd. Pharmaceuticals
Glenmark Pharmaceuticals Ltd. Pharmaceuticals
Godfrey Phillips India Ltd. Cigarettes
Godrej Consumer Products Ltd. Personal care
Godrej Industries Ltd. Chemicals—inorganic
Godrej Properties Ltd. Construction
Graphite India Ltd. Electrodes
Grasim Industries Ltd. Cement and cement products
Great Eastern Shipping Co. Ltd. Shipping
Great Offshore Ltd. Oil exploration/production
Greaves Cotton Ltd. Diesel engines
Gujarat Alkalies & Chemicals Ltd. Chemicals—inorganic
Gujarat Fluorochemicals Ltd. Chemicals—organic
Gujarat Gas Co. Ltd. Gas
Gujarat Industries Power Co. Ltd. Power
Gujarat Mineral Development Corporation Ltd. Mining
Gujarat NRE Coke Ltd. Mining
Gujarat Narmada Valley Fertilisers Co. Ltd. Fertilizers
Gujarat Pipavav Port Ltd. Shipping
Gujarat State Fertilizers & Chemicals Ltd. Fertilizers
(continued)
Annexure 1.1: Constituent Companies and Sectors of NSE 500 … 21

(continued)
Company name Industry
Gujarat State Petronet Ltd. Gas
H.E.G. Ltd. Electrodes
HCL Infosystems Ltd. Computers—hardware
HCL Technologies Ltd. Computers—software
HDFC Bank Ltd. Banks
HSIL Ltd. Packaging
HT Media Ltd. Printing and publishing
Hathway Cable & Datacom Ltd. Media and entertainment
Havells India Ltd. Electrical equipment
Hero MotoCorp Ltd. Automobiles—2 and 3 wheelers
Hexaware Technologies Ltd. Computers—software
Himachal Fut Com Ltd. Telecommunication—equipment
Himatsingka Seide Ltd. Textile products
Hindalco Industries Ltd. Aluminium
Hindustan Construction Co. Ltd. Construction
Hindustan Oil Exploration Co. Ltd. Oil exploration/production
Hindustan Petroleum Corporation Ltd. Refineries
Hindustan Unilever Ltd. Diversified
Hindustan Zinc Ltd. Metals
Honeywell Automation India Ltd. Electronics—industrial
Hotel Leela Venture Ltd. Hotels
Housing Development Finance Corporation Ltd. Finance—housing
Housing Development and Infrastructure Ltd. Construction
Hubtown Ltd. Construction
I T C Ltd. Cigarettes
ICICI Bank Ltd. Banks
ICRA Ltd. Finance
IDBI Bank Ltd. Banks
IDFC Ltd. Financial institution
IFCI Ltd. Financial institution
IL&FS Engineering and Construction Company Ltd. Construction
ING Vysya Bank Ltd. Banks
IRB Infrastructure Developers Ltd. Construction
IVRCL Ltd. Construction
Idea Cellular Ltd. Telecommunication—services
Ind-Swift Laboratories Ltd. Pharmaceuticals
India Cements Ltd. Cement and cement products
India Glycols Ltd. Chemicals—organic
India Infoline Ltd. Finance
Indiabulls Financial Services Ltd. Finance
(continued)
22 1 Introduction

(continued)
Company name Industry
Indiabulls Power Ltd. Power
Indiabulls Real Estate Ltd. Construction
Indiabulls Securities Ltd. Finance
Indian Bank Banks
Indian Hotels Co. Ltd. Hotels
Indian Oil Corporation Ltd. Refineries
Indian Overseas Bank Banks
Indo Rama Synthetics Ltd. Textiles—synthetic
Indraprastha Gas Ltd. Gas
Indraprastha Medical Corporation Ltd. Miscellaneous
IndusInd Bank Ltd. Banks
Info Edge (India) Ltd. Computers—software
Infosys Ltd. Computers—software
Infotech Enterprises Ltd. Computers—software
Ingersoll Rand (India) Ltd. Compressors/pumps
Innoventive Industries Ltd. Steel and steel products
Ipca Laboratories Ltd. Pharmaceuticals
J.B. Chemicals & Pharmaceuticals Ltd. Pharmaceuticals
J.Kumar Infraprojects Ltd. Construction
JBF Industries Ltd. Textiles—synthetic
JK Tyre & Industries Ltd. Tyres
JM Financial Ltd. Finance
JSW Energy Ltd. Power
JSW ISPAT Steel Ltd. Steel and steel products
JSW Steel Ltd. Steel and steel products
Jagran Prakashan Ltd. Printing and publishing
Jai Balaji Industries Ltd. Steel and steel products
Jai Corp Ltd. Plastic and plastic products
Jain Irrigation Systems Ltd. Plastic and plastic products
Jaiprakash Associates Ltd. Construction
Jaiprakash Power Ventures Ltd. Power
Jammu & Kashmir Bank Ltd. Banks
Jaypee Infratech Ltd. Construction
Jet Airways (India) Ltd. Travel and transport
Jindal Poly Films Ltd. Packaging
Jindal Saw Ltd. Steel and steel products
Jindal South West Hold Ltd. Finance
Jindal Stainless Ltd. Steel and steel products
Jindal Steel & Power Ltd. Steel and steel products
Jubilant Foodworks Ltd. Food and food processing
(continued)
Annexure 1.1: Constituent Companies and Sectors of NSE 500 … 23

(continued)
Company name Industry
Jubilant Life Sciences Ltd. Pharmaceuticals
Jyoti Structures Ltd. Transmission towers
K.S. Oils Ltd. Solvent extraction
KCP Ltd. Cement and cement products
KPIT Cummins Infosystem Ltd. Computers—software
KSB Pumps Ltd. Compressors/pumps
KSK Energy Ventures Ltd Power
Kajaria Ceramics Ltd. Ceramics and sanitary ware
Kalpataru Power Transmission Ltd. Transmission towers
Kansai Nerolac Paints Ltd. Paints
Karnataka Bank Ltd. Banks
Karur Vysya Bank Ltd. Banks
Karuturi Global Ltd. Miscellaneous
KEC International Ltd. Transmission towers
Kemrock Industries and Exports Ltd. Plastic and plastic products
Kesoram Industries Ltd. Tyres
Kotak Mahindra Bank Ltd. Banks
Kwality Dairy (India) Ltd. Food and food processing
L&T Finance Holdings Ltd. Finance
LIC Housing Finance Ltd. Finance—housing
Lakshmi Machine Works Ltd. Textile machinery
Lakshmi Vilas Bank Ltd. Banks
Lanco Infratech Ltd. Construction
Larsen & Toubro Ltd. Engineering
Lovable Lingerie Ltd. Textile products
Lupin Ltd. Pharmaceuticals
MRF Ltd. Tyres
MVL Ltd. Construction
Madras Cements Ltd. Cement and cement products
Mahanagar Telephone Nigam Ltd. Telecommunication—services
Maharashtra Seamless Ltd. Steel and steel products
Mahindra & Mahindra Financial Services Ltd. Finance
Mahindra & Mahindra Ltd. Automobiles—4 wheelers
Mahindra Lifespace Developers Ltd. Construction
Man Infraconstruction Ltd. Construction
Mandhana Industries Ltd. Textile products
Mangalore Chemicals & Fertilizers Ltd. Pesticides and agrochemicals
Mangalore Refinery & Petrochemicals Ltd. Refineries
Marico Ltd. Personal care
Maruti Suzuki India Ltd. Automobiles—4 wheelers
(continued)
24 1 Introduction

(continued)
Company name Industry
Mastek Ltd. Computers—software
Max India Ltd. Packaging
McLeod Russel India Ltd. Tea and coffee
Mercator Ltd. Mining
Merck Ltd. Pharmaceuticals
Mind Tree Ltd. Computers—software
Monnet Ispat and Energy Ltd. Steel and steel products
Monsanto India Ltd. Pesticides and agrochemicals
Motherson Sumi Systems Ltd. Auto ancillaries
Motilal Oswal Financial Services Ltd. Finance
Mphasis Ltd. Computers—software
Muthoot Finance Ltd. Finance
NCC Ltd. Construction
NHPC Ltd. Power
NIIT Ltd. Computers—software
NMDC Ltd. Mining
NTPC Ltd. Power
National Aluminium Co. Ltd. Aluminium
Nava Bharat Ventures Ltd. Power
Navneet Publications (India) Ltd. Printing and publishing
Network18 Media & Investments Ltd. Finance
Neyveli Lignite Corporation Ltd. Power
Nilkamal Ltd. Plastic and plastic products
Noida-Toll Bridge Co. Ltd. Construction
Oberoi Realty Ltd. Construction
Oil & Natural Gas Corporation Ltd. Oil exploration/production
Oil India Ltd. Oil exploration/production
Omaxe Ltd. Construction
Opto Circuits (I) Ltd. Pharmaceuticals
Oracle Financial Services Software Ltd. Computers—software
Orbit Corporation Ltd. Construction
Orchid Chemicals & Pharmaceuticals Ltd. Pharmaceuticals
Orient Paper & Industries Ltd. Cement and cement products
Oriental Bank of Commerce Banks
Oriental Hotels Ltd. Hotels
Orissa Min Dev Co. Ltd. Mining
Oswal Chemicals & Fertilizers Ltd. Trading
PSL Ltd. Steel and steel products
PTC India Ltd. Power
Page Industries Ltd. Textile products
(continued)
Annexure 1.1: Constituent Companies and Sectors of NSE 500 … 25

(continued)
Company name Industry
Pantaloon Retail (India) Ltd. Miscellaneous
Parsvnath Developer Ltd. Construction
Patel Engineering Ltd. Construction
Peninsula Land Ltd. Construction
Persistent Systems Ltd. Computers—software
Petronet LNG Ltd. Gas
Pfizer Ltd. Pharmaceuticals
Phoenix Mills Ltd. Construction
Pidilite Industries Ltd. Chemicals—speciality
Pipavav Defence and Offshore Engineering Company Ltd. Shipping
Piramal Enterprises Ltd. Pharmaceuticals
Polaris Financial Technology Ltd. Computers—software
Power Finance Corporation Ltd. Financial institution
Power Grid Corporation of India Ltd. Power
Praj Industries Ltd. Engineering
Prakash Industries Ltd. Steel and steel products
Prestige Estates Projects Ltd. Construction
Prime Focus Ltd Media and entertainment
Prism Cement Ltd. Cement and cement products
Procter & Gamble Hygiene & Health Care Ltd. Personal care
Punj Lloyd Ltd. Construction
Punjab National Bank Banks
Puravankara Projects Ltd. Construction
Radico Khaitan Ltd Brew/distilleries
Rajesh Exports Ltd. Gems jewellery and watches
Rallis India Ltd. Pesticides and agrochemicals
Ramco Industries Ltd. Cement and cement products
Ramky Infra Ltd. Construction
Ranbaxy Laboratories Ltd. Pharmaceuticals
Rashtriya Chemicals & Fertilizers Ltd. Fertilizers
Raymond Ltd. Textile products
Redington (India) Ltd. Trading
Rei Agro Ltd. Food and food processing
Reliance Capital Ltd. Finance
Reliance Communications Ltd. Telecommunication—services
Reliance Industrial Infrastructure Ltd. Engineering
Reliance Industries Ltd. Refineries
Reliance Infrastructure Ltd. Power
Reliance Power Ltd. Power
Religare Enterprises Ltd. Finance
(continued)
26 1 Introduction

(continued)
Company name Industry
Rolta India Ltd. Computers—software
Ruchi Soya Industries Ltd. Solvent extraction
Rural Electrification Corporation Ltd. Financial institution
S. Kumars Nationwide Ltd. Textile products
S.E. Investments Ltd. Finance
SKF India Ltd. Bearings
SKS Microfinance Ltd. Finance
SREI Infrastructure Finance Ltd. Finance
SRF Ltd. Textiles—synthetic
Sadbhav Engineering Ltd Construction
Sanofi India Ltd. Pharmaceuticals
Sesa Goa Ltd. Mining
Shanthi Gears Ltd. Auto ancillaries
Shasun Pharmaceuticals Ltd. Pharmaceuticals
Shipping Corporation of India Ltd. Shipping
Shoppers Stop Ltd. Miscellaneous
Shree Ashtavinayak Cine Vision Ltd. Media and entertainment
Shree Cement Ltd. Cement and cement products
Shree Renuka Sugars Ltd. Sugar
Shrenuj & Co. Ltd. Gems jewellery and watches
Shri Lakshmi Cotsyn Ltd. Textiles—cotton
Shriram City Union Finance Ltd. Finance
Shriram Transport Finance Co. Ltd. Finance
Siemens Ltd. Electrical equipment
Simplex Infrastructures Ltd. Construction
Sintex Industries Ltd. Plastic and plastic products
Sobha Developers Ltd. Construction
Sona Koyo Steering Systems Ltd. Auto ancillaries
Sonata Software Ltd. Computers—software
South Indian Bank Ltd. Banks
State Bank of Bikaner & Jaipur Ltd. Banks
State Bank of India Banks
State Bank of Travancore Banks
Steel Authority of India Ltd. Steel and steel products
Sterling Biotech Ltd. Pharmaceuticals
Sterlite Technologies Ltd. Electrical equipment
Strides Arcolab Ltd. Pharmaceuticals
Sujana Towers Ltd. Telecommunication—equipment
Sun Pharmaceutical Industries Ltd. Pharmaceuticals
Sun TV Network Ltd. Media and entertainment
(continued)
Annexure 1.1: Constituent Companies and Sectors of NSE 500 … 27

(continued)
Company name Industry
Sundaram Finance Ltd. Finance
Sundram Fasteners Ltd. Fastners
Sunteck Realty Ltd. Construction
Supreme Industries Ltd. Plastic and plastic products
Supreme Infrastructure India Ltd. Construction
Supreme Petrochem Ltd. Petrochemicals
Suzlon Energy Ltd. Electrical equipment
Swaraj Engines Ltd. Diesel engines
Syndicate Bank Banks
TD Power Systems Ltd. Electrical equipment
TTK Prestige Ltd. Consumer durables
TV18 Broadcast Ltd. Media and entertainment
TVS Motor Company Ltd. Automobiles—2 and 3 wheelers
Tamil Nadu Newsprint & Papers Ltd. Paper and paper products
Tata Chemicals Ltd. Chemicals—inorganic
Tata Coffee Ltd. Tea and coffee
Tata Communications Ltd. Telecommunication—services
Tata Consultancy Services Ltd. Computers—software
Tata Elxsi Ltd. Computers—software
Tata Global Beverages Ltd. Tea and coffee
Tata Investment Corporation Ltd. Finance
Tata Motors Ltd. Automobiles—4 wheelers
Tata Power Co. Ltd. Power
Tata Sponge Iron Ltd. Steel and steel products
Tata Steel Ltd. Steel and steel products
Tech Mahindra Ltd. Computers—software
Techno Elt & Eng Co. Ltd. Engineering
Thermax Ltd. Electrical equipment
Thomas Cook (India) Ltd. Travel and transport
Tinplate Company of India Ltd. Steel and steel products
Titan Industries Ltd. Gems jewellery and watches
Torrent Pharmaceuticals Ltd. Pharmaceuticals
Torrent Power Ltd. Power
Tree House Education & Accessories Ltd. Miscellaneous
Trent Ltd. Miscellaneous
Tube Investments of India Ltd. Cycles
Tulip Telecom Ltd. Telecommunication—services
UCO Bank Banks
UFLEX Ltd. Packaging
Ultra Tech Cement Ltd. Cement and cement products
(continued)
28 1 Introduction

(continued)
Company name Industry
Unichem Laboratories Ltd. Pharmaceuticals
Union Bank of India Banks
Unitech Ltd. Construction
United Breweries (Holdings) Ltd. Finance
United Breweries Ltd. Brew/distilleries
United Phosphorus Ltd. Pesticides and agrochemicals
United Spirits Ltd. Brew/distilleries
Unity Infraprojects Ltd. Construction
Usha Martin Ltd. Steel and steel products
Uttam Galva Steels Ltd. Steel and steel products
V.I.P. Industries Ltd. Plastic and plastic products
VST Industries Ltd. Cigarettes
Vakrangee Software Ltd. Computers—software
Varun Shipping Co. Ltd. Shipping
Venky’s (India) Ltd. Food and food processing
Vesuvius India Ltd. Refractories
Videocon Industries Ltd. Consumer durables
Vijaya Bank Banks
Voltas Ltd. Engineering
WABCO India Ltd. Auto ancillaries
Welspun Corp Ltd. Steel and steel products
West Coast Paper Mills Ltd. Paper and paper products
Whirlpool of India Ltd. Consumer durables
Wipro Ltd. Computers—software
Wyeth Ltd. Pharmaceuticals
Yes Bank Ltd. Banks
Zee Entertainment Enterprises Ltd. Media and entertainment
Zensar Technologies Ltd. Computers—software
Zodiac Clothing Co. Ltd. Textile products
Zydus Wellness Ltd. Food and food processing
eClerx Services Ltd. Computers—software

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Chapter 2
Rates of Return on Equity Funds
(ROEF)—Corporates’ Perspective

Introduction

The most important financial objective of any firm is to maximize the wealth of its
owners or ordinary shareholders which, inter-alia, depends on the earnings of the
firm on its equity funds, technically referred to as ‘return on equity funds (ROEF)’
(in common parlance, return on equity (ROE)); the terms ROEF/ROE have been
used interchangeably in this text. The returns test is more than a just conventional
test of economic efficiency; it is a test of whether the resources are gainfully
employed or not and whether the business enterprise is operating competitively or
not (Jain et al. 2013).
In the subsequent chapter (Chap. 4), the rates of return earned by equity
investors, emanating from the market, for varying holding periods, are calculated
and presented for the sample companies. This exercise has been undertaken from
the point of view of the equity investors. Returns in the context of the study include
both capital gains (returns from market transactions) and dividend payments from
the company.
Returns primarily depend on the fundamental strength and financial performance
of the underlying company. Given the significance of financial viability of business
operations, the objective of this chapter is to assess the financial performance of the
sample companies in terms of ROE, with a special focus on comparing returns
earned by the corporates during the pre- and post-recession periods. This exercise
has been undertaken from the corporates’ perspective. In the literature reviewed,
there was hardly any literature related to ROE in the context of equity returns (from
the firm’s perspective), thus, filling the existing gap in the literature.
For better exposition, this chapter has been divided into four sections. Section I
provides a brief literature review on the factors that affect ROE and its associated
risks. Section II contains the scope and methodology related to the determination of
the ROE. Section III presents the computed ROE and its descriptive statistics.
Section IV contains the summary of important observations/findings.

© Springer Science+Business Media Singapore 2016 33

S. Singh et al., Equity Markets in India, India Studies
in Business and Economics, DOI 10.1007/978-981-10-0868-9_2
34 2 Rates of Return on Equity Funds (ROEF)—Corporates’ Perspective

Section I: Literature Review

The literature review focuses on the risk factors/determinants affecting ROE, in

particular, and returns, in general. Literature on the recent financial crisis and its
impact (if any) on Indian companies has also been presented, albeit, briefly.

Risk Factors/Determinants Affecting ROE

Beaver (1966) contended that a failing firm was costly to the suppliers of capital
because the reorganization or liquidation costs consumed a major portion of firm’s
value. Nerlove (1968) investigated the factors affecting the rate of return on
investment in the common stock using the multiple regression technique and
concluded that the firm’s sales growth was the only important explanatory variable.
Auerbach (1979) examined the impact of taxes on the corporate equity policy using
a simple dynamic model.
Nwaeze (1997) explored the movements in ROE for electric utilities and man-
ufacturing firms and their effect on profits and share prices. Frank and Jagannathan
(1998) examined data from the Hong Kong stock market for the effect of taxes on
dividends and capital gains. Stulz (1999) analysed the impact of globalization on
the cost of equity capital. In their study, Collins and Kemsley (2000) deduced that
capital gains as well as dividend taxes reduced the valuation of the reinvested
portion of earnings.
Ferreira and Santa-Clara (2011) studied data from 1927 to 2007 to forecast the
components of stock market returns in the USA. The resultant significant compo-
nents were dividend–price ratio, earnings growth and price-earnings growth.
Kandel et al. (2011) studied how a firm’s shareholding structure affected its
financial and operating performance. Becker et al. (2013) tested the prediction,
namely when corporate pay-out was taxed, internal equity (retained earnings) was
cheaper than external equity (share issues).
As is evident, literature available around returns on equity in the context of
corporate firms is scant. It was thus considered necessary to report ROEF and its
analysis, for a large economy like India, in a humble attempt to fill this research gap.

Impact of Recent Financial Crisis on India

Investments have been predominantly financed by domestic savings in India. The

Government’s fiscal deficit has been high by international standards but is also
largely financed internally through a vibrant and well-developed government
securities market, and thus, despite large fiscal deficits, macroeconomic and
financial stability has been maintained.
Section I: Literature Review 35

The Reserve Bank of India (RBI, India’s central bank) in October 2008 stated
that India had (at that time) not been seriously affected by the financial crisis, as per
the response prepared for the International Monetary Fund (IMF)—Financial
Stability Forum (FSF) (Source: RBI Website. http://rbidocs.rbi.org.in/rdocs/
Speeches/PDFs/87784.pdf; Economic Surveys of India).
However, with the increasing integration of the Indian economy and its financial
markets with the rest of the world, there is recognition that the country does face
some downside risks from these international developments. The risks arise mainly
from the potential reversal of capital flows on a sustained medium-term basis. As
might be expected, the main impact of the global financial turmoil in India ema-
nated from the significant change experienced in the capital account. Total net
capital flows fell from US$17.3 billion in April–June 2007 to US$13.2 billion in
April–June 2008 (UNCTAD Website 2011).
On the positive side, however, the characteristics of India’s external and
financial sector management coupled with adequate foreign exchange reserves and
the growing underlying strength of the Indian economy reduced the susceptibility of
the Indian economy to global turbulence (Source: Reserve Bank of India Website.
http://www.rbi.org.in/scripts/WSSViewDetail.aspx?TYPE=Section&PARAM1=2.
Accessed on 4 December 2011).
As per the Economic Survey of India of 2010–11, the Indian economy has
emerged with remarkable rapidity from the slowdown caused by the global
financial crisis of 2007–09. With the growth in 2009–10, estimated at 8 % by the
Quick Estimates, released on 31 January 2011, the turnaround has been fast and
strong (Source: http://indiabudget.nic.in/. Accessed on 17 November 2011).

Section II: Scope, Data and Methodology

The research methodology adopted in the study to compute ROEF and its
descriptive statistics (for corresponding periods) has been delineated hereunder.

Scope

The sample comprises the NSE 500 companies that comprise the top 500 compa-
nies listed on the NSE based on their market capitalization. They represented
96.76 % of the free-float market capitalization of the stocks listed on the NSE as on
31 December 2013 (Source: National Stock Exchange (NSE) Website. http://www.
nseindia.com/products/content/equities/indices/cnx_500.htm). Hence, virtually, the
chosen sample presents a census on equity market returns in India.
The sample is representative in nature as the NSE 500 companies represent all
industry groups. The period of the study for this chapter is 2004–2014.
36 2 Rates of Return on Equity Funds (ROEF)—Corporates’ Perspective

NSE 500 Index Background

The company, Standard & Poor’s (S&P), introduced its first stock-based index in
1923 in the USA. Traditionally market-value weighted, the index is now float
weighted. That is, S&P now calculates the market capitalizations relevant to the
index using only the number of shares (called ‘float’) available for public trading.
This transition was made in two steps, the first on 18 March 2005 and the second on
16 September 2005 (Source: Wikipedia Website. http://en.wikipedia.org/wiki/S%
26P_CNX_500).
Its Indian counterpart, the CNX 500 (hereby referred to as NSE 500) is the first
broad-based benchmark of the Indian capital market. The Credit Rating Information
Services of India Limited (CRISIL) and the NSE together own and manage the
index through a joint venture called the India Index Services and Products Limited
(IISL) (Investopedia 2013).

Secondary Data and Analysis

Individual Companies and Portfolios

The basic computation of ROEF is for individual companies. The average ROEF
for the year has been built up from individual company ROEFs. This method is
tedious but has the advantage of not only ensuring greater accuracy but also of
providing many more insights. However, the presentation emphasizes the entire
portfolio’s ROEFs. This has been done in order to provide a benchmark and an
over-all picture of returns on equity. Also, most of the serious equity investors,
including individuals as well as institutions, have diversified portfolios.

Definition of ROEF

Return on equity (ROEF) is the ratio of net income (after the payment of preference
dividends) of a firm (during a year) to its shareholders’ equity funds during that
year. It is a measure of the profitability of the equity shareholders’ investments.
The formula to calculate ROEF for a particular year is given as follows:


ROEF ¼ EAT  Dp =Average shareholders' equity funds ð2:1Þ

where
EAT Earnings after taxes,
Dp Preference dividend (if applicable).
Section II: Scope, Data and Methodology 37

Average shareholders’ equity funds = the sum of ordinary shareholder’s equity

funds at the beginning and at the end of the year, divided by 2. It is useful to iterate
here that the shareholders’ equity funds also include the reserves and surplus
(retained through the years) less the accumulated losses (if any).

Initial Public Offering (IPO) Adjustment

In the scenario where the company has made an initial public offering (IPO), in a
particular year, its equity amounts would vary substantially when we compare the
opening and closing figures. Hence, an adjustment is required in the calculation of
the ROEF to reflect this change and also to normalize the otherwise distorted
figures.
For example—Company ABC has an equity capital of Rs. 100 crores at the
beginning of the year (the financial year beginning in India is April 1). On
December 1, nine months from the beginning of the year, the company raises fresh
capital through an IPO, thus increasing the equity capital to Rs. 200 crores. It is
reasonable to infer that the earnings for that year have been made on an investment
of Rs. 100 crores for the first nine months and on Rs. 200 crores for the remaining
three months.
By the above calculation, the denominator representing average shareholders’
equity would be computed as (100 + 200)/2 = Rs. 150 crores. However,
Rs. 200 crores have been employed only towards the last quarter of that year,
necessitating an adjustment, to reflect such usage. It is reasonable to assume that,
perhaps, the funds were not used for commercial purposes in that financial year
since they were made available only towards the end of that year, and it would take
time to deploy the funds into projects, straight away. Further, to make such
adjustments related to the exact amount of funds deployed till the end of the said
financial year is not plausible, due to the lack of appropriate data.
Hence, to aid calculations, the adjustment for the average equity capital values
(taking 365 as the number of days in a year) has been made in the following
manner:

ððCapital at the beginning of the year  365Þ þ ðAdditional capital introduced during the year
 ðNumber of days for which it has been employedÞÞÞ=365

This computational adjustment has been incorporated for all sample companies
that issued additional or follow-on equity during the period of the study.
38 2 Rates of Return on Equity Funds (ROEF)—Corporates’ Perspective

Data Sources and Analysis

The relevant data (secondary) were collected from the Bloomberg® database, for
eleven years (2004–2014). Descriptive statistical values/positional values, i.e.
mean, standard deviation, variance, coefficient of variation, skewness, kurtosis and
quartile values, have been computed for each holding period. The entire set of data
has been analysed using Microsoft Excel® spreadsheets and the statistics software
SPSS®, namely Statistical Package for Social Sciences. The impact of recession (if
any) has been tested through the paired t-test statistic.
The period of the study is of particular importance because of the recession
(originating due to the American financial crisis) that impacted the world economy
towards the second half of 2008 (Source: UNCTAD investment briefs, investment
issues analysis branch of UNCTAD 2009).
Consequently, the study period has been divided into two subphases to ascertain
the impact of recession. The five years of 2003–2004 to 2007–2008 denote the
prerecession phase (phase 1) and the subsequent six years of 2008–2009 to 2013–
2014 denote the post-recession phase (phase 2) for the purpose of this study. It
needs to be noted that though the impact of recession was assumed to be felt
towards the second half of 2008 (June 2008, cited above), the entire year has been
included in the post-recession phase primarily due to two reasons; first, data were
available in a consolidated manner (in the balance sheets) and second, it was not
feasible to separate it for a particular year (2008) on the basis of when recession
actually started impacting a particular data variable (Jain et al. 2013).

Section III: Rates of Return from the Company’s

Perspective—ROEF

The real owners of the business firm are the ordinary shareholders who bear all the
risk and are entitled to all residual profits after all outside claims including pref-
erence dividends are met in full. In this section, the rates of return from the com-
pany’s perspective have been computed. The measure, ROE, has been computed on
an annual basis.
ROEF, for the purpose, was calculated separately for each constituent company
in the sample, for 10 years, viz., 2003–2013 (years ending 2004–2014). A weighted
average of the ROEF thus computed for the 500 constituent companies of the NSE
500 was taken as the average ROEF for that particular year. The unavailability of
corporate financial data prior to 2003 is the reason for the non-computation of
ROEF for the years prior to 2003.
Table 2.1 presents the average ROEF earned by the constituent companies of the
NSE 500 index for the years ending 2004–2014 and their descriptive statistics, viz.,
mean, standard deviation, variance, coefficient of variation, skewness, kurtosis and
Table 2.1 Mean, standard deviation, coefficient of variation, skewness, kurtosis, median and quartile values related to return on equity funds (ROEF) of
sample companies, 2004–2014
Year endinga Number Mean Standard Coefficient of Skewness Kurtosis Median Quartile 1 Quartile 3
deviation variation (%)
2004 424 21.28 15.76 74.06 3.22 18.38 18.88 11.79 26.36
2005 436 21.91 15.36 70.10 1.90 5.33 19.06 11.78 26.82
2006 456 22.58 18.15 80.38 2.60 9.40 17.78 11.91 27.26
2007 465 22.42 16.47 73.46 2.63 11.09 19.51 12.43 27.44
2008 463 20.74 13.51 65.14 1.94 6.63 18.11 12.35 25.79
2009 455 18.44 13.42 72.78 3.02 19.01 16.30 10.21 23.76
2010 469 17.91 12.82 71.58 2.74 16.21 16.46 9.18 23.63
2011 468 17.09 12.60 73.73 3.27 20.84 14.81 9.32 22.26
2012 441 15.72 13.92 88.55 3.98 25.44 13.45 8.33 19.44
2013 467 16.19 13.61 84.06 3.65 24.65 13.89 8.41 20.55
2014 455 15.81 13.73 86.84 2.82 15.37 13.27 6.69 20.54
2004–2014 454 19.10 14.49 76.43 2.89 15.67 16.50 10.22 23.99
Phase 1 (2003–2004 to 449 21.79 15.85 72.63 2.46 10.17 18.67 12.05 26.73
Section III: Rates of Return from the Company’s Perspective—ROEF

2007–2008)
Phase 2 (2008–2009 to 459 16.86 13.35 79.59 3.25 20.25 14.70 8.69 21.70
2013–2014)
Figures are in percentages
(i) aThe Indian financial year begins on April 1 and ends on March 31 of the following year. The same holds true for all subsequent tables and notations
(ii) Extreme values of 150 % or more and negative values are excluded
39
40 2 Rates of Return on Equity Funds (ROEF)—Corporates’ Perspective

Fig. 2.1 Mean values of ROEF for sample companies, 2004–2014

quartile values. Figure 2.1 denotes the average ROEF for the sample companies
pictorially. The frequency distribution is presented in Table 2.2.
Given the current interest rates prevailing in the capital market and social
responsibilities the companies have to perform, the average rate of return on equity
(ROEF) of 19.10 %, prima facie, can be considered satisfactory. Further, this figure is
encouraging when compared to the average ROEF of 17 %, reported by Jain et al.
(2013) for the BSE 200 companies over the period, 2001–2011. However, recession
did impact the ROEF; the decline in the ROE to 16.86 % in phase 2 (post-recession)
compared to 21.79 % of phase 1 (prerecession) is statistically significant, as per the
paired t-test. It would perhaps be useful to note here that even though there was a drop
in the ROE, post-recession, the sample companies were still able to record 16.86 %
returns which are comparable with the average returns for the period 2001–2011.
Frequency distribution data further reinforce the above contention (Table 2.2).
The percentage of companies having negative ROEF is 8.60 % in 2014. This is in
contrast to the findings of an earlier study conducted by the authors on Indian public
sector undertakings (PSUs) where 20 % of such companies had negative ROEF.
Around one-third of the sample companies lie in the 10–20 % ROEF bracket.
One-fifth of the companies reported a ROEF of more than 20 %, an indication of
the fundamental robustness of the sample companies and, in turn, the Indian cor-
porate sector.

Paired t-test
Paired differences t df Significance
Mean Standard Standard 95 % (2-tailed)
deviation error confidence
mean interval of the
difference
Lower Upper
Phase 1–Phase 2 4.71 1.47 0.66 2.90 6.54 7.19 4 0.002
Table 2.2 Frequency distribution related to ROEF of sample companies, 2004–2014
ROEF (%) 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Less than 0 6.45 5.67 3.51 3.47 4.66 6.85 4.23 5.01 8.28 7.00 8.60
0–10 17.63 18.45 17.73 16.94 15.99 32.23 27.32 27.65 30.10 31.00 33.00
10–20 32.69 31.03 38.14 34.49 36.44 31.24 34.07 38.28 40.80 38.00 33.60
20–30 24.95 26.21 20.00 25.31 24.90 12.70 23.59 20.04 13.73 16.00 14.60
30–40 9.46 7.55 9.28 10.82 9.92 8.87 6.24 5.01 3.23 4.00 5.60
40–50 2.80 4.61 4.54 3.27 2.63 1.81 2.01 1.80 1.21 4.00 3.00
Above 50 5.59 6.08 6.80 5.31 3.64 1.81 2.01 1.60 2.42 1.00 1.80
Total 100 100 100 100 100 100 100 100 100 100 100
Note Total (100) may not tally due to rounding off
Section III: Rates of Return from the Company’s Perspective—ROEF
41
42 2 Rates of Return on Equity Funds (ROEF)—Corporates’ Perspective

Hence, the sample companies appear to be providing adequate returns to their

owners adhering to the primary objective of maximizing the wealth of its share-
holders. The standard deviation and the coefficient of variation are, however,
indicative of the volatility available in the ROEF of the sample companies. This
could perhaps be attributable to the varying nature of the sectors represented in the
sample.
Positive skewness, through the period of the study, is indicative of larger values
of ROEF dominating the sample, which is also supported by the frequency dis-
tribution. Approximately, seven-tenths of the sample companies report a ROEF of
greater than 10 %, for the entire period of the study, except for the years 2009 and
2012, when this ratio reduced, ostensibly due to the impact of recession occurring
in 2008, and the slowdown in the Indian economy in the year 2011, respectively.
The average quartile values (10.22 for quartile 1 and 23.99 % for quartile 3) also
support the above contention of adequate returns.
Interestingly, a high kurtosis figure is indicative of the ROEF data exhibiting
characteristics of a distribution containing high values that exhibit a high degree of
clustering around the mean. The behaviour of volatility in returns (in detail),
specifically market returns, has been analysed separately, in Chap. 7.

Section IV: Summary

This chapter presents the equity returns, measured through the ROE, for the Indian
stock market, represented by the NSE 500 companies.
The returns earned by the sample companies, prima facie, appear to be stable
and attractive (as an investment choice). Even though the recession in phase 2 did
witness a reduction in the computed value of ROEF (a reduction of more than 4 %
from 21.79 to 16.86 %), which was statistically significant, the reduced returns were
still comparable with the average returns recorded for the period, 2001–2011 (Jain
et al. 2013). These findings are notable as they support the RBI’s views on the
resilience of the Indian economy.
It appears safe to assume that the sample companies, constituting of 96.27 % of
the total market capitalization at NSE, continue to be an attractive investment
destination for long-term investors who base their investments on fundamentals.
Moreover, it is rather encouraging to note that the returns of the sample com-
panies appear robust when compared to the findings of Gupta and Choudhary
(2000). Hence, it appears safe to assume that the success story of the Indian equity
market continues, both in terms of the returns and in their increasing market breadth
and coverage.
References 43

References

Auerbach AJ (1979) Share valuation and corporate equity policy. J Public Econ 11(3):291–305
Beaver W (1966) ‘Financial ratios as predictors of failure; empirical research in accounting’,
selected studies. J Acc Res 5:71–111 Supplement to vol 4
Becker B, Jacob M, Jacob M (2013) Payout taxes and the allocation of investment. J Financ Econ
107(1):1–24
Collins J, Kemsley D (2000) Capital gains and dividend taxes in firm valuation: evidence of triple
taxation. Acc Rev 75(4):405–427
Economic Surveys of India website (2011). http://indiabudget.nic.in/. Accessed on 17 Nov 2011
Ferreira MA, Santa-Clara P (2011) Forecasting stock market returns: the sum of the parts is more
than the whole. J Financ Econ 100(3):514–537
Frank M, Jagannathan R (1998) Why do stock prices drop by less than the value of the dividend?
Evidence from a country without taxes. J Financ Econ 47(3):161–188
Gupta LC, Choudhary UK (2000) ‘Returns on Indian equity shares’, sponsored by Bombay stock
exchange in collaboration with the society for capital market research and development, New
Delhi
Investopedia website (2013). http://www.investopedia.com/terms/s/sp_cnx_nifty.asp. Accessed on
31 Dec 2013
Jain PK, Singh S, Yadav SS (2013) Financial management practices: an empirical study of Indian
corporates. Springer, New York. ISBN 978-81-322-0989-8
Kandel E, Massa M, Simonov A (2011) Do small shareholders count? J Financ Econ 101(3):
641–665
National Stock Exchange website (2014). http://www.nseindia.com/products/content/equities/
indices/cnx_500.htm. Accessed on 10 March 2014
Nerlove M (1968) Factors affecting return in investment in individual common stocks. Rev Econ
Stat 50(3):312–329
Nwaeze E (1997) Rate-of-return regulation and the behaviour of the return on equity for electric
utilities. J Econ Bus 49:491–510 (September/October Issue)
Reserve Bank of India’s website (2011). http://rbidocs.rbi.org.in/rdocs/Speeches/PDFs/87784.pdf.
Accessed on 17 Nov 2011
Stulz R (1999) Globalization of equity markets and the cost of capital. In: Conference proceeding,
SBF/NYSE conference on global equity markets
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unctad.org/en/docs/webdiaeia20095_en.pdf. Accessed on 17 Nov 2011
Wikipedia website (2014). http://en.wikipedia.org/wiki/S%26P_CNX_500. Accessed on 10
Mar 2014
Chapter 3
Expected Rates of Return

Introduction

Before computing returns earned on equity shares in India (Chap. 4), it would be
useful to have an estimate of the expected returns in the Indian stock market. Only
after arriving at this required return, it would be useful/insightful first to ascertain
whether the rate of return earned by equity investors is adequate or not and second
to compare the two sets of returns—expected and actual. Amongst the measures
available in the literature to estimate the required return, the capital asset pricing
model (CAPM) remains, perhaps, the most utilized. This chapter is devoted to the
computation of the estimated required rate of return for the sample companies based
on the CAPM. The estimated returns are then compared with the actual market
returns posted by the market index, to provide a better understanding of returns,
from both the expectations and the actual market index returns’ perspectives.
Expected returns are conditional on the fundamental strength and financial per-
formance of the underlying company whose shares the investors purchase. Further, it
is also dependent on the company’s relative performance vis-à-vis the underlying
market. The measure that finds mention in the literature is the firm’s beta (β), which
is the sensitivity of the security’s returns vis-à-vis the market returns. Beta, being a
market measure, captures only the systematic or market risk associated with com-
pany returns and is an important part of the CAPM, determining expected ROE.
For better exposition, this chapter has been divided into five sections. The first
section provides a brief literature review on the factors that affect the CAPM and the
studies associated with the model. The second section contains the scope and
methodology to compute the estimated returns using the CAPM as well as the risk
premium approach. The third section presents the computed expected returns and its
comparison with the annual market index returns for the corresponding periods.
The fourth section contains the cost of equity computed as a measure of the
reward/return for the risk undertaken. Important points are summarized in the fifth
section.

© Springer Science+Business Media Singapore 2016 45

S. Singh et al., Equity Markets in India, India Studies
in Business and Economics, DOI 10.1007/978-981-10-0868-9_3
46 3 Expected Rates of Return

Section I: Literature Review

The literature review focuses on the risk factors/determinants affecting the CAPM
in particular and expected returns, in general.
Sharpe (1964), Lintner (1965) and Mossin (1966) developed the capital asset
pricing model (CAPM) which measured the performance of assets in terms of
returns. They proposed that an asset’s risk could be measured by the covariance of
the asset’s return with the market portfolio return.
Hamada (1969) also analytically proved that if a firm increased its leverage, it
directly affected its beta. The study of individual firms’ risk as related to their
underlying characteristics began with the seminal work of Beaver et al. (1970)
who examined the relationship of certain accounting ratios (payout, liquidity and
earning variability) to the firm’s systematic risk (beta) and reported a strong and
significant association between them. Rubinstein (1973) developed a model which
included two components of operating risk of a firm—the amount of fixed
and variable costs employed in the production technology and the covariability of
firm’s output with market return. Lev (1974) reported that a negative relationship
existed between the level of unit variable cost and systematic risk.
Robichek and Cohn (1974) tested the influence of real economic growth and
inflation on the systematic risk (beta) of individual firms. They reported that these
macrovariables shed no light on the determinants of the systematic risk and that
only for a small number of firms can variations in beta be explained by real growth
and inflation. In contrast, however, Hamada (1972) reported that, conditional on the
validity of Modigliani and Miller’s model, leverage accounted for a substantial
portion (21–24 %) of the systematic risk. Logue and Merville (1972), based on a
multiple regression technique, attempted to relate financial variables and estimated
beta. Assets size, return on assets and financial leverage were found to be significant
variables. Along similar lines, Rosenberg and McKibben (1973) analysed the joint
influence of the firm’s accounting data and its historical stock returns on the
systematic and specific risks of its common stocks.
Breen and Lerner (1973) tested the beta variance through independent variables
such as the ratio of debt to equity, growth of earnings, stability of earnings growth,
size of company, dividend payout ratio and number of shares traded. Melicher
(1974) divided risk into systematic or market risk and specific or diversified risk.
Black and Scholes (1974) suggested that it was not possible to demonstrate using
CAPM that the expected returns on high-yield common stocks differed from the
expected returns on low-yield common stocks. Galai and Masulis (1976) linked the
firm’s equity beta with factors such as level of financial leverage, debt maturity,
variation in income, cyclicality, operating leverage and dividends.
Hill and Stone (1980) empirically confirmed that a positive relationship existed
between covariability of firm’s profitability and market return. Gordon and
Bradford (1980) measured the relative valuation of dividends and capital gains in
the stock market, using a variant of the CAPM. Hawawini and Michael (1982)
Section I: Literature Review 47

presented an empirical examination of the relationship between the average

return and the risk of a comprehensive sample of 200 securities which traded
continuously from 1966–1980 on the Brussels Stock Exchange. Based on their
findings, they could not reject the hypothesis that the pricing of common stocks on
the Brussels Stock Exchange conformed to the CAPM. Cohen et al. (1983)
developed an analytical model that indicated how estimates of the market model
beta parameter could be biased by friction in the trading process (information,
decision and transaction costs) which led to a distinction between observed and
‘true’ returns.
Mandelker and Rhee (1984) reported a positive relationship between systematic
risk and degree of operating leverage. Moreover, a positive relationship was also
observed between the degree of financial leverage and systematic risk. Ang et al.
(1985) included the degree of operating leverage as an independent variable in the
regression model to explain systematic risk, but they failed to produce conclusive
results. Handa et al. (1989) examined the behaviour of beta as a function of the
return measurement interval and whether the size effect tests were sensitive to beta
estimation. Greig (1992) re-examined the Ou and Penman (1989) conclusion that
fundamental analysis identified equity values not currently reflected in stock prices
and thus systematically predicted abnormal returns.
Koutmos et al. (1994) investigated the degree of volatility persistence and the
time-varying behaviour of systematic risk (beta) for ten international stock markets,
using the GARCH model. The findings suggested that small capitalization markets
exhibited considerably higher volatility persistence than large capitalization mar-
kets. Ismail et al. (1994) focused on beta prediction in the extreme risk categories
and considered the predictive contribution of accounting information across the risk
spectrum. Their results provided evidence that inclusion of accounting risk mea-
sures, alone or in combination with market beta, substantially improved beta pre-
diction for high-risk securities, but not for low and medium-risk securities. Fletcher
(1997) examined the conditional relationship between beta and returns in the United
Kingdom (UK) from 1975–1994. His results supported the findings of Fama and
French (1992) and Strong and Xu (1997) as there was no evidence of a significant
risk premium on beta, when the unconditional relationship between beta and returns
was examined. Brooks et al. (1998) explored the issue of beta instability in the
Singaporean stock market over the period 1986–1993. Analysis of the eight-year
interval revealed a very high incidence of beta instability, namely at about 40 % of
the individual stocks tested.
Allen and Cleary (1998) studied the returns on the Malaysian stock market for
the duration 1977–1992 and concluded an inverse relationship between beta and
expected returns. They observed that the accounting variables like ratio of
book-to-market equity and value of outstanding securities could help in explaining
increments in non-systematic risk. Sheu et al. (1998) analysed the cross-sectional
relationships between market beta, trading volume and stock returns, on the Taiwan
stock exchange from 1976–1996. They reported that market beta and trading vol-
ume could be combined to explain the cross section of average returns. Reyes
48 3 Expected Rates of Return

(1999) analysed the relationship between firm size and time-varying betas of UK
stocks and demonstrated that the time-varying coefficient was not statistically
significant for both the small and large firm stock indices. Gangemi et al. (2000)
analysed Australia’s country risk using a country beta market model on the lines of
Harvey and Zhou (1993) and Erb et al. (1996a, b). They observed that exchange
rates were the only macroeconomic factor that had significant impact on Australia’s
country beta.
Lau et al. (2002) examined the relationship of stock returns with beta, size, the
earnings-to-price (E/P) ratio, the cash flow-to-price ratio, the book-to-market equity
ratio and sales growth (SG) by studying the data of the Singapore and Malaysian
stock markets for the period 1988–1996. The analysis revealed a negative rela-
tionship between size and stock returns and between weighted average annual sales
growth and stock returns for the Singapore stock market. For the Malaysian stock
market, they noted a negative size effect and a positive E/P effect on stock returns.
Elsas et al. (2003) compared the unconditional and conditional test procedure using
Monte Carlo simulations and reported that the conditional test significantly sup-
ported the relation between beta and return. Turner and Morrell (2003) documented
the calculation of the cost of equity capital in a sample of airlines, in comparison
with industry-calculated values. They applied the CAPM to airlines stock prices and
market indices. Tang and Shum (2003) investigated the conditional relationship
between beta and returns in 13 international stock markets for the period 1991–
2000. They reported a significant positive relationship between beta and returns in
upmarket periods (positive market excess returns), but a significant negative rela-
tionship in downmarket periods (negative market excess returns).
Fernandez (2006) estimated the CAPM at different timescales for the Chilean
stock market, by resorting to wavelet analysis. He reported evidence in support of
the CAPM at a medium-term horizon. Ho et al. (2006) examined empirically the
pricing effects of beta, firm size and book-to-market equity, but conditional on
market situations, i.e. whether the market was up or down, using Hong Kong equity
stock data for cross-sectional regression method. On similar lines, Morelli (2007)
examined the role of beta, size and book-to-market equity as competing risk
measurements in explaining the cross-sectional returns of UK securities for the
period 1980–2000. Cai et al. (2007) focused on the effects of event risk on asset
price and modelled investors’ optimal portfolio policy in the case of potential event
risk in the Chinese stock market and derived a liquidity-based asset pricing model.
Iqbal and Brook (2007) investigated the ordinary least square (OLS) beta estimates
and different alternative estimators designed to correct the downward bias in the
OLS beta, on a sample of 89 stocks from the Karachi stock exchange. They
compared the applicability of the two asset pricing models, namely the CAPM and
the Fama–French model. It was concluded that although the alternative techniques
were successful in bias reduction, the results from the improved estimators did not
appear to be different from the OLS benchmark.
Hooper et al. (2008) compared a series of competing models to forecast beta
in order to reduce forecast error. It was reported that an autoregressive model with
Section I: Literature Review 49

two lags produced the lowest or close to the lowest error for quarterly stock beta
forecasts. Lally and Swidler (2008) investigated the relationship between the market
weight of a single stock and the betas of that stock as well as of the residual
portfolio. Adrian and Franzoni (2009) modelled conditional betas using the Kalman
filter as it focused on low-frequency variation in betas. Manjunatha and
Mallikarjunappa (2009) attempted to test the validity of the combination effect of
the two-parameter CAPM to determine the security/portfolio returns. Hearn (2010)
contrasted the performance of the CAPM, augmented by size and liquidity factors,
with its time-varying coefficient counterpart, using a unique market universe
compiled from constituent stocks of blue-chip indices—BSE-100 (India), KSE-30
(Pakistan), DSE-20 (Bangladesh) and Dow Jones Titans (Sri Lanka). The evidence
suggested that substantial size and liquidity effects were present in all markets with
the exception of Sri Lanka. Guermat and Freeman (2010) introduced a new, more
robust, net beta test which shared a number of characteristics with conditional beta
tests. They demonstrated theoretically, by simulation and using market data, that the
net beta estimators had lower standard errors than those generated by the standard
Fama–MacBeth test.
Ray (2010) analysed the stability of beta for the Indian market for a ten year
period, 1999–2009. The monthly returns data of 30 selected stocks were considered
for examining the stability of beta in different market phases. Masih et al. (2010)
estimated the systematic risk ‘beta’ at different timescales in the context of the
emerging Gulf Cooperation Council (GCC) equity markets by applying a relatively
new approach (known as wavelet analysis). They reported that value at risk
(VaR) measured at different timescales suggested that risk tended to be concen-
trated more at the higher frequencies (lower timescales) of the data. Durand and Ng
(2011) applied the methodology proposed by Pettengil et al. (1995) on eleven
Pacific Basin emerging markets. Their study supported the beta-based tests. Morelli
(2011) examined the role of beta in explaining security returns in the UK stock
market over the period of 1980–2006 by applying a joint conditionality and
incorporating various versions of ARCH models to estimate time-varying betas.
Majumder (2011) developed a model which incorporated market sentiments in the
domain of the standard rational model of asset pricing.
Da et al. (2012) evaluated the empirical evidence against the standard CAPM
from the perspective that it could nevertheless provide a reasonable estimate of a
project’s cost of capital, provided that any embedded real options associated with
the project were evaluated separately for capital budgeting purposes. Hasan et al.
(2012) investigated the risk-return trade-off within the CAPM structure for the
Dhaka stock exchange. Manjunatha and Mallikarjunappa (2012) examined the
validity of the five parameter models (the combination of five variables, viz. beta
(β), size, E/P, book value/market value (BV/MV) and market risk premium
(Rm − Rf) on the Indian stock returns using cross-sectional regression. The results
reported that the combination of β, size, E/P, BV/MV and (Rm − Rf) variables
explained the variation in security returns.
50 3 Expected Rates of Return

Section II: Scope, Data and Methodology

The research methodology adopted in the study to compute the estimated returns
(using the CAPM) and its comparison with market returns (for corresponding
periods) has been delineated hereunder. Further, the cost of equity so computed
would reflect the expected rates of return on equity shares. The methodology
adopted to compute the same is also provided in this section.

Scope

The NSE 500 index of India comprises of the top 500 companies listed on the NSE
based on their market capitalization and is the chosen sample for this study. The
total traded value for the last six months ending December 2013 of all index
constituents was approximately 97.01 % of the traded value of all stocks on NSE
(Source: National Stock Exchange (NSE 2014) Website. http://www.nseindia.com/
products/content/equities/indices/cnx_500.htm). Hence, virtually, the chosen sam-
ple presents a census on equity market returns in India.
The date of sample selection was 11 March 2013. The period of the study for this
chapter is 2001–2014. This universe was chosen for the convenience of access to
the data required and also on the assumption that it would be an accurate repre-
sentation of the equity returns in India.
Further, the index returns for the NSE 500 index were taken as the proxy for
market returns in the CAPM.

NSE 500 Index Background

The company Standard & Poor’s (S&P) introduced its first stock-based index in
1923 in the United States of America (USA). The index had traditionally been
market-value weighted; that is, the movements in the prices of the stocks with the
higher market capitalizations (the share price times the number of shares out-
standing) had a greater effect on the index than the companies with the smaller
market capitalizations. However, the index is now float weighted (Source:
Wikipedia Website. http://en.wikipedia.org/wiki/S%26P_CNX_500).
The CNX 500 is the Indian counterpart (hereby referred to as NSE 500). CNX
stands for the Credit Rating Information Services of India Limited (CRISIL) and the
NSE. These two bodies own and manage the index through a joint venture called
the India Index Services and Products Limited (IISL) (Investopedia 2013).
The NSE 500 companies are disaggregated into 72 industry indices. Industry
weightages in the index reflect the industry weightages in the market. (Source:
National Stock Exchange (NSE 2014) Website. http://www.nseindia.com/products/
content/equities/indices/cnx_500.htm).
Section II: Scope, Data and Methodology 51

Secondary Data and Analysis

The CAPM Model

The CAPM model uses the following computation:

EðRi Þ ¼ Rf þ bi ðEðRm Þ  Rf Þ ð3:1Þ

where
• E(Ri) is the expected return on the security i;
• Rf is the risk-free rate of interest, such as interest arising from government
bonds;
• βi (the beta) is the sensitivity of the expected excess asset returns to the expected
excess

Cov(Ri ; Rm Þ
bi ¼ ð3:2Þ
VarðRm Þ

• market returns, or also;

• E(Rm) is the expected return of the market.

Deployment of the CAPM

In deploying the CAPM, the following methodology has been adopted:

– The risk-free return for the 364-day treasury bills has been taken as the proxy for
risk-free return,
– The annual NSE index returns have been taken as the proxy for market returns,
and
– The weighted beta for the sample has been taken as the beta for the model. The
market capitalization of the constituent companies in the sample has been taken
as the weight.

Cost of Equity (Ke) or Expected Rates of Return on Equity Shares

In section “Expected Rates of Return—Cost of Equity”, the cost of equity has been
computed for the sample companies, as a measure of the return expected for the risk
undertaken. The formula derived through the theory proposed by Ross (1976) and
used for the same is as follows:
52 3 Expected Rates of Return

ke ¼ r f þ b þ f ð3:3Þ

where
rf = Risk-free rate of return
b = Business risk premium
f = Financial risk premium
Whilst the degree of operating leverage (DOL) measures the operating risk, the
degree of financial leverage (DFL) measures the financial risk. Therefore, in an
attempt to compute the cost of equity through the above-stated equation, the DOL
and DFL of the sample companies were computed for the period, 2001–2014.

DOL and DFL

Degree of operating leverage is calculated as percentage change in earnings before

interest and taxes (EBIT) divided by percentage change in net sales. Degree of
financial leverage is calculated as percentage change in earnings per share
(EPS) divided by percentage change in EBIT.
Further, it may be noted that the negative values have been excluded from
analysis as they do not serve the intended purpose of measuring risk on the one
hand and would have caused distortion in determination of average values on the
other. To have better and more representative data on the subject, we have also
excluded extreme values (exceeding 5) of DOL/DFL.

Data Sources and Analysis

The relevant data (secondary) were collected from the Bloomberg® database, for
fourteen years (2001–2014), and from the Website of the Reserve Bank of India
(RBI). Descriptive statistical values/positional values, i.e. mean, standard deviation,
variance, coefficient of variation, minimum, maximum, skewness, kurtosis and
quartile values, have been computed for each year. The entire set of data has been
analysed using Microsoft Excel® spreadsheets and the statistics software SPSS®,
namely Statistical Package for Social Sciences.

Section III: Expected Rates of Return Based on Capm

In this section, the expected rates of return for the sample companies have been
computed. The model, CAPM, has been used to compute expected returns on an
annual basis, in order to facilitate comparison with annual market index returns for
the corresponding periods.
Section III: Expected Rates of Return Based on Capm 53

The unavailability of corporate financial data prior to 2001 is the reason for the
non-computation of expected returns for the years prior to 2001. Hence, comparison
between the market index returns and the expected returns would be made for the
period 2001–2014.
Table 3.1 presents the expected returns for the years 2001–2014 and the cor-
responding market index returns. To enable better comparison, Table 3.2 presents
the computed mean, standard deviation, variance, coefficient of variation, mini-
mum, maximum, skewness, kurtosis and quartile values of both the expected and
the market index returns for the period.
As is evident from Table 3.1, the expected returns and the actual market index
returns appear to follow the same pattern. Both the expected actual returns dropped
drastically in 2009 and became negative, perhaps as a result of the recession that
originated in the USA in 2008. Hence, the CAPM model appears to be an appro-
priate model to estimate expected returns in the Indian stock market, represented

Table 3.1 Expected returns Year Average expected return Index returns
for the sample companies
and their comparison with 2001 −14.26 −42.99
market index returns for 2002 5.29 2.82
the period, 2001–2014 2003 −2.72 −10.78
(figures are in percentage) 2004 59.86 106.39
2005 13.14 18.89
2006 35.56 61.21
2007 8.09 8.07
2008 17.77 21.64
2009 −22.55 −39.89
2010 66.29 85.54
2011 6.89 6.47
2012 −5.53 −9.01
2013 5.64 5.13
2014 15.09 17.00

Table 3.2 Mean, standard Statistic Expected returns Index returns

deviation, variance,
coefficient of variation, Mean returns 13.47 16.46
minimum, maximum, Standard deviation 25.33 42.50
skewness, kurtosis and Variance 641.63 1806.16
quartile values of expected Coefficient of variation 188.05 258.20
and market index returns,
Minimum returns −22.55 −42.99
2001–2014
Maximum returns 66.29 106.39
Skewness 0.98 0.84
Kurtosis 0.66 0.50
Lower quartile −3.42 −9.45
Upper quartile 22.22 31.53
54 3 Expected Rates of Return

through the sample companies. Table 3.2, in this regard, is perhaps more revealing.
The average expected returns for the period are 13.47 % compared to average
market index returns of 16.46 %. The standard deviations, coefficient of variation
and variance figures are also similar, indicating that expected returns mirror the
volatility present in the market. However, expectedly, the market index presents a
volatility that is substantially higher than the expectations. The skewness and
kurtosis figures are low indicating returns lying closer to the previous and subse-
quent return values. A paired t-test was administered to analyse whether the average
expected returns were statistically different from market returns. As is evident from
the t-statistic, there is no statistically significant difference between the expected
and the market index returns.

Paired t-test
Paired differences t df Significance
Mean Standard Standard 95 % (2-tailed)
deviation error confidence
mean interval of the
difference
Lower Upper
Expected 2.99 18.25 4.88 −13.53 7.54 −0.61 13 0.55
returns—index
returns

The Pearson correlation coefficient between expected and actual market

index returns was 0.98, further substantiating that the CAPM is an appropriate
tool to forecast actual market index returns. When comparing this data with the
returns computed for varying holding periods (Chap. 4), it is safe to postulate that
the Indian stock market provides volatility and returns to the technical (short-term)
investors and also allows returns over the long run to the fundamental (long-term)
investors. Buy-and-hold strategy returns over the long term mirror the computed
ROEF (Chap. 2). However, in the presence of volatility in the short run which
increases the risk, it would perhaps be wiser to invest in the long run in the
Indian stock market. Such a strategy should result in relatively less risky and
more stable returns vis-à-vis the short-run returns.
It is important to emphasize that expected returns which are computed, based on
the CAPM model, are taken into consideration only the systematic risk of the
security under consideration. Since systematic risk is a function of the covariance of
the security’s returns with the variance in market returns, the returns may be
negative in response to the market (as is evident from Table 3.1).
However, the cost of equity (returns expected by the equity providers) for a
company can never be negative. Hence, simply basing our analysis on expected
returns based on the CAPM model would be incomplete. There is a requirement to
compute the returns expected by the equity providers based on the risk undertaken
by investing in that particular security. The same is undertaken in Sect. ‘Expected
Rates of Return—Cost of Equity’.
Section IV: Expected Rates of Return—Cost of Equity 55

Section IV: Expected Rates of Return—Cost of Equity

Would an investor in India be satisfied with 8–10 % return on equity investment?

The answer is likely to be in the negative; this rate of return can be easily earned by
investing in safe instruments such as the public provident fund (PPF), the Indira
Vikas Patra (IVP), long-term deposit with commercial banks and so on (with vir-
tually full safety of investments). Obviously, the investors would like to be com-
pensated for the extra risk they are assuming by investing in the equity shares of a
corporate enterprise.
A corporate firm is subject to business risk (b). This apart, there is a variability in
the rates of return available to equity holders (as they are the last claimants on
dividends as well as repayment of capital in the event of liquidation of a company),
known as financial risk (f). As a compensation to the higher risk exposure, equity
holders expect a higher return, and therefore, higher cost is associated with them. In
brief, the cost of equity (ke) is as follows:

ke ¼ r f þ b þ f ð3:4Þ

The business risk is measured through a ratio called the degree of operating
leverage (DOL), and the financial risk is measured through the degree of financial
leverage (DFL). Therefore, in an attempt to compute the cost of equity through the
above-stated equation, the DOL and DFL of the constituent companies have been
computed for the period 2001–2014.
Relevant data pertaining to mean, standard deviation, coefficient of variation,
skewness, kurtosis, median and quartile values of DOL and DFL of the sample
companies are contained in Table 3.3. Frequency distribution pertaining to DOL
and DFL of the sample companies is presented in Table 3.4. Figures 3.1 and 3.2
present the average DOL and DFL, graphically.
The average DOL for the sample companies is 1.46 and has remained stable
through phases 1 and 2. The paired t-test does not indicate any statistically sig-
nificant changes in mean values over the two phases indicating stable operating risk
conditions. Similarly, average financial leverage in the sample companies has been
1.32. Thus, the sample companies have managed their combined risk within con-
trollable limits, an indication of sound risk management practices.
The skewness and kurtosis figures indicate that only few companies reported
large values of the two measures of risk indicating low-risk statistics (for sizeable
corporates). As per the frequency distribution, nearly 60 % of sample companies
have low DOL of less than 1.5 (Table 3.4) in 2014 compared to the reverse in 2001.
Hence, the risk in the sample companies appears to have reduced through the period
of the study (2001–2014). DFL also presents similar properties. The lowering of
risk is further emphasized through the values of both DOL and DFL being above 5
in 2001 for more than 30 % of the sample companies, which has reduced sub-
stantially over the period of the study. These findings are similar to the findings on
Table 3.3 Mean, standard deviation, coefficient of variation, skewness, kurtosis, median and quartile values of degree of operating leverage (DOL) and
56

degree of financial leverage (DFL) of sample companies, 2001–2014

Year ending Leverage Number Mean Standard Coefficient of Skewness Kurtosis Median Quartile Quartile
deviation variation (%) 1 3
2001 DOL 237 1.53 1.08 70.59 1.14 0.87 1.26 0.78 2.03
DFL 255 1.53 1.10 71.90 0.15 0.82 1.18 0.81 2.01
2002 DOL 237 1.53 1.08 70.59 1.14 0.87 1.26 0.78 2.03
DFL 256 1.52 1.10 72.37 0.15 0.81 1.18 0.80 2.01
2003 DOL 257 1.43 1.16 81.12 1.18 0.77 1.07 0.60 1.98
DFL 256 1.56 1.07 68.59 0.15 1.35 1.23 0.91 2.01
2004 DOL 285 1.46 1.08 73.97 1.12 0.75 1.21 0.69 1.96
DFL 310 1.49 0.99 66.44 0.14 1.34 1.23 0.86 1.84
2005 DOL 312 1.49 1.08 72.48 1.14 0.87 1.18 0.71 1.96
DFL 341 1.30 0.87 66.92 0.13 4.85 1.10 0.81 1.53
2006 DOL 329 1.63 1.15 70.55 1.12 0.48 1.25 0.82 2.17
DFL 373 1.18 0.81 68.64 0.13 4.91 1.04 0.73 1.34
2007 DOL 367 1.50 1.00 66.67 1.33 1.51 1.21 0.85 1.92
DFL 414 1.08 0.72 66.67 0.12 4.62 0.98 0.65 1.28
2008 DOL 368 1.45 0.92 63.45 1.30 1.67 1.20 0.88 1.77
DFL 425 1.13 0.76 67.26 0.12 5.41 1.00 0.72 1.23
2009 DOL 310 1.34 0.96 71.64 1.27 1.29 1.07 0.69 1.69
DFL 410 1.25 0.82 65.60 0.12 3.75 1.08 0.84 1.43
2010 DOL 311 1.63 1.12 68.71 0.87 −0.03 1.26 0.79 2.31
DFL 382 1.37 0.94 68.61 0.13 2.64 1.11 0.82 1.75
2011 DOL 351 1.27 0.94 74.02 1.51 2.34 1.00 0.70 1.63
DFL 417 1.28 0.78 60.94 0.12 3.79 1.09 0.83 1.54
(continued)
3 Expected Rates of Return
Table 3.3 (continued)
Year ending Leverage Number Mean Standard Coefficient of Skewness Kurtosis Median Quartile Quartile
deviation variation (%) 1 3
2012 DOL 329 1.19 0.84 70.59 1.49 2.88 1.03 0.66 1.43
DFL 396 1.15 0.83 72.17 0.12 4.54 1.01 0.69 1.39
2013 DOL 310 1.37 0.95 69.34 1.41 2.00 1.11 0.78 1.68
DFL 390 1.32 0.86 65.15 0.12 3.06 1.11 0.85 1.56
2014 DOL 305 1.64 1.10 67.07 0.98 0.40 1.34 0.90 2.22
DFL 379 1.31 0.87 66.41 0.13 2.64 1.09 0.82 1.54
2001–2014 DOL 308 1.46 1.03 70.77 1.21 1.19 1.18 0.76 1.91
DFL 356 1.32 0.90 67.79 0.13 3.22 1.10 0.79 1.61
Phase 1 DOL 299 1.50 1.07 71.18 1.18 0.97 1.21 0.76 1.98
(2000–2001 to DFL 329 1.35 0.93 68.60 0.14 3.01 1.12 0.79 1.66
2007–2008)
Phase 2 DOL 319 1.41 0.99 70.23 1.26 1.48 1.14 0.75 1.83
(2008–2009 to DFL 396 1.28 0.85 66.48 0.12 3.40 1.08 0.81 1.54
Section IV: Expected Rates of Return—Cost of Equity

2013–2014)
57
 58

Table 3.4 Frequency distribution pertaining to the degree of operating leverage (DOL) and degree of financial leverage (DFL) of sample companies,
2001–2014 (figures are in percentages)
Leverage Range 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
DOL Less than 0 19.60 20.00 18.40 18.80 19.20 17.40 12.60 17.00 27.80 22.60 23.00 27.20 26.00 27.60
DFL 15.20 15.00 17.80 14.80 17.60 14.40 8.40 11.60 13.40 15.80 12.60 17.60 16.60 17.60
DOL 0.0–0.5 7.00 7.00 11.60 9.40 9.00 7.00 6.40 7.40 8.40 8.00 8.80 10.80 8.80 7.60
DFL 8.40 8.00 6.40 7.80 7.40 10.60 13.80 12.40 10.80 8.20 8.40 14.00 8.00 8.20
DOL 0.5–1.0 10.40 10.00 12.00 14.00 15.60 16.00 21.00 18.60 18.80 14.00 26.40 20.80 15.20 12.20
DFL 10.20 10.00 9.40 13.60 21.20 22.80 29.60 29.80 23.60 20.20 24.60 24.40 23.00 23.80
DOL 1.0–1.5 11.60 11.00 9.40 12.80 13.60 14.80 19.60 21.40 16.00 13.40 16.00 19.00 19.40 14.80
DFL 13.40 13.00 14.60 17.40 22.60 27.00 26.00 28.80 28.60 23.80 29.20 24.80 26.60 24.60
DOL 1.5–2.0 6.60 6.00 6.00 7.20 9.80 9.60 10.40 12.40 7.00 8.60 6.20 5.20 7.00 9.20
DFL 7.20 7.00 8.80 9.40 8.60 6.80 5.20 4.60 8.00 9.80 9.80 8.00 9.40 7.20
DOL 2.0–5.0 12.40 13.00 12.80 14.40 14.40 18.80 16.40 14.60 11.80 19.00 12.80 10.20 11.80 18.00
DFL 13.00 13.00 13.00 13.60 9.00 8.60 8.80 9.60 10.80 14.60 11.20 8.20 11.40 12.40
DOL Above 5.0 32.80 32.80 30.00 24.00 18.20 16.60 13.80 9.20 10.00 15.00 6.60 6.80 11.80 11.20
DFL 33.40 33.40 30.80 23.00 14.00 10.80 8.60 3.20 4.40 7.60 3.80 3.00 5.20 6.40
Total (%) 100 100 100 100 100 100 100 100 100 100 100 100 100 100
3 Expected Rates of Return
Section IV: Expected Rates of Return—Cost of Equity 59

Mean Values of Operating Leverage of Sample Companies, 2001-2014

2

0
2001 2002
2003 2004
2005 2006
2007 2008
2009 2010
2011 2012 2013 2014

Fig. 3.1 Mean values of operating leverage of the sample companies, 2001–2014

Mean Values of Financial Leverage of Sample Companies, 2001-2014

2

1.5

0.5

0
2001 2002
2003 2004
2005 2006
2007 2008
2009 2010 2011
2012 2013 2014

Fig. 3.2 Mean values of financial leverage of the sample companies, 2001–2014

public sector enterprises over a period of 1991–2003, reporting a DOL of 1.18 and a
DFL of 1.09, respectively.

Paired t-test
Paired differences t df Significance
Mean Standard Standard Lower Upper (2-tailed)
deviation error mean
DOL Phase 0.11 0.14 0.06 −0.04 0.25 1.19 5 0.12
1—Phase 2
DFL Phase 0.15 0.19 0.78 −0.05 0.35 2.00 5 0.11
1—Phase 2

In order to arrive at an approximation of the cost of equity, the values of DOL

and DFL were assigned a probable risk premium rate, in percentage terms, as
provided in Table 3.5. For example, a rate of 1 % was assigned to a DOL/DFL of
even less than 0, as the investment in the shares of a corporate enterprise is by
60 3 Expected Rates of Return

nature more risky than a government debt security; business and financial risk
notwithstanding a shareholder only has residual claim over the net earnings of a
company, and even that can be retained by the company.
Based on the average DOL and DFL values for each year, the following risk
premia (in percentage terms) provided in Table 3.5 have been assigned to the
corresponding periods, in order to arrive at the cost of equity (Table 3.6).

Table 3.5 Assignment of risk premium rate for DOL and DFL
Leverage Range Risk premium assigned
(rate per cent)
DOL Less than 0 1.00
DFL 1.00
DOL 0.0–0.5 1.50
DFL 1.50
DOL 0.5–1.0 2.00
DFL 2.00
DOL 1.0–1.5 3.00
DFL 3.00
DOL 1.5–2.0 4.00
DFL 4.00
DOL 2.0–5.0 5.00
DFL 5.00
DOL Above 5.0 10.00
DFL 10.00

Table 3.6 Cost of equity based on the risk premium approach

Year Risk-free Business Business risk Financial Financial risk Cost of
ending rate (in risk premium (in risk (DFL) premium (in equity (in
per cent) (DOL) rate per cent) rate per cent) rate per cent)
2001 9.44 1.53 4.00 1.53 4.00 17.44
2002 7.34 1.53 4.00 1.52 4.00 15.34
2003 5.71 1.43 3.00 1.56 4.00 12.71
2004 6.11 1.46 3.00 1.49 3.00 12.11
2005 7.34 1.49 3.00 1.30 3.00 13.34
2006 7.89 1.63 4.00 1.18 3.00 14.89
2007 8.12 1.50 4.00 1.08 3.00 15.12
2008 7.69 1.45 3.00 1.13 3.00 13.69
2009 7.23 1.34 3.00 1.25 3.00 13.23
2010 7.92 1.63 4.00 1.37 3.00 14.92
2011 8.52 1.27 3.00 1.28 3.00 14.52
2012 8.40 1.19 3.00 1.15 3.00 14.40
2013 8.36 1.37 3.00 1.32 3.00 14.36
2014 8.41 1.64 2.50 1.31 3.00 13.91
2001–2014 7.75 1.46 3.00 1.32 3.00 13.75
Section IV: Expected Rates of Return—Cost of Equity 61

Thus, the cost of equity is likely to be less than/nearly twice the risk-free rate
prevalent in the market for a typical corporate firm. The average cost of equity over
the period of the study (2001–2014) for the sample companies has been nearly
14 %, assuming the average risk-free rate to be 7.75 %. The same is substantiated
by the average expected returns of 13.47 % computed via the CAPM. Obviously,
the individual company’s cost of equity would be dependent on its relative risk
complexion vis-à-vis the other securities available in the market.

Section V: Summary

This chapter presents the expected equity returns, measured through the CAPM and
the risk premium approach, for the Indian stock market, represented by the NSE
500 companies.
The CAPM appears to be an appropriate model to calculate expected returns
emanating from the Indian stock market. The average expected returns are 13.47 %,
and the average market index returns are 16.46 %, indicative of the market being
able to perform better than the expected returns by the technical investors.
The average cost of equity (ke) for the sample companies based on the risk
premium approach, over the period of the study, is also around 14 % (13.75 %).
The average ROE computed in Chap. 2 is 19.20 %, indicative of the fundamental
strength of the sample companies in earning returns which are above the
expectations.
Hence, prima facie, the sample companies, constituting 96.27 % of the total
market capitalization at NSE, continue to be an attractive investment destination for
both fundamental (long-term) and technical (short-term traders) investors.
However, in the presence of volatility in the short run which increases the risk, it
would perhaps be prudent to invest in the long run in the Indian stock market. Such
a strategy should result in relatively less risky and more stable returns vis-à-vis the
short-run returns.

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Chapter 4
Rates of Return—Investors’ Perspective

Introduction

An investor who purchases the equity shares of a company has two sources of
income from such an investment. The first is dividends—the sharing of the after-tax
profits of a company with its owners—and the second is capital appreciation.
Typically, for high-growth companies (like many such companies in the sample
comprising the top 500 companies listed at the National Stock Exchange (NSE)),
dividend income is not a favoured option. The reason is that these companies prefer
to retain their earnings in order to finance their growth needs. This is the primary
reason why dividend yields in India have been low (Jain et al. 2013).
The second and more important source of income for the investor from equity
investment is the potential of earning capital gains. Even if a company does not pay
dividends or pays inadequate dividends, the demand for its shares in the open
market (a stock exchange) may remain unchanged (in fact, may sometimes
increase) due to its strong underlying fundamentals and earnings growth potential.
This would result in an increase in the market price of its shares, allowing the
investor who had bought the shares at a relatively lower price to sell them at the
higher price and book a profit (capital gains) on the sale.
This chapter assesses at equity returns from the sample companies from the
investors’ point of view, factoring both sources of income—viz., dividends and
capital gains. The sample for the study comprises the NSE 500 companies and the
period, under study, is spread over the past two decades (1993–2014). It is pertinent
to note here that a study on equity returns for the period 1985–1999 was conducted
by Gupta and Choudhury (2000). Comparisons with this study have been made,
wherever appropriate, to provide the readers with a larger perspective on the
evolution and behaviour of equity returns in India, for a period of nearly three
decades (1985–2014). Further, a brief comparison with the alternative investment
choice, viz., debt instruments, has also been made for a more complete analysis of
returns from the investors’ point of view.

© Springer Science+Business Media Singapore 2016 65

S. Singh et al., Equity Markets in India, India Studies
in Business and Economics, DOI 10.1007/978-981-10-0868-9_4
66 4 Rates of Return—Investors’ Perspective

For better exposition, the chapter is divided into five sections. Section 1 contains
the literature review. Section 2 details the methodology adopted. Section 3 presents
the period-wise total returns for varying holding durations. Section 4 discusses the
overall characteristics of the returns for the period studied along with the com-
parison with returns on debt instruments. Section 5 contains the concluding
observations.

Section I: Literature Review

For better comprehension, the literature reviewed has been split into the factors
affecting returns and the behaviour of share prices.

Factors Affecting Returns

Gordon (1959) attempted to explain the variation in the price of the stock by
developing a model, enumerating the parameters that investors considered and the
weights they accorded to these parameters in buying common stocks.
Miller and Modigliani (1961) documented that the effect of a firm’s dividend
policy on the current price of its shares is important not only to the corporate
managers but also to the investors planning portfolios and further to the economists
seeking to understand and appraise the functioning of the capital markets. They
stated that from the perspective of the dividend policy, what counts is the imper-
fection that might lead an investor to have a systematic preference between a dollar
of current dividends and a dollar of capital gains.
Black and Scholes (1974) suggested that it was not possible to demonstrate,
using the capital asset pricing model (CAPM), that the expected returns on
high-yield common stocks differed from the expected returns on low-yield common
stocks either before or after taxes. They contended that the best method for testing
the effects of dividend policy on stock prices was to test the effects of dividend
yields on stock returns.
Ben-Zion and Shalit (1975) determined that the dividend record of any firm
could be used to measure the firm’s success in maintaining its target dividend
policy, its underlying earnings stability and its duration. Gordon (1959) measured
the relative valuation of dividends and capital gains in the stock market, using a
variant of the CAPM. They observed that dividends were not valued differently
from capital gains.
Handa et al. (1989) examined the behaviour of beta as a function of the return
measurement interval and whether the size-effect tests were sensitive to the estimation
of beta. It was observed that the betas of high-risk securities increased with the return
interval, whereas the betas of low-risk securities decreased with the return interval.
Their results suggested that only the annual betas explained the return variation.
Section I: Literature Review 67

The findings of the study of Bernheim and Wantz (1995) implied that an increase
in the dividend taxation increased the share price response. De Angelo et al. (1996)
studied the signalling content of decisions made by the managers regarding divi-
dends, focusing on the companies whose annual earnings declined after nine or
more consecutive years of growth. Their results indicated that the managers’ div-
idend decisions in the year of the earnings downturn were not useful signals of the
future prospects of earnings.
Benartzi et al. (1997) analysed whether the information content of a dividend
announcement had an impact on the future earnings. Their results yielded limited
support for this relationship. Penman and Sougiannis (1997) demonstrated empir-
ically that earnings estimated according to generally accepted accounting principles
(GAAP) had properties which could be used to serve as a substitute for dividends in
equity valuation analysis.
Francis et al. (2000) compared the reliability of the value estimates from three
models—the discounted dividend model, the discounted free cash model and the
discounted abnormal earnings (AE) model. The five-year forecasts (1989–1993) for
3000 firms were used for the study. It was observed that the discounted AE model
was more accurate and reliable than the other two models. The results also suggested
that the AE values estimated explained more of the variation in market prices.
In their study, Collin and Kemsley (2000) concluded that capital gains and
dividend taxes both reduced the valuation of the reinvested portion of earnings.
Pethe and Karnik (2000) studied the inter-relationships between stock prices and
macroeconomic variables. They considered the exchange rate of rupee versus
dollar, prime lending rate, narrow and broad money supply, and the index of
industrial production. They did not observe a stable and long-term relationship
between the stock prices and the macroeconomic variables.
Gopinath et al. (2010) provided evidence based on the transactions data of a
sample of the National Association of Securities Dealers Automated Quotations
Systems (NASDAQ) stocks indicating that the trades of large firms were related to
the proxies of market-wide and firm-specific information. For large firms, an
increase in the number of trades seemed to have a beneficial effect on the liquidity,
measured by the bid-ask spreads.
Harris et al. (2001) supported the hypothesis that at least a substantial portion of
the dividend tax was capitalized in equity values. They stated this with respect to
the signalling hypothesis; for example, the higher were the expected future earn-
ings, the greater was the amount of expected internal funds available to finance
investment (assuming other parameters were kept constant) and the more likely was
a firm to pay dividends.
Grullon and Michaely (2002) report that firms have gradually substituted share
repurchases for dividends. According to Goyal and Welch (2003), firms that cut their
dividends and did not repurchase experienced a significantly negative price drop to
the announced dividend cut. When investors perceived that dividends were being
replaced by repurchases, they viewed the reduction in dividends as less negative.
Dichev and Yu (2011) used the dollar-weighted returns (a form of internal rate of
return, IRR) to assess the properties of actual investor returns on the hedge funds
68 4 Rates of Return—Investors’ Perspective

and compared them to the buy-and-hold fund returns, holding the belief that the
returns of the hedge fund investors depended not only on the returns of the funds
they held but also on the timing and magnitude of the capital flows in and out of
these funds. Their major finding was that the annualized dollar-weighted returns
were 3–7 % lower than the corresponding buy-and-hold fund returns.
Alti and Sulaeman (2011) reported that the firms issued new shares when the
high stock returns coincided with strong demand from the institutional investors.

Behaviour of Share Prices

Beaver (1966) argued that a company on the verge of bankruptcy was costly to the
suppliers of capital because reorganization or liquidation costs consumed a major
portion of the firm’s value. Apart from the financial ratios being a good predictor to
analyse a firm’s probability of failure, he also concluded that the other important
tool to predict the failure of a firm were the changes in the market price of the stock.
Praetz (1972) presented both theoretical and empirical evidence about a prob-
ability distribution which described the behaviour of share price changes. Osborne’s
Brownian motion theory of share price changes was modified to account for the
changing variance in prices in the share market. This produced a scaled
t-distribution which was a significant fit to a series of share price indices. Schipper
and Smith (1986) investigated the share price reactions of the parent firms to the
announcements of public offerings of the stock of wholly owned subsidiaries. The
average abnormal gains associated with ‘equity carve-out’ announcements con-
trasted with the average abnormal losses documented upon the announcements of
public offerings of the parent entity’s equity.
Greig (1992) re-examined Ou and Penman (1989)’s conclusion that fundamental
analysis identified the equity values not currently reflected in the stock prices, and
thus, systematically predicted the abnormal returns. Their fundamental summary
measure, Pr, the estimated probability of an earnings increase, was used as a proxy
for the firm size and the CAPM risk. After controlling cross-sectional differences in
CAPM beta and firm size, no significant incremental predictive ability was attri-
butable to Pr. Further, Holthausen and Larcker (1992) examined the profitability of
a trading strategy which was based on a logit model designed to predict the sign of
the subsequent twelve-month excess returns from accounting ratios (Ou and
Penman 1989). Over the 1978–1988 period, the average annual excess returns
produced by the trading strategy ranged between 4.30 and 9.50 %, depending on the
specific measure of excess returns and the weighting scheme involved. However,
their strategy did not earn excess returns.
Lynch and Mendenhall (1997) analysed price and volume data for firms added to
and deleted from the S&P 500 index since 1989 for a distinct pattern of stock price
movements. The price reversal after addition and deletion strongly suggested the
existence of temporary price effects, caused by index fund trading associated with
S&P 500 composition changes. Further, Blume et al. (1989) observed that the price
Section I: Literature Review 69

of a typical stock that was added to or deleted from the index and required max-
imum trading did not adjust fully, immediately after the announcement nor had it
fully adjusted by the opening on the change date. This finding suggested that an
indexer could enhance the realized returns by buying at the opening date, following
the announcement rather than waiting until the close on the change date.
Ex-dividend day share price adjustment in the USA and elsewhere has been
commonly interpreted as reflecting taxes. To explore this further, Frank and
Jagannathan (1998) examined data from the Hong Kong stock market, where
neither the dividends nor the capital gains were taxed but still similar pricing effects
were observed. Saatcioglu and Starks (1998) examined the stock price–volume
relation in a set of six Latin American markets. Using monthly index data, they
documented a positive relation between the volume and the magnitude of price
change.
The study by Trueman et al. (2003) examined the pricing of the Internet firms
around their earnings announcements. The stock prices of the Internet firms
increased during the 5 days prior to the earnings announcement and reduced during
the 5 days following the announcement. On considering the several potential
explanations for the observed price patterns, it was concluded that the price pressure
(due to investor optimism and share demand) was the only parameter that received
some support. Berger (2003) extended this study and focused on the major concerns
raised by the price pressure explanation offered. Goyal and Welch (2003) observed
that the primary source of poor predictive ability was parameter instability; for
example, the dividend yield (as a parameter) failed to forecast the annual returns or
the dividend growth rates.
Belter et al. (2005) presented a new dividend-adjusted blue-chip index for the
Danish stock market covering the period 1985–2002. In contrast to other indices on
the Danish stock market, the index was calculated on a daily basis. They used this
index to analyse the time series properties of the daily, weekly and monthly returns,
and the predictability of multiperiod returns.
Marisetty et al. (2008) investigated the securities price reaction to the
announcements of rights issues by listed Indian firms during the period 1997–2005.
They documented a positive but statistically insignificant price reaction to such
announcements. Maniar et al. (2009) examined the effect of the expiration day of
the index futures and options on the trading volume, variance and price of the
underlying shares and observed that at the expiration hour, there was a significant
increase in the volatility and insignificant pressure on the returns of the underlying
securities.
Savor (2012) studied how the information presence affected the post-event
performance of stocks experiencing large price changes, using regression analysis.
The results implied that the investors under-reacted to news about the fundamentals
and over-reacted to the other ‘shocks’ that moved the stock prices. Annaert et al.
(2012) introduced a new monthly return series for the Belgian-owned equity, based
on the Brussels stock market data for the period 1832–1914. Dividend income was
considered to constitute the major part of total returns and the dividend distributions
had a clear seasonal pattern.
70 4 Rates of Return—Investors’ Perspective

Johnson and So (2012) examined the information content of the option and equity
volumes when the agents were privately informed and the trade direction was
unobserved. Golez (2012) showed that the S&P 500 futures were pulled towards the
at-the-money strike price on the days when the serial options on the S&P 500 futures
expired (pinning) and were pushed away from the cost-of-carry-adjusted
at-the-money strike price, right before the expiration of options on the S&P 500
index (anti-cross-pinning).
Wahal and Yavuz (2013) analysed the role of style investing on asset-level
return predictability. Style investing refers to an investment approach in which the
rotation amongst different ‘styles’ is supposed to be important for successful
investing, for example, placing money in the broad category of assets, such as
‘growth’ or ‘emerging markets’. They based their analysis on the prediction pro-
vided by Barberis and Shleifer (2003) that under certain conditions, style investing
could generate predictability in returns. They concluded that the investing beha-
viour in which investors chased style-returns amplified the waves in asset returns.

Section II: Scope, Data and Methodology

The research methodology adopted in the study to analyse equity returns in India
has been delineated in this section.

Scope

The sample comprises the NSE 500 companies. The NSE 500 index of India
comprises the top 500 companies listed on the NSE based on their market capi-
talization. The NSE 500 index represented 96.76 % of the free-float market capi-
talization and 97.01 % of the traded value of the stocks listed on the NSE as on 31
December 2013 (Source: National Stock Exchange (NSE) Website. http://www.
nseindia.com/products/content/equities/indices/cnx_500.htm). Hence, virtually, the
chosen sample presents a census on equity market returns in India.
The sample is representative in nature as the NSE 500 companies represent all
industry groups. The date of sample selection was 11 March 2013. The period of
the study is 1993–2014.

NSE 500 Index Background

The company Standard & Poor’s (S&P) introduced its first stock-based index in
1923 in the USA. The index is float weighted now. That is, S&P calculates
the market capitalization relevant to the index using only the number of shares
Section II: Scope, Data and Methodology 71

(called ‘float’) available for public trading (Source: Wikipedia website, http://en.
wikipedia.org/wiki/S%26P_CNX_500).
The CNX 500 (hereby referred to as NSE 500) is India’s first broad-based
benchmark of the Indian capital market. It is owned and managed by the Credit
Rating Information Services of India Limited (CRISIL) and the NSE. Without the
additional abbreviation to S&P CNX, the index name would be S&P CRISIL NSE
index (Investopedia 2013).
The NSE 500 companies are disaggregated into 72 industry indices (as on the
date of sample selection). Industry weightages in the index reflect the industry
weightages in the market (Source: National Stock Exchange (NSE) website, http://
www.nseindia.com/products/content/equities/indices/cnx_500.htm).

Secondary Data and Analysis

Focus on Long-Term Returns

Within the study period, distinct holding periods of various durations have been
computed, as explained below. This has helped to bring out the effect of varying
market conditions on the returns. The effect of the investment duration on returns is
also brought out through the same. Since different investors have different time
horizons for investments, the computation of returns according to the different
investment durations serves a useful purpose.
The main focus is on the holding periods of medium and long durations, par-
ticularly five, ten and fifteen years. Computations for other durations have also been
made, but in order to keep the presentation simple and not to allow the data to
overwhelm the reader, the emphasis is on selected durations only. Further, we also
considered it useful to compute returns for the one-year holding period.

Individual Companies and Portfolios

The basic computation of returns is for individual companies. The portfolio returns
have been built up from individual company returns. This method requires more
effort and time but has the advantage not only of ensuring greater accuracy but also
of providing many more insights. However, the presentation emphasizes the entire
portfolio’s returns. The rationale is that it provides a benchmark as well as credible
statistics of equity returns. Such analysis is likely to be more useful as most of the
professional equity investors, including individuals as well as institutions, have
diversified portfolios.
72 4 Rates of Return—Investors’ Perspective

Holding Periods

Within the study period, periods of varying plausible durations have been covered.
For example, twenty-one 1-year periods (1993–1994, 1994–1995, 1995–1996,
1996–1997….2012–2013, 2013–2014), seventeen 5-year holding periods (i.e.
1993–1998, 1994–1999, 1995–2000, 1996–2001…2008–2013, 2009–2014),
twelve 10-year periods (i.e. 1993–2003, 1994–2004, 1995–2005…2003–2013,
2004–2014) and seven 15-year periods (i.e. 1993–2008, 1994–2009, 1995–2010…
1998–2013, 1999–2014) have been covered. This was designed to bring out the
effect of differing market conditions as well as the impact of differing durations of
investment.

Share Prices

The share prices used in the computations are the average of the respective year’s
high and low prices. It is useful to mention here that the use of the year’s ‘average’
price, however derived, had important advantages over the alternatives of using
share prices at some fixed date, say, the year-end. As a large proportion of the listed
shares in India are the shares of small- and medium-sized companies and are not
traded daily, the use of the share prices on a fixed date would have resulted in the
exclusion of such shares from the study. Also, the prices at any particular point of
time are liable to be affected by chance factors. Tests conducted by Gupta (1981)
have shown that the average of the high and low prices quite closely approximate
the average based on more frequently collected price quotations, such as the daily,
weekly or monthly prices.

Definition of Returns

The returns represent total returns, including both capital appreciation and divi-
dends. They have been measured by deploying the method of (IRR).
The IRR is the discount rate ‘r’ in the following equation:
h i h i
Initial Purchase Price ¼ D1 =ð1 þ r Þ1 þ D2 =ð1 þ r Þ2 þ . . .½Dn þ Sn =ð1 þ r Þn 
ð4:1Þ

where
r is the discount rate;
D1, D2 … Dn are the year-to-year cash dividends; and,
Sn is the terminal price on the sale of investment at the end of n years
Section II: Scope, Data and Methodology 73

Bonus and Rights Issue Adjustments

Share prices and dividend data, used for computing the returns, have been adjusted
for the bonus and rights issues made during the period of the study. For bonus
issues, the adjustment is straight forward. For example, if a company issues 1:1
bonus, the prebonus price and dividend of one share should be compared with the
sum of post-bonus price and dividend on two shares combined. Hence, the
post-bonus share prices and dividend rate in all subsequent years are multiplied by a
‘bonus adjustment factor’ (which is derived as the ratio of the number of shares
after the bonus issue to the number of shares before the bonus issue). The bonus
adjustment factor will be 2/1 in the case of 1:1 bonus issue and 3/1 in the case of 2:1
bonus issue. The adjustment factor is recalculated after every bonus issue.
In the case of a rights issue, the adjustment is relatively more difficult. The
adjustment method is designed to keep the shareholder’s investment after the rights
issue unchanged, i.e. exactly the same as before the rights issue. Most rights issues
are often made significantly below the prevailing market price. Every shareholder
has the option either to subscribe to the rights issue or to sell his/her right to someone
else. The rights are traded in the market in the same way as shares. If the investor
subscribes to the right, he/she will be making an additional investment which has
been ruled out for the present purpose. If he/she sells his/her right, the price realized
by him/her has the effect of reducing his/her investment, even though he/she con-
tinues to hold the same number of shares as before the rights issue. The reduction
occurs because the ex-rights price is invariably lower than the cum-rights price. As
mentioned earlier, it is assumed that the investor keeps his/her investment unchan-
ged throughout the holding period. The ‘rights adjustment factor’ is intended to
ensure this. It is derived by assuming that the shareholder first sells his ‘right’ and
then immediately reinvests the sale proceeds by buying more shares of the company
at the ex-right price. The assumption is that fractional shares can also be bought. The
result of this is that the number of shares held by him/her will increase such that the
value of his/her holding at the ex-right price will be the same as the value of his/her
earlier holding at the cum-right price. For the detailed formulae and illustrative
examples on bonus and rights issue adjustments, please refer to Annexure 4.1.

Weights for Computing Portfolio Returns

The returns over a holding period were first computed for each individual company
and then weights were attached to each, based on the market capitalization of each
company at the beginning of each holding period. Hence, the relative weights of the
individual companies in the portfolio would vary from period to period. Even if the
companies remain the same, the relative prices of their shares and, therefore, the
relative weights could change from one period to another. The shares included in
the portfolio are assumed to be purchased in the initial year of each holding period
at that year’s average price (average of high and low) and disposed of in the
terminal year of the particular holding period at that year’s average price.
74 4 Rates of Return—Investors’ Perspective

It is important to mention here that when the market capitalization at the

beginning of each holding period is used as the relative weight, there is no
auto-correlation between returns and market capitalization. The portfolio for each
holding period is new even if the companies remain the same because a portfolio is
defined by two characteristics, viz., (1) the total acquisition cost and (2) the relative
weights of the component companies. These two characteristics, which can make
all the difference to the rates of return (RoR), go on changing from one holding
period to another.

Dividends

Cash dividends are taken into account in the respective years and are not assumed
to be reinvested.

Transaction Costs and Taxes

Brokerage, other transaction costs and personal income taxes have not been fac-
tored in the computation of returns. Whilst the reason for excluding brokerage and
other transaction costs is logistic convenience, the reasons for income tax are two:
first is that the personal income tax rates vary from investor to investor and second
is that dividends were free of tax during part of the study period of 21 years.

Data Sources and Analysis

The relevant data (secondary) were collected from the Bloomberg® database, for
twenty-one years (1994–2014). Descriptive statistical values/positional values, i.e.
mean, standard deviation, variance, coefficient of variation, minimum, maximum,
skewness, kurtosis and quartile values, have been computed for each holding
period. The entire set of data has been analysed using Microsoft Excel® spread-
sheets and the statistics software SPSS®, namely Statistical Package for Social
Sciences.

Section III: Portfolio Returns for Varied Holding Periods

The objective of this section is to enumerate RoR earned on the NSE portfolio for
varied holding periods ranging from 1 year to 15 years. The relevant data (along
with their mean, standard deviation, variance, coefficient of variation, minimum,
maximum, skewness, kurtosis and quartile values) are presented in Tables 4.1, 4.2,
4.3 and 4.4. These tables represent RoR for holding periods of 15, 10, 5 and 1 year,
Section III: Portfolio Returns for Varied Holding Periods 75

Table 4.1 Rates of return for the fifteen-year holding period (when equities were purchased at the
year’s average price and then sold 15 years later, at the terminal year’s average price)
Holding Rates of return (per cent per Holding Rates of return (per cent per
period annum) on the NSE 500 period annum) on the NSE 500
portfolio portfolio
1993–08 16.24 1997–12 19.81
1994–09 12.77 1998–13 20.07
1995–10 19.37 1999–14 20.72
1996–11 19.89
Statistic Value
Mean returns 18.41 %
Standard deviation 2.88 %
Variance 8.28 %
Coefficient of variation 15.64 %
Minimum returns 12.77 %
Maximum returns 20.72 %
Skewness −1.62
Kurtosis 1.95
Lower quartile 16.24 %
Upper quartile 20.07 %

Table 4.2 Rates of return for the ten-year holding period (when equities were purchased at the
year’s average price and then sold 10 years later, at the terminal year’s average price)
Holding Rates of return (per cent per Holding Rates of return (per cent per
period annum) on the NSE 500 portfolio period annum) on the NSE 500 portfolio
1993–03 4.37 1999–09 18.50
1994–04 11.87 2000–10 14.90
1995–05 16.61 2001–11 25.79
1996–06 21.78 2002–12 23.58
1997–07 24.07 2003–13 25.38
1998–08 26.02 2004–14 22.58
Statistic Value
Mean returns 19.62 %
Standard deviation 6.65 %
Variance 44.21 %
Coefficient of variation 33.89 %
Minimum returns 4.37 %
Maximum returns 26.02 %
Skewness −1.21
Kurtosis 1.07
Lower quartile 15.33 %
Upper quartile 25.05 %
76 4 Rates of Return—Investors’ Perspective

Table 4.3 Rates of return for the five-year holding period (when equities were purchased at the
year’s average price and then sold 5 years later, at the terminal year’s average price)
Holding Rates of return (per cent per Holding Rates of return (per cent per
period annum) on the NSE 500 portfolio period annum) on the NSE 500 portfolio
1993– −1.09 2002– 36.19
1998 2007
1994– 2.14 2003– 36.70
1999 2008
1995– 28.83 2004– 44.18
2000 2009
1996– 8.90 2005– 14.60
2001 2010
1997– 8.90 2006– 25.08
2002 2011
1998– 12.60 2007– 16.18
2003 2012
1999– 10.13 2008– 11.71
2004 2013
2000– 22.53 2009– 11.47
2005 2014
2001– 5.55
2006
Statistic Value
Mean returns 17.33 %
Standard deviation 12.92 %
Variance 166.94 %
Coefficient of variation 74.56 %
Minimum returns −1.09 %
Maximum returns 44.18 %
Skewness 0.72
Kurtosis −0.35
Lower quartile 8.90 %
Upper quartile 26.96 %

respectively. The RoR have been depicted in Figs. 4.1, 4.2, 4.3 and 4.4,
respectively.
Even though the average annual returns of the fifteen-year holding period
[18.41 % (Table 4.1)] are comparable with the ten-year holding period average
annual returns (19.62 %), the coefficient of variation for the fifteen-year holding
period (15.64 %) is less than half of its counterpart in the ten-year holding period
[44.21 % (Table 4.2)]. This is an indication of the market providing substantial and
safe returns with longer holding periods. Low negative skewness and the kurtosis
figures are an indication of nearly similar return values when compared to the
average returns which is evident from the values in these tables.
Section III: Portfolio Returns for Varied Holding Periods 77

Table 4.4 Rates of return for the one-year holding period

Holding Rates of Return (per cent per Holding Rates of return (per cent per
Period annum) on the NSE 500 Portfolio period annum) on the NSE 500 Portfolio
1993 0.13 2004 25.49
1994 −17.11 2005 65.81
1995 7.39 2006 17.26
1996 −2.60 2007 27.45
1997 9.04 2008 −36.45
1998 17.59 2009 94.42
1999 164.60 2010 14.62
2000 −53.65 2011 −3.60
2001 15.09 2012 12.77
2002 −2.41 2013 10.96
2003 100.47 2014 22.60
Phase 1 (1993–2002) 13.81
Phase 2 (2003–2008) 33.34
Phase 3 (2009–2014) 25.30
Statistic Value
Mean returns 22.27 %
Standard deviation 47.53 %
Variance 2258.72 %
Coefficient of variation 213.43 %
Minimum returns −53.65
Maximum returns 164.60 %
Skewness 1.49
Kurtosis 3.08
Lower quartile −2.46 %
Upper quartile 25.98 %

It is to be borne in mind that the returns in the holding period, 1993–2003, are
low due to the following reasons: (i) only few of the sample companies were
present for trading in the specified period, (ii) NSE started trading only in 1994 and
hence the volume and price levels were not encouraging initially. Further, the
decline in return in the 1999–2009 and 2000–2010 holding periods may be
attributed to the US financial crisis that originated in 2008 and had substantial
repercussions in stock markets worldwide.
The average returns for the ten-year holding period are close to 20 % (Table 4.2)
with a coefficient of variation of 33.89 % which indicates relatively stable returns
for this holding period vis-à-vis the five-year holding period. It is eloquently borne
out by the fact that the coefficient of variation for 5-year holding period is more than
twice (at 74.56 %) vis-à-vis 10-year holding period (having coefficient of variation
78 4 Rates of Return—Investors’ Perspective

Fig. 4.1 Rates of return for the fifteen-year holding period

of nearly 34 %). Thus, the 10-year holding period appears to be an attractive

investment option for the long-term investor.
From Table 4.3, it is evident that the average returns are 17.33 % for the period.
There appears, however, a significant variance in the returns. This should be seen in
the light of the fact that the returns for the first two periods (1993–1998 and 1994–
1999) could be abnormally low due to the reasons mentioned earlier. Hence, the
variance computed could be on the higher side. The same is also indicated by
the low skewness and negative kurtosis figures, both indicating lower volatility in
the distribution.
Table 4.4 presents the computed returns for the twenty-one 1-year holding
periods to give an indication of short-run returns. The striking feature of these
returns is perhaps the substantial volatility evident in the returns. The returns vary
from a minimum of −53.65 % to a maximum of 164.60 % over the past two
decades. The same is evident from the high skewness and kurtosis values, both
indicating higher values dominating the distribution and peaks in the data (indi-
cating volatility), respectively. Even though the focus of this study is on medium-
and long-term returns, it is useful to understand the behaviour of short-term returns
(based on 1-year holding period), as well, in order to arrive at a more compre-
hensive perspective.
Section IV: Overall Characteristics of Returns 79

Fig. 4.2 Rates of return for the ten-year holding period

Section IV: Overall Characteristics of Returns

The Indian equity market, represented by the NSE 500 companies (constituting
96.27 % of the market capitalization), appears to be an attractive investment des-
tination for long-term investors as well as short-term investors. Mean annual returns
are over 20 % (22.27 %) for 1-year holding period (Table 4.4), 17.33 % for the
5-year holding period (Table 4.3), 19.62 % for the 10-year holding period
(Table 4.2) and 18.41 % for the 15-year holding period (Table 4.1). Although, there
does not exist substantial difference in RoR for holding periods of 5, 10 and
15 years, yet the markets appear to favour the long-term investor as the volatility,
measured through the coefficient of variation, falls substantially as the investment
horizon (holding period) increases.
Equity returns have been extremely volatile in the short run with a coefficient of
variation of 213.43 % for the 1-year holding period which decreased significantly to
15.64 % for the 15-year holding period.
In sum, it is reasonable and safe to contend that Indian equity markets provide
robust and stable returns over the long-term investment horizon, say 5-, 10- or
15-year holding periods. In the short run too (one year), the average returns of
22.27 % (in absolute terms) are attractive. However, the speculative market lends
80 4 Rates of Return—Investors’ Perspective

Fig. 4.3 Rates of return for the five-year holding period

volatility to the returns making it a less safe option vis-à-vis the long-term
counterpart. The same is also corroborated by the minimum and maximum value of
returns over different time horizons. From the foregoing, it appears advisable to
adopt a long-term investment horizon whilst investing in the Indian equity market
to earn better/higher/safer returns.
Moreover, it is rather encouraging to note that the returns of the sample com-
panies appear robust compared to the findings of Gupta and Choudhary (2000) as
their sample comprised of the Sensex portfolio (an index of the top 30 companies
based on market capitalization) and such returns would have been high as the
constituent companies are amongst the best performers; whereas the sample of NSE
500 companies is a much larger and broad-based sample and hence the returns
reported are indicative of the near complete market returns. Hence, it appears safe to
assume that the success story of the Indian equity market continues, both in terms of
the returns and in their increasing market breadth and coverage.
Section IV: Overall Characteristics of Returns 81

Fig. 4.4 Rates of return for the one-year holding period

Periods of High Returns

From the beginning of the National Stock Exchange and the study period (1993–
2014), the returns were generally high, often well over 20 % per annum, for the
sample companies. Substantially, high returns of 25–30 % for several five-, ten- and
fifteen-year periods were earned on the portfolio comprising the NSE 500 com-
panies. In terms of annual returns, the years 1999, 2003 and 2009 recorded
abnormally high returns.

Periods of Low Returns and Losses

On the other hand, even negative returns (losses) were noted during the study
period; such negative returns have been observed primarily in the one-year time
period, for example, in the years 1994, 1996, 2000, 2002, 2008 and 2011. This
could, in part, be attributed to the substantial foreign institutional investment out-
flows from the capital markets in these years (Shrivastav 2013), the Satyam scam of
2008 and also due to the speculative pressures on return volatility in the short run.
82 4 Rates of Return—Investors’ Perspective

However, over longer investment horizons, even though the returns were low, they
were never negative, except for the 1993–1998 periods.

Magnitude of Variations

The variations in returns have been large, particularly in the short run (one-year
holding period). For instance, returns increased from a negative 2.41 % in 2002 to
100.47 % in 2003 and from −36.45 % in 2008 to 94.42 % in 2009 (Table 4.4). In
marked contrast, returns dropped drastically from a high of 164.60 % in 1999 to the
loss of −53.65 % in 2000. The volatility thus exhibited in the short run would
certainly not lead to a comfortable experience for the risk-averse investor.

Three Phases

For a clearer understanding of the short-run returns, the twenty-one-year study

period was divided into three phases. This exercise was carried out simply to
understand the overall trend of returns over the period of the study. Phase 1 covered
the first half of the study period (1993–2002). The second, more recent half of the
study period comprised of the remaining years from 2003-2014. This period was
subdivided into two 6-year periods, viz., phase 2 (2003–2008) and phase 3 (2009–
2014). From the average returns recorded for phase 2 (33.34 %) vis-à-vis the
average returns recorded for phase 1 (13.81 %) and phase 3 (25.30 %), it is evident
that phase 2 witnessed a period of high returns, indicative of a bullish market phase
during the study period.

Two Components of Total Return

The total return has two components, viz., capital appreciation and dividends.
During the calculations, it was observed that the total return was dominated by the
capital appreciation component (as expected) and such dominance has increased
over time. The same was reported by Gupta and Choudhary (2000) in their study.

Declining Importance of Dividend

A decline in the contribution of dividends to the total returns on equities is con-

firmed by declining dividend yields (i.e. dividend per share as per cent of the
market price). This should not be taken to mean that dividend per share has
Section IV: Overall Characteristics of Returns 83

declined. In fact, the dividend has been increasing as the earning-per-share

(EPS) has been going up. The falling dividend yield is due to the share prices rising
faster than the dividend growth.
Further, the Indian companies have been recording a declining dividend payout
(D/P) ratio over the past two decades, an indication of higher retentions due to the
sound investment/growth opportunities available with them. This is resulting in
higher capital appreciation in terms of the rising share prices for investors (Jain
et al. 2013).

Comparison with Debt Instruments

Any analysis of equity returns would be incomplete without a comparison of such

returns with the returns offered by investment avenues/alternatives available with
investors, say, primarily corporate debt instruments and banks’ fixed deposits.
Apart from returns, it is useful to state here that equity investment gives the investor
ownership rights in the working of a business enterprise, an aspect not available in
debt investment. The comparisons of both long-term returns and short-term returns
are necessary to provide a complete perspective. In strict sense, equity returns are
not comparable with the stated competing investment outlets (given the more risky
nature of equity returns); the comparison is likely to be useful as these sources (in
practice) are competitive in nature. As per finance theory, returns on equity should
be higher vis-a-vis debt instruments and fixed deposits to compensate the investor
(s) for assuming extra risk. Viewed in this context, the discussion would provide the
extent of risk premium (if any) available to equity investors in India.

a. Long-Term Returns’ Comparisons

The best annual interest rates available on 15-years, 10-years and 5-years fixed
deposits (to compare with the 15-years, 10-years and 5-years equity holding peri-
ods) have been 10 % on an average over the study period (Source: Moneycontrol
website 2014). The average returns for the equity portfolios of these durations were
18.41, 19.62 and 17.33 % for 15-, 10- and 5-year holding periods, respectively.
It is to be noted that interest earned on deposits is taxed in the hands of the
investor in India, as are capital gains. At the time of writing this chapter, the interest
income (taxed at the personal income tax slab of the individual) could attract a
maximum tax rate of 30 %, whereas the long-term capital gains tax is 20 %. It is
evident from the tax rates that the after-tax computation of equity returns would be
greater than the after-tax computation of interest income (assuming the highest tax
slab rate of 30 %). The other advantage that accrues to equity investment is the
liquidity (in terms of transaction and the entry/exit into/from the market). On both
the counts of taxes and liquidity, equity investment appears a better alternative than
debt. However, it is important to consider the volatility present in equity
84 4 Rates of Return—Investors’ Perspective

investment. For the risk-averse investor, debt instruments provide attractive return
with low risk. Assuming debt instruments to be nearly risk-free, the ‘risk premium’
on equity, prima-facie, appears to be approximately 8 % in India (from the statistics
computed). This finds support in the figures mentioned in the surveys conducted by
Pricewaterhouse Coopers and Ernst and Young to determine the equity risk pre-
mium in India [Pricewaterhouse Coopers website (2015) and Ernst and Young
website (2015)].
Overall, it appears that India continues to be an attractive investment destination
for both equity and debt instruments as it caters to the requirements of both the
risk-taking and risk-averse investor.

b. Short-Term Returns’ Comparison

Figure 4.5 presents the average call money interest rates and 1-year bank interest
rates for a period of 25 years (1976–2011). The 1-year bank interest rates have been
relatively stable (fluctuations ranging from 8 to 12 % over 25 years). The call
money market rates, comparatively, have shown wider fluctuations with rates rising
to nearly 20 %, manifesting the vast volatility in short-term equity returns.
However, debt instrument returns (interest rates) provide safer (as is expected)
returns when compared to 1-year equity returns. For example, when equity returns

Fig. 4.5 Twenty-five years of bank interest rates in India (source Capitalmind website 2014)
Section IV: Overall Characteristics of Returns 85

Table 4.5 Comparison of different investment avenues—2015

Investment Risks/liquidity Returns Taxation Suitability
option
Equity High risk and Market linked Long-term Needs high-risk
high liquidity. returns. Good capital gain appetite
No limit on potential taxed at the rate
amount invested of 20 % and
short-term
capital gain
taxed at slab
rates
Bank fixed Very low risk Low returns of Returns are fully Good for very
deposits and low maximum of taxable low-risk
(FDs) liquidity. No 9.15 %, but investors and
limit on amount assured those in the nil
invested or low-tax
brackets
Post office Low risk and Monthly Since returns are Good for very
schemes low liquidity. income saving taxable, the low-risk
Limit on amount (MIS) scheme post-tax returns investors and
to be invested provide 8 % will be still those in the nil
interest. Time lower or low-tax
deposit 6.25– brackets.
7.5 % However, high
inflation may eat
into the returns
Public Low risk with Assured Interest is Good tax saving
provident very low returns of tax-free investment
fund (PPF) liquidity 8.70 % per option. Suitable
(15-year lock-in annum for investors in
period. Partial high-tax bracket
withdrawal
allowed after
6 years). Limit
on amount to be
invested
Kisan vikas Low risk with Amount Interest fully Not very
patra low liquidity doubles in taxable attractive vis-à-
(KVP) (2 years and 100 months vis other options
6 months like 5-year Bank
lock-in). No FDs
limit on amount
to be invested
National Low risk with Assured Interest fully Not very
savings low liquidity returns of taxable attractive vis-à-
certificate (5 years lock-in). 8.50 % per vis other options
(NSC) No limit on annum like 5-year Bank
amount to be FDs
invested
(continued)
86 4 Rates of Return—Investors’ Perspective

Table 4.5 (continued)

Investment Risks/liquidity Returns Taxation Suitability
option
Unit linked Low to high risk Low to high Depend on Not an attractive
insurance depending on the depending on investment option due to
plans investment the investment option high charges,
(ULIPs) option, i.e. pure option low flexibility
debt or mixed or and low
pure equity. Low diversification
liquidity (3–
5 years lock-in
period)

were −3.60 % in 2011 and −53.65 % in 2000, the bank interest rates were nearly
9 %. Hence, it appears that India provides debt markets as a safer option in times of
volatility in equity returns providing the investors with the much required choice to
counter such volatility, which is present in one market. However, in 2008, both
equity returns and interest rates fell due to the financial crisis, which is perhaps to be
expected, indicating that certain fundamental and systematic factors may affect both
markets adversely, leaving the investor with no choice but to diversify into inter-
national financial markets.
Further, in an attempt to aid investors, Table 4.5 has been prepared to provide a
comparative analysis of equity and various debt instruments investment avenues
available in India, based on aspects such as risk/liquidity, returns, taxation and
suitability with respect to 2015. However, it would be unfair to compare these
avenues directly as each of them represents an individual investor’s unique risk–
return profile and preference.

Section V: Concluding Observations

This chapter presents the equity returns for the Indian stock market, represented by
the NSE 500 companies for the past two decades (1993–2014).
The returns have been computed for varying holding periods, viz., fifteen-, ten-,
five- and one-year periods. Along with returns, other statistics, used to measure risk
or volatility, have also been computed to present the overall picture of risk and
return emanating from the Indian equities. The returns for all periods average
around 20 % which is encouraging. However, the volatility present in the short term
(one-year holding period) is substantially high (with a coefficient of variation of
213.43) indicating speculative forces at play. It is gratifying to note that such
volatility decreases significantly as the holding period increases; the coefficient of
variation decreases substantially to 15.64 % for the fifteen-year holding period,
indicating that the market favours long-term investors.
Section V: Concluding Observations 87

The findings are in contrast to Gupta and Choudhary (2000) with respect to the
volatility exhibited in returns for the period. Gupta and Choudhary (2000) reported
high returns but with high volatility for almost all holding periods, whereas in this
case, the volatility is substantial for the one-year holding period but reduces, to a
marked extent, over longer holding periods of five, ten and fifteen years. Further,
recent returns over the past decade (phases 2 and 3) have been substantially higher
than the previous one (phase 1). This, perhaps, is a growing indication of the
inherent fundamental strength of the Indian companies and also of the growing
sophistication in the capital market trading/dealings.
It appears safe to assume that the Indian stock markets offer attractive returns in
the short run as well as the long run. But, it would be prudent to stay invested for a
longer period if the investor is risk-averse, as the volatility present in the short run
may eat away into short-run returns.
Further, to get a complete perspective, equity returns were compared with
long-term and short-term debt returns (interest rates). In terms of after-tax returns
and liquidity, equity returns in India fare better than debt returns. However, in terms
of risk (volatility), debt returns provide a safer option. Further, the debt markets
provide recourse to the investor in terms of diversification when equity markets are
volatile, due to their continued stability.
In sum, India appears to be an attractive investment destination for both the
risk-taking and the risk-averse investors. Indian companies are recording robust
growth in their profitability (Jain et al. 2013) and are going to be strong contributors
to the overall economic growth and development of the country.

Annexure 4.1

Disclaimer: These examples have been adapted from the Website ‘Accounting
Simplified.com’ for illustrative purposes to enhance the understanding of the
readers.

Example of Bonus Share Adjustment

ABC Ltd., which has a year-end of 31 December 2012, issued 1 for 4 bonus shares
on 30 June 2012.
Following information relates to ABC Ltd.:
Ordinary Shares as on 1 January 2011= 40,00,000 (40 lakhs)
Earnings attributable to ordinary shareholders:
INR 50,00,000 2011
INR 50,00,000 2012
88 4 Rates of Return—Investors’ Perspective

Calculation of Earnings Per Share for 2011 and 2012 for presentation in financial
statements for the year ended 31 December 2012 would be as follows:

Step 1: Calculate the number of bonus shares

Number of shares eligible for bonus shares 40,00,000
Number of bonus shares (40,00,000 × 1/4) 10,00,000
Step 2: Calculate weighted average Shares
2011 Shares at the start of the year 40,00,000
Add: Bonus shares (Step 1) 10,00,000
Weighted average shares 50,00,000
2012 Shares at the start of the year 40,00,000
Add: Bonus shares (Step 1) 10,00,000
Weighted average shares 50,00,000

Note that even though bonus shares were issued half way through 2012, they are
included in the calculation of weighted average shares without time apportionment
for both 2012 and 2011 (i.e. as if the bonus shares had been issued before the year
2011).

Step 3: Calculate earnings per share

2011 Earnings attributable to ordinary share holders INR 50,00,000
Weighted Average Shares (Step 2) 50,00,000
Earnings per share (INR 50,00,000/50,00,000) INR 1
2012 Earnings attributable to ordinary share holders INR 50,00,000
Weighted Average Shares (Step 2) 50,00,000
Earnings per share (INR 50,00,000/50,00,000) INR 1

Note that despite the bonus issue, there is no change in the earnings per share
for the two years as there is no change in earnings. The effect of bonus issue is
eliminated by incorporating the bonus shares adjustment in the calculation of
weighted average shares for both years.
The EPS calculated as above illustrates the fact that the performance of ABC
Ltd. has remained stable over the past two years. If no adjustment for bonus shares
had been made, EPS for 2012 would be lower than 2011 despite the fact that there
is neither a change in the earnings nor in the resources to earn a return to
shareholders. This would have presented an unfair comparison of the performance
of ABC Ltd.
Calculation of weighted average shares for subsequent periods will also
incorporate bonus shares in similar manner (i.e. added in full without time
apportionment).
Annexure 4.1 89

Example for Rights Issue Adjustment

ABC Ltd. issued 1 for 4 rights shares on 31 March 2013 at an exercise price of INR
1. Market value of its shares immediately prior to the rights issue was INR 1.5 per
share. ABC Ltd. had 10 lakh shares before the issuance of rights shares. All rights
were exercised by shareholders on 31 March 2012.
Formula

Market Value of shares prior to rights issue þ Cash raised from rights issue
Theoretical Ex  Rights Price =
Number of shares after rights issue

Theoretical Ex-Rights Price may be calculated as follows:

Step 1: Calculate market value of ABC Ltd. prior to the rights issue
Market Value before rights issue (INR 1.5 × 10 lakh shares) INR 15,00,000
Step 2: Calculate cash proceeds raised from the rights issue
Cash raised from rights issue (INR 1 × 2,50,000*) INR 2,50,000
*(10 lakh/4 = 2,50,000 rights shares)
Step 3: Calculate number of shares after the rights issue
Number of Shares (10,00,000 + 2,50,000 [step 2]) 12,50,000
Step 4: Calculate Theoretical Ex-Rights Price
Theoretical Ex  Rights Price ¼ INR 15;00;000 ðStep 1Þ þ INR 250;000ðStep 2Þ ¼ INR 1:4 per share
12;50;000ðStep 3Þ

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Chapter 5
Rates of Return—Disaggregative Analysis

After assessing the different aspects of returns at an aggregate level for the sample
firms, it would be equally useful to analyse the returns on a disaggregative basis.
The sample under study is a large one with 500 companies and almost 97 % of the
market capitalization. Hence, there could be aspects within the sample companies,
viz. the age of the company, the size of the company, the ownership structure and
the underlying sector/industry affiliation to which the company belongs, that could
impact its returns.
In line with the above considerations, this chapter presents a disaggregative
analysis of the returns earned by the companies based on their age, size, ownership
structure and the underlying sector/industry affiliation. For better exposition, this
chapter has been organized into five sections. Section I contains the introduction,
highlighting the parameters being considered; Section II enumerates briefly the
literature review focusing on disaggregative analysis. Section III contains the
methodology used in the analysis. The presentation of returns based on the age,
size, ownership structure and underlying sector/industry affiliation of the sample
companies and their interpretations form the subject matter of Section IV. The
summary is presented in Section V.

Section I: Introduction

The sample comprising of the NSE 500 companies is segregated on the basis of
age, size, ownership structure and the underlying sector/industry affiliation. This
section provides a brief overview of the modus operandi in which each aspect has
been considered.

© Springer Science+Business Media Singapore 2016 93

S. Singh et al., Equity Markets in India, India Studies
in Business and Economics, DOI 10.1007/978-981-10-0868-9_5
94 5 Rates of Return—Disaggregative Analysis

Fig. 5.1 Segregation of the Segregation on the Basis of Age

sample companies on the
basis of age

Young Middle-aged Old

Age

The constituent companies are divided into 3 categories based on their age, namely
‘young’, ‘middle-aged’ and ‘old’. The quartile values of age form the basis for the
segregation. All companies that fall within the first quartile are classified as
‘young’, the companies that fall between the first and third quartiles are classified as
‘middle-aged’ and those lying above the quartile 3 are referred to as ‘old’. As a
result of this classification, 133 companies fall in the ‘young’ category, 245 com-
panies in the ‘middle-aged’ category and 122 companies in the ‘old’ category
(Fig. 5.1).

Size

For the purpose of analysis, the constituent companies have been divided into 3
categories based on their size, namely ‘small’, ‘medium’ and ‘large’. The quartile
values of the company’s market capitalization, for each year, form the basis for the
segregation. All companies within the first quartile have been classified as ‘small’,
companies between the first and third quartiles designated as ‘medium’ and those
lying above the quartile 3 as ‘large’.

Ownership Structure

The ownership structure of the sample companies is primarily based on whether

these companies are family-owned companies or non-family-owned companies.
Section I: Introduction 95

A family-owned company is one in which the decision-making is influenced by

more than one member of the same family who have a close association with the
company, through leadership and/or ownership (Entrepreneur website 2015). The
family owns a significant portion of the stock, though not necessarily a majority
(Harvard Business Review 2012). From the non-family-owned companies, a further
segregation on the basis of whether these companies are public sector undertakings
(PSUs) or not has been made. Thus, the segregation of the sample companies on the
basis of ownership structure is ‘family-owned’, ‘PSUs’ and ‘non-PSU/non-family’.
On analysis of the ownership structure, it has been observed that more than
two-third (70.20 %) of the NSE 500 companies are family-owned businesses. The
remaining less than one-third (29.80 %) of the non-family-owned businesses have
more than one-fourth (26.17 %) of the constituent companies being central/state
government-owned PSUs. In terms of numbers, there are 351 (70.20 %)
family-owned businesses, 39 (7.80 %) PSUs and 110 (22 %) non-family/non-PSU
companies in the sample. As a result, more than three-fourth (78 %) of the NSE 500
companies are either family-owned or government-owned businesses and less than
one-fourth are non-family corporates (Fig. 5.2). From these statistics, it is apparent
that the family-owned business enterprises constitute the major segment of the
Indian corporate sector, warranting effective corporate governance. The following is
witnessed in this context: the Indian economy is dominated by large entities with
majority shareholding in the hands of a few.
Economically, this may not be a desirable situation for any country, more so for a
socialist economy, like India. The objective of a socialist economy is to ensure that
the wealth created in the economy does not lie under the control of a few families or
organizations, but is rather equitably distributed amongst the population. It is
imperative that the Indian government put in systems to encourage entrepreneurial

Fig. 5.2 Segregation on the Segregation on the Basis of

basis of ownership structure
of sample companies Ownership Structure

Family Owned PSUs

Non-PSU/Non-Family
96 5 Rates of Return—Disaggregative Analysis

development in the country so that more and more non-family/government-owned

businesses may contribute towards wealth creation and distribution.

Underlying Sector/Industry Affiliation

For the purpose of the disaggregative analysis, the 500 companies were regrouped
into constituent sectors to reduce the number of sectors to 10 from 73, primarily
with intent to have an adequate/good number of companies in each sector for better
statistical analysis.

Section II: Literature Review

Few studies have been conducted to analyse the characteristics of companies and
their impact (if any) on their risk and/or returns.
Fisher (1959) demonstrated that firm’s size and financial leverage were impor-
tant determinants of equity risk. However, the study of individual firms’ risk as
related to their underlying characteristics began with the seminal work of Beaver
et al. (1970); their study examined the relationship of certain accounting ratios
(payout, liquidity, earning variability, etc.) to the firm’s systematic risk (beta) and
reported a strong and significant association between them. Ben-Zion and Shalit
(1975) investigated the major determinants of equity risk through the analysis of the
firm’s underlying characteristics, specifically the firm’s size, its financial leverage
and its dividend record.
Logue and Merville (1972) employed a multiple regression technique to relate
financial variables and estimated beta. Assets size, return on assets and financial
leverage were reported to be significant. Hamada (1972) and Galai and Masulis
(1976) linked the firm’s equity beta with factors such as level of financial leverage,
debt maturity, variation in income, cyclicality, operating leverage, dividends and
growth. Banz (1981) examined the empirical relationship between the returns and
the total market value of New York Stock Exchange (NYSE) common stocks. It
was observed that smaller firms (by and large) had higher risk-adjusted returns than
larger firms. Wong and Lye (1990) provided evidence on the relationship between
stock returns and the effects of firm size and earnings-to-price ratio (E/P). It was
concluded that stock returns were significantly related to both size and E/P.
Fletcher (1997) examined the conditional relationship between beta and returns
in the UK for a time span of 20 years, 1975–1994. His result supported the findings
of Fama and French (1992) as well as of Strong and Xu (1997) as there was no
evidence of a significant risk premium on beta when the unconditional relationship
between beta and return was examined. He also did not observe any significant
relationship between size and returns. Lau et al. (2002) assessed the relationship
Section II: Literature Review 97

between stock returns and beta, size, the earnings-to-price (E/P) ratio, the cash
flow-to-price ratio, the book-to-market equity ratio and sales growth (SG) by
analysing the data of the Singapore and Malaysian stock markets for the period
1988–1996. The analysis revealed a negative relationship between size and stock
returns as well as between weighted average annual sales growth and stock returns
for the Singapore stock market. For the Malaysian stock market, they noted a
negative size effect and a positive E/P effect on stock returns.
Ho et al. (2006) examined the pricing effects of beta, firm size and book-to-
market value (BV/MV), but conditional on market situations, i.e. whether the
market was bullish or bearish, using Hong Kong equity stock data. Manjunatha and
Mallikarjunappa (2012) examined the validity of the five parameter model (the
combination of five variables, viz. beta (β), size, E/P, BV/MV and market risk
premium (Rm-Rf)) on the Indian stock returns using cross-sectional regression. The
results indicated that the combination of β, size, E/P, BV/MV and (Rm-Rf) variables
explained the variation in security returns.
The study undertaken in this chapter is a modest attempt to present a disag-
gregative analysis focusing on the parameters of age, size, ownership structure and
underlying sector/industry affiliation, with respect to returns, of the sample com-
panies from the Indian stock market.

Section III: Methodology

The research methodology adopted in this chapter to conduct the disaggregative

analysis by dividing the sample companies on the basis of age, size, ownership
structure and underlying sector/industry affiliation has been delineated in this
section.

Scope

The sample comprises of the top 500 companies listed on the NSE based on their
market capitalization and is a part of the NSE 500 index. The NSE 500 index
represented about 96.76 % of the free-float market capitalization and 97.01 % of the
total traded value at NSE (source: National Stock Exchange (NSE) Website. http://
www.nseindia.com/products/content/equities/indices/cnx_500.htm). Hence, virtu-
ally, the chosen sample presents a census on equity market returns in India.
The date of sample selection was 11 March 2013 studied over the period of
2001–2014. This universe has been chosen as it is most likely to be an accurate
representation of the Indian stock market (given the above facts).
98 5 Rates of Return—Disaggregative Analysis

NSE 500 Index Background

Introduced by the company Standard & Poor’s (S&P), the index has traditionally
been market value-weighted; that is, movements in the prices of stocks with higher
market capitalizations (the share price times the number of shares outstanding) have
a greater effect on the index than companies with smaller market capitalizations.
However, the index is now float-weighted (source: Wikipedia Website. http://en.
wikipedia.org/wiki/S%26P_CNX_500).
Its Indian counterpart, the CNX 500 (hereby referred to as NSE 500) is India’s
first broad-based benchmark of the Indian capital market. The NSE 500 companies
were disaggregated into 72 industry indices (as on the date of sample selection).
Industry weightages in the index reflect the industry weightages in the market. For
example, if the housing sector has a 5 % weightage in the universe of stocks traded
on NSE, housing stocks in the index would also have a representation of 5 % in the
index (source: National Stock Exchange (NSE) Website. http://www.nseindia.com/
products/content/equities/indices/cnx_500.htm).

Secondary Data and Analysis

Individual Companies and Disaggregated Portfolios

The basic computation of returns is for individual companies. The disaggregated

portfolio returns have been built up from individual company returns. This method
requires more effort and time but has the advantage of not only ensuring greater
accuracy but also providing better insights. However, the presentation emphasizes
the entire disaggregated portfolio’s returns. The rationale is that it provides a
benchmark as well as credible statistics of equity returns. Such analysis is likely to
be more useful as most of the professional equity investors, including individuals
and institutions, have diversified portfolios based on varying parameters.

Share Prices

The share prices used in the computations are the average of the respective year’s
high and low prices. It is useful to mention here that the use of the year’s ‘average’
price, however derived, had important advantages over the alternatives of using
share prices at some fixed date, say, the year-end. As a large proportion of the listed
shares in India are the shares of small and medium-sized companies and are not
traded daily, the use of the share prices on a fixed date would have resulted in the
exclusion of such shares from the study. Also, the prices at any particular point of
time are liable to be affected by chance factors. Tests conducted by Gupta (1981)
Section III: Methodology 99

have shown that the average of the high and low prices quite closely approximate
the average based on more frequently collected price quotations, such as the daily,
weekly or monthly prices.

Definition of Returns

The returns represent total returns, including both capital appreciation and dividends.
They have been measured by deploying the method of internal rate of return (IRR).
The IRR is the discount rate ‘r’ in the following equation:
h i h i
Initial Purchase Price ¼ D1 =ð1 þ r Þ1 þ D2 =ð1 þ r Þ2 þ    þ ½Dn þ Sn =ð1 þ r Þn  ð5:1Þ

where
r is the discount rate;
D1, D2,…, Dn are the year-to-year cash dividends; and
Sn is the terminal price on the sale of investment at the end of n years.

Bonus and Rights Issue Adjustments

Share prices and dividend data, used for computing the returns, have been adjusted
for the bonus and rights issues made during the period of the study. For bonus
issues, the adjustment is straightforward. For example, if a company issues 1:1
bonus, the prebonus price and dividend of one share should be compared with the
post-bonus price and dividend on two shares combined. Hence, the post-bonus
share prices and dividend rate in all subsequent years are multiplied by a ‘bonus
adjustment factor’ (which is derived as the ratio of the number of shares after the
bonus issue to the number of shares before the bonus issue). The bonus adjustment
factor will be 2/1 in the case of 1:1 bonus issue and 3/1 in the case of 2:1 bonus
issue. The adjustment factor is recalculated after every bonus issue.
In the case of a rights issue, the adjustment is relatively more difficult. The
adjustment method is designed to keep the shareholder’s investment after the rights
issue unchanged, i.e. exactly the same as before the rights issue. Most rights issues
are often made significantly below the prevailing market price. Every shareholder
has the option either to subscribe to the rights issue or to sell his/her right to
someone else. The rights are traded in the market in the same way as shares. If the
investor subscribes to the right, he/she will be making an additional investment
which has been ruled out for the present purpose. If he/she sells his/her right, the
price realized by him/her has the effect of reducing his/her investment, even though
he/she continues to hold the same number of shares as before the rights issue. The
reduction occurs because the ex-right price is invariably lower than the cum-right
price. As mentioned earlier, it is assumed that the investor keeps his/her investment
100 5 Rates of Return—Disaggregative Analysis

unchanged throughout the holding period. The ‘rights adjustment factor’ is intended
to ensure this. It is derived by assuming that the shareholder first sells his ‘right’ and
then immediately reinvests the sale proceeds by buying more shares of the company
at the ex-right price. The assumption is that fractional shares can also be bought.
The result of this is that the number of shares held by him/her will increase such that
the value of his/her holding at the ex-right price will be the same as the value
of his/her earlier holding at the cum-right price. For the detailed formulae and
illustrative examples on bonus and rights issue adjustments, please refer to
Annexure 4.1 of Chap. 4.

Weights for Computing Portfolio Returns

The returns over a year were first computed for each individual company, and then,
weights were attached to each, based on the market capitalization of each company
at the beginning of each year. Hence, the relative weights of the individual com-
panies in the portfolio would vary from period to period. Even if the companies
remain the same, the relative prices of their shares and, therefore, the relative
weights could change from one period to another.

Dividends

Cash dividends are taken into account in the respective years and are not assumed
to be reinvested.

Transaction Costs and Taxes

Brokerage, other transaction costs and personal income taxes have not been fac-
tored in the computation of returns. Whilst the reason for excluding brokerage and
other transaction costs is logistic convenience, the reasons for income tax are two:
first is that the personal income tax rates vary from investor to investor and second
is that dividends were free of tax during part of the study period of 21 years.

Data Sources and Analysis

The relevant data (secondary) were collected from the Bloomberg® and
AceEquity® databases, for fourteen years (2001–2014). Descriptive statistical
values/positional values, i.e. mean, standard deviation, variance, coefficient of
variation, minimum, maximum, skewness, kurtosis and quartile, have been com-
puted for each holding period. The entire set of data has been analysed using
Microsoft Excel® spreadsheets and the statistics software SPSS®, or Statistical
Package for Social Sciences.
Section III: Methodology 101

Table 5.1 Mean, minimum, Mean 41.04

maximum, standard deviation,
Minimum 4
coefficient of variation,
skewness, kurtosis, median Maximum 151
and quartile values related to Standard deviation 26.69
the age of sample companies Coefficient of variation 65.03
Skewness 1.25
Kurtosis 1.29
Median 30.50
Quartile 1 22
Quartile 3 56
Figures are in years

Age

Table 5.1 presents the mean, minimum, maximum, standard deviation, coefficient
of variation, skewness, kurtosis, median and quartile values related to the age of
sample companies. The age was calculated with reference to the year of the
incorporation of the company.
The constituent companies have been divided into 3 categories based on their
age—‘young’, ‘middle-aged’ and ‘old’. All companies that fall within the first
quartile have been classified as ‘young’, companies that fall between the first and
third quartiles as ‘middle-aged’ and those lying above the quartile 3 as ‘old’. As a
result of this classification, 122 companies fall in the ‘old’ category, 245 companies
in the ‘middle-aged’ category and 133 companies in the ‘young’ category.
As per the table, the average age of the sample companies is around four dec-
ades. However, the median of 30.50 years indicates that around half of companies
in the sample were incorporated around the time of the liberalization of the Indian
economy in 1991 (more than two decades ago) and the subsequent emphasis placed
on private (company) participation in the economy.

Size

Table 5.2 presents the mean, minimum, maximum, standard deviation, coefficient
of variation, skewness, kurtosis, median and quartile values related to the size of
sample companies. The market capitalization from 2001 to 2014, of each company,
was taken to be the basis for the calculations.
The constituent companies have been divided into 3 categories based on their
size—‘small’, ‘medium’ and ‘large’. All companies that fall within the first quartile
have been classified as ‘small’, companies between the first and third quartiles
classified as ‘medium’ and those lying above the quartile 3 as ‘large’.
As per the table, the average size of the sample companies (in terms of market
capitalization) is around INR one lakh crores. However, the much lower median of
INR 20,917.75 crores indicates that around half of companies in the sample are
102 5 Rates of Return—Disaggregative Analysis

Table 5.2 Mean, minimum, Mean 92,993.30

maximum, standard deviation,
Minimum 663.67
coefficient of variation,
skewness, kurtosis, median Maximum 2,622,377.78
and quartile values related to Standard deviation 247,119.11
the size of sample companies Coefficient of variation 265.74
Skewness 5.96
Kurtosis 44.61
Median 20,917.75
Quartile 1 9843.24
Quartile 3 58,529.66
Figures are in INR crores

significantly smaller. The same is also corroborated by the high skewness and
higher kurtosis that indicates that the sample is dominated a small number of very
large companies. For example, Reliance Industries is the largest company in the
sample, with an average market capitalization over 2001–2014 of INR
2,622,377.78 crores, more than 26 times the average!

Ownership Structure

The ownership structure of the sample companies has been determined as follows:
family-owned companies and non-family-owned companies. From the
non-family-owned companies, a further segregation on the basis of whether these
companies are public sector undertakings (PSUs) or not has been made. Therefore,
the segregation of the sample companies on the basis of ownership structure is
‘family-owned’, ‘PSUs’ and ‘non-PSU/non-family’.
In terms of numbers, there are 351 (70.20 %) family-owned businesses, 39
(7.80 %) PSUs and 110 (22 %) non-family/non-PSU companies in the sample. As a
result, more than three-fourth (78 %) of the NSE 500 companies are either
family-owned or government-owned businesses and less than one-fourth are
non-family corporates.

Underlying Sector/Industry Affiliation

For the purpose of the disaggregative analysis, the 500 companies were regrouped
into constituent sectors to reduce the number of sectors to 10 from 73, primarily for
the sake of providing an adequate/good number of companies in each sector and for
the sake of better statistical analysis. The detailed segregation is provided in
Table 5.3.
Section III: Methodology 103

Table 5.3 Sector-wise reclassification of sample companies

Sectors Number of Percentage of
companies companies
Commodity (metal, metal products, mining, oil 53 10.60
and gas)
Aluminium 2
Castings/forgings 2
Gas 6
Metals 1
Mining 8
Oil exploration/production 6
Refineries 7
Refractories 1
Steel and steel products 19
Sector not available 1
Consumer goods 40 8.00
Air conditioners 1
Brew/distilleries 3
Cigarettes 3
Consumer durables 4
Gems jewellery and watches 4
Leather and leather products 1
Retail 1
Personal care 7
Plastic and plastic products 8
Sugar 5
Tea and coffee 3
Finance 76 15.20
Banks 36
Finance 31
Finance—housing 4
Financial institution 4
Stock broking/trading 1
Health care 36 7.20
Hospitals 3
Pharmaceuticals 33
ICT (Internet, communications and technology) 42 8.40
Computers—hardware 1
Computers—software 29
Telecommunication—equipment 2
Telecommunication—services 7
Transmission towers 3
(continued)
104 5 Rates of Return—Disaggregative Analysis

Table 5.3 (continued)

Sectors Number of Percentage of
companies companies
Infrastructure 59 11.80
Cement and cement products 12
Construction 47
Power and electricals 51 10.20
Cables—power 1
Compressors/pumps 4
Electrical equipment 12
Electrodes 3
Electronics—industrial 2
Electrical engineering 8
Fasteners 1
Power generation 19
Electricity trading 1
Transport 52 10.40
Auto ancillaries 14
Automobiles—2 and 3 wheelers 3
Automobiles—4 wheelers 6
Bearings 2
Cycles 1
Diesel engines 3
Shipping 8
Travel and transport 10
Tyres 5
Textile and chemicals 50 10.00
Abrasives 1
Chemicals—inorganic 6
Chemicals—organic 2
Chemicals—specialty 4
Dyes and pigments 1
Fertilizers 5
Paints 4
Pesticides and agrochemicals 4
Petrochemicals 3
Solvent extraction 3
Textile machinery 1
Textile products 10
Textiles—cotton 1
Textiles—synthetic 5
(continued)
Section IV: Returns Based on the Age, Size, Ownership Structure … 105

Table 5.3 (continued)

Sectors Number of Percentage of
companies companies
Miscellaneous 41 8.20
Sanitary ware 1
Diversified 2
Food and food processing 9
Hotels 4
Entertainment 9
Education 1
Packaging 6
Roses 1
Apparel 1
Paper and paper products 3
Printing and publishing 3
Total 500 100

Section IV: Returns Based on the Age, Size, Ownership

Structure and Underlying Sector/Industry Affiliation
of Sample Companies

This section presents the disaggregated returns of the sample companies on the
basis of their age, size, ownership structure and underlying sector/industry
affiliation.

Age

As has already been mentioned, the companies have been segregated into young,
middle-aged and old. Table 5.4 presents the weighted annual average returns from
2001 to 2014 for the different classifications of age and the statistics of mean,
standard deviation, variance, coefficient of variation, minimum, maximum, skew-
ness, kurtosis and quartile values of returns.
On the basis of age, the ‘young’ companies with mean returns of 43.33 % fare
far better than their ‘middle-aged’ and ‘old’ counterparts with mean returns of 33.72
and 31.10 %, respectively. This is perhaps to be expected, as the companies in this
segment have been observed to be affiliated with emerging and important sectors
for India, such as power and infrastructure. Additionally, being new, these com-
panies are equipped with new technologies, with new production processes and
perhaps also with skilled labour force. There appears to be a negative correlation
between age and returns. The old companies seem to be saddled with ‘old’ tech-
nologies, old machines, more labour force (and that too relatively less skilled) and
Table 5.4 Weighted annual average returns and statistics of mean, standard deviation, variation, coefficient of variation, skewness, kurtosis and quartile
106

values of returns on the basis of age of sample companies, 2001–2014

Year Weighted average Mean Standard Variance Coefficient Minimum Maximum Skewness Kurtosis Lower Upper
annual returns returns deviation of variation returns returns quartile quartile
Young
2001 −21.68 −6.34 20.19 407.63 −318.45 −91.44 8.30 −3.09 8.71 0.00 0.00
2002 15.59 8.39 58.77 3454.19 700.48 −62.86 560.33 8.35 77.34 0.00 0.00
2003 −3.84 −1.48 11.61 134.74 −784.46 −81.01 42.31 −3.24 23.76 0.00 0.00
2004 233.79 38.20 97.50 9506.97 255.24 −14.56 546.91 3.19 10.99 0.00 1.14
2005 116.32 62.48 400.79 160630.33 641.47 −17.45 459.45 9.80 98.64 0.00 6.73
2006 53.94 23.03 50.07 2506.83 217.41 −20.01 257.76 2.64 7.54 0.00 25.57
2007 37.38 11.04 34.58 1195.82 313.22 −68.81 211.11 2.51 11.06 0.00 15.06
2008 24.54 20.15 50.47 2547.12 250.47 −62.55 269.16 2.04 6.57 0.00 37.55
2009 −35.25 −35.32 28.92 836.19 −81.88 −85.67 9.71 0.01 −1.35 −59.61 0.00
2010 125.71 125.14 118.42 14023.94 94.63 −5.03 525.56 1.09 0.89 29.51 189.71
2011 14.84 2.46 38.99 1520.25 1584.96 −73.98 195.63 1.70 5.30 −24.84 18.53
2012 1.06 −7.45 32.11 1031.29 −431.01 −77.25 111.35 0.67 1.32 −25.74 9.30
2013 18.58 2.09 40.49 1639.07 1937.32 −70.25 213.50 2.04 7.97 −19.70 18.30
2014 25.61 15.36 39.86 1588.94 259.51 −55.37 188.47 1.50 3.88 −6.41 29.69
Average 43.33 18.41 73.06 14358.81 331.35 −56.16 257.11 2.09 18.76 −7.63 25.11
Middle-aged
2001 −18.13 −10.41 55.48 3078.22 253.68 −89.01 530.09 5.33 45.95 −37.81 0.00
2002 15.10 19.04 48.30 2333.09 490.47 −67.63 339.26 2.37 10.10 −2.15 33.01
2003 1.01 8.08 39.63 1570.78 123.47 −82.81 223.58 1.91 6.95 −6.15 14.75
2004 142.05 108.55 134.03 17965.33 346.29 0.00 732.43 2.12 5.58 3.32 158.98
(continued)
5 Rates of Return—Disaggregative Analysis
Table 5.4 (continued)
Year Weighted average Mean Standard Variance Coefficient Minimum Maximum Skewness Kurtosis Lower Upper
annual returns returns deviation of variation returns returns quartile quartile
2005 61.67 85.14 294.83 86924.38 126.48 −31.53 708.55 12.18 163.72 0.60 89.38
2006 75.49 75.19 95.10 9044.22 738.89 −34.31 747.58 2.63 12.47 1.45 106.00
2007 43.65 17.95 132.63 17590.04 263.12 −67.34 802.61 10.03 114.93 −15.09 14.18
2008 44.12 28.85 75.91 5762.32 −68.32 −55.95 636.77 3.73 22.54 −10.25 49.63
2009 −27.05 −40.84 27.90 778.55 67.56 −87.03 54.01 0.64 0.04 −63.76 −19.93
2010 105.74 156.05 105.43 11115.43 362.49 −46.03 642.00 1.23 3.10 82.81 213.95
2011 7.13 11.33 41.07 1686.73 −1247.47 −63.38 229.38 1.44 4.28 −15.62 30.34
2012 −7.19 −2.57 32.06 1027.74 −1886.47 −73.49 160.91 1.35 4.15 −24.82 14.39
2013 5.13 −1.70 32.07 1028.19 181.57 −75.80 96.56 0.50 0.29 −26.08 17.23
2014 23.42 26.05 47.30 2237.73 253.68 −90.47 237.21 1.18 2.88 −1.63 51.22
Average 33.72 34.34 82.98 11581.63 −55.80 −61.77 438.64 3.33 28.36 −8.23 55.22
Old
2001 −32.45 −6.79 33.10 1095.62 −487.48 −89.22 120.18 0.47 1.71 −26.26 9.27
2002 24.04 20.90 37.23 1386.03 178.13 −28.57 161.18 1.70 2.82 0.00 29.57
2003 −3.80 12.83 34.78 1209.48 271.08 −55.00 203.50 1.78 7.68 −5.07 32.75
2004 124.35 123.72 108.53 11777.96 87.72 0.00 485.21 1.00 0.75 32.53 185.00
Section IV: Returns Based on the Age, Size, Ownership Structure …

2005 54.40 65.00 87.25 7613.18 134.23 −36.97 467.47 1.89 4.32 3.97 99.94
2006 72.92 73.26 76.89 5911.48 104.95 −23.41 382.93 1.43 2.69 9.62 115.93
2007 8.28 −4.26 26.52 703.28 −622.54 −61.16 89.59 1.02 1.63 −20.96 3.33
2008 37.15 24.37 39.13 1531.20 160.57 −73.84 153.61 0.80 1.42 0.32 45.25
2009 −16.39 −34.10 26.99 728.44 −79.15 −84.24 30.01 0.31 −0.69 −56.28 −14.05
2010 110.67 150.43 106.49 11341.03 70.79 0.00 635.95 1.81 5.49 82.61 188.94
(continued)
107
Table 5.4 (continued)
108

Year Weighted average Mean Standard Variance Coefficient Minimum Maximum Skewness Kurtosis Lower Upper
annual returns returns deviation of variation returns returns quartile quartile
2011 26.17 20.31 43.91 1928.42 216.20 −69.13 259.32 1.94 8.77 −3.18 40.49
2012 3.24 −2.86 31.18 972.50 −1090.21 −62.88 129.51 1.18 2.83 −22.94 12.73
2013 7.38 −3.62 27.43 752.27 −757.73 −48.53 83.91 0.80 0.58 −24.43 12.03
2014 19.42 13.33 33.90 1148.94 254.31 −39.47 160.79 1.34 3.28 −8.27 27.31
Average 31.10 32.32 50.95 3435.70 −111.37 −48.03 240.23 1.25 3.09 −2.74 56.32
5 Rates of Return—Disaggregative Analysis
Section IV: Returns Based on the Age, Size, Ownership Structure … 109

so on. Nevertheless, the returns for all 3 segments are commendable. Further, it is
worth noting that the returns for all-age companies are subject to very high
volatility reflected in the high standard deviation and coefficient of variation. The
high kurtosis figure in each segment is an indication of a small number of com-
panies recording very high returns.
In terms of stability of returns though, the ‘old’ companies, with an upper
quartile value of 56.32 %, appear safer. The negative returns in 2001 for all clas-
sifications of age may be attributed to the global economic slowdown in the wake of
the 9/11 terrorist attack in the USA. The returns were negative in 2009 as a result of
the recession emanating from the financial crisis in the USA in 2008; however, all 3
segregations recovered admirably in 2010, with returns exceeding 100 %.
According to the Organization for Economic Cooperation and Development
(OECD), India’s growth rate languished below 5 % in 2011 and 2012, due to high
interest rates, high inflation and weak investment (OECD India Brochure 2012).
The same perhaps is reflected in the significant lowering of returns in 2011 and
2012. However, returns appear to have recovered, 2013 onwards.
In 2014, amongst the ‘young’ companies, BF Utilities has recorded high returns,
whilst Unity Infraprojects has recorded low returns. Ironically, both companies
belong to the ‘infrastructure’ sector, perhaps an indication of the volatility available
within the sector. Amongst the ‘middle-aged’ and ‘old’ companies, Aurobindo
Pharma and Monsanto India recorded high returns, respectively.

Size

This subsection presents the analysis of returns on the basis of size through
Table 5.5.
The ‘small’ and ‘medium’-sized companies fare better (at robust returns of 40 %)
than their ‘large’ counterparts by 10 percentage points. In other words, the small
and medium capitalization (cap) companies lead the returns compared to large cap
companies. This may be attributed to the aspect that they are growth companies
with increasing market share, whilst the large companies are mature companies
with low further growth or expansion opportunities. As is perhaps expected,
volatility remains evident in these segments as well. The findings are similar to the
findings of Banz (1981), Wong and Lye (1990), Lau et al. (2002) and Manjunatha
and Mallikarjunappa (2012). These apparent ‘age’ and ‘size’ anomalies are also
indicative of the status of market efficiency. The aspect of market efficiency has
been explored further in Chap. 8.
Tata Elxsi recorded high returns in the ‘small’ segment, whilst Aurobindo
Pharma recorded high returns in the ‘medium’-sized segment, as well. Amongst the
‘large’ companies, Reliance Communications recorded high returns.
Table 5.5 Weighted annual average returns and statistics of mean, standard deviation, variation, coefficient of variation, skewness, kurtosis and quartile
110

values of returns on the basis of size of sample companies, 2001−2014

Year Weighted average Mean Standard Variance Coefficient Minimum Maximum Skewness Kurtosis Lower Upper
annual returns returns deviation of variation returns returns quartile quartile
Small
2001 −19.55 −8.97 23.53 553.81 −262.32 −91.44 42.84 −1.24 1.57 −21.66 0.00
2002 41.03 10.58 56.11 3148.71 530.34 −50.06 560.33 7.84 75.28 0.00 8.52
2003 15.67 8.15 29.39 864.04 360.61 −54.72 148.00 2.12 7.67 0.00 10.19
2004 87.95 51.59 99.75 9949.35 193.35 −14.56 660.08 3.21 13.17 0.00 66.09
2005 99.94 47.05 93.13 8672.96 197.94 −43.79 629.20 3.67 18.02 0.00 70.41
2006 75.75 39.57 71.22 5072.17 179.98 −40.69 344.48 2.17 4.86 0.00 67.98
2007 8.6 −0.08 36.72 1348.45 −45900.00 −77.70 240.79 2.67 14.65 −20.70 1.73
2008 26.16 12.81 51.93 2696.37 405.39 −76.38 252.94 2.32 7.47 −7.64 20.07
2009 −43.23 −39.03 27.81 773.24 −71.25 −82.49 14.68 0.34 −1.25 −62.30 −12.84
2010 165.86 137.86 130.27 16969.38 94.49 0.00 642.00 1.32 2.19 33.57 191.39
2011 14.92 6.08 41.89 1754.60 688.98 −55.88 229.38 1.94 6.91 −20.21 23.03
2012 1.51 0.01 34.88 1216.88 348800.00 −53.03 150.24 1.65 4.55 −22.36 14.73
2013 22.69 12.69 47.58 2264.11 374.94 −59.14 200.31 1.96 4.54 −16.22 25.71
2014 66.23 45.73 78.79 6208.09 172.29 −53.23 513.24 3.04 13.85 −1.03 73.33
Average 40.25 23.15 58.79 4392.30 21840.34 −53.79 330.61 2.36 12.39 −9.90 40.02
Medium
2001 −20.04 −1.51 65.93 4346.65 −4366.23 −85.93 616.14 6.96 62.92 −20.12 0.00
2002 32.07 16.49 39.11 1529.95 237.17 −52.44 176.17 1.80 3.54 0.00 27.25
2003 12.28 7.82 35.98 1294.60 460.10 −81.46 203.50 2.43 11.27 0.00 12.69
2004 165.86 106.96 147.35 21710.57 137.76 0.00 732.43 1.99 4.59 0.00 155.68
(continued)
5 Rates of Return—Disaggregative Analysis
Table 5.5 (continued)
Year Weighted average Mean Standard Variance Coefficient Minimum Maximum Skewness Kurtosis Lower Upper
annual returns returns deviation of variation returns returns quartile quartile
2005 75.57 49.05 74.77 5590.14 152.44 −25.93 312.90 1.81 2.92 0.00 83.99
2006 84.89 61.73 88.76 7877.99 143.79 −22.49 435.43 1.76 3.42 0.00 100.36
2007 15.8 19.50 150.36 22609.51 771.08 −68.81 1639.70 10.19 110.11 −6.58 10.26
2008 40.71 26.52 55.42 3070.87 208.97 −55.95 385.93 3.30 16.46 0.00 41.87
2009 −41.82 −37.00 27.80 773.08 −75.14 −85.83 30.01 0.09 −1.01 −63.27 −12.95
2010 156.74 136.59 100.34 10068.80 73.46 −1.39 493.06 0.74 0.49 66.33 198.63
2011 11.31 11.57 42.49 1805.07 367.24 −73.98 195.63 1.17 2.73 −17.74 32.60
2012 3.39 −2.29 36.99 1368.33 −1615.28 −73.49 160.91 1.25 2.90 −27.51 14.56
2013 8.04 −4.36 36.21 1311.40 −830.50 −75.80 142.88 0.95 2.21 −28.15 15.24
2014 27.75 18.13 49.74 2474.21 274.35 −55.37 237.21 1.71 4.42 −11.86 40.21
Average 40.90 29.23 67.95 6130.80 −290.06 −54.21 411.56 2.58 16.21 −7.78 51.46
Large
2001 −23.67 −7.99 33.00 1089.19 −413.02 −89.22 143.00 0.96 5.50 −24.51 0.00
2002 27.95 20.25 43.26 1871.03 213.63 −45.35 161.93 1.74 2.45 0.00 27.61
2003 −0.96 4.30 28.65 820.99 666.28 −61.65 121.42 1.45 4.10 −6.24 9.23
2004 141.92 116.28 125.60 15775.06 108.02 0.00 671.38 1.57 3.49 0.00 180.83
Section IV: Returns Based on the Age, Size, Ownership Structure …

2005 36.87 67.46 364.41 132793.12 540.19 −36.97 4068.89 10.55 116.04 0.00 46.32
2006 70.34 63.82 84.23 7094.36 131.98 −23.41 747.58 4.43 33.22 0.25 95.35
2007 29.38 14.36 77.33 5979.26 538.51 −45.36 802.61 8.64 86.10 −10.32 20.07
2008 35.67 31.87 53.39 2850.74 167.52 −68.62 335.53 2.00 7.80 0.00 60.99
2009 −25.52 −29.28 27.66 765.08 −94.47 −87.03 54.01 0.26 −0.23 −52.43 −6.21
2010 100.76 121.27 88.26 7789.87 72.78 −46.03 412.63 1.02 1.39 64.42 168.65
(continued)
111
Table 5.5 (continued)
112

Year Weighted average Mean Standard Variance Coefficient Minimum Maximum Skewness Kurtosis Lower Upper
annual returns returns deviation of variation returns returns quartile quartile
2011 12.22 11.59 31.79 1010.83 274.29 −45.85 149.37 1.04 2.97 −10.68 29.63
2012 −3.63 −3.77 23.51 552.73 −623.61 −53.55 83.41 0.40 0.47 −20.81 12.70
2013 11.22 5.11 38.40 1474.53 751.47 −74.66 235.22 2.89 15.36 −16.03 19.21
2014 20.77 14.75 30.07 904.21 203.86 −75.21 125.94 0.55 2.56 −0.22 27.26
Average 30.95 30.72 74.97 12912.21 181.25 −53.78 579.49 2.68 20.09 −5.47 49.40
5 Rates of Return—Disaggregative Analysis
Section IV: Returns Based on the Age, Size, Ownership Structure … 113

Ownership Structure

This subsection presents the analysis of returns on the basis of ownership structure
through Table 5.6.
As stated earlier, the ownership structure of the Indian corporates is dominated
by ‘family-owned’ businesses and their mean returns at 36.92 % are also the highest
amongst the three segments. Amongst the PSUs, the high kurtosis figures indicate
that the returns are high for only a small number of PSUs. The ‘non-PSU/non-
family’ segment has the lowest returns. Therefore, they appear unattractive, as an
investment choice. The ‘family-owned’ and ‘PSU’ segments thus, not surprisingly,
continue to be popular choices for equity investors.
Aurobindo Pharma, with a majority shareholding of the Reddy family, recorded
high returns, whilst Bharat Earth Movers Limited (BEML), a PSU, recorded high
returns. Monsanto India recorded high returns in the non-PSU/non-family segment.

Underlying Sector/Industry Affiliation

This subsection presents the analysis of returns on the basis of underlying

sector/industry affiliation through Table 5.7.
Amongst the underlying sectors, the ‘transport’ and ‘infrastructure’ sectors
recorded high returns of more than 40 %. There is evidence of high volatility
(standard deviation, variance and coefficient of variation) amongst the sectors.
However, relatively low skewness figures indicate a near-normal distribution of
returns, within the sectors.
Bharat Forge in the ‘commodities’ sector, Finolex in the ‘consumer goods’
sector, Indiabulls Securities in the ‘finance’ sector, Aurobindo Pharma in the
‘healthcare’ sector, Tata Elxsi in the ‘ICT’ sector, BF Utilities in the ‘infrastructure’
sector, Kajaria Ceramics in the ‘miscellaneous’ sector, Finolex Cables in the
‘power’ sector, TVS Motor Company in the ‘transport’ sector and Monsanto India
in the ‘textiles’ sector recorded high returns.

Section V: Summary

This chapter presents a disaggregative analysis of the returns of the sample com-
panies on the basis of age, size, ownership structure and underlying sector. Written
on the lines of the chapter on market returns(computed on an aggregative basis), the
objective of this chapter was to enrich the understanding of the reader/investor on
equity returns and on disaggregative parameters such as age, size, ownership
structure and underlying sector/industry affiliation.
Table 5.6 Weighted annual average returns and statistics of mean, standard deviation, variation, coefficient of variation, skewness, kurtosis and quartile
114

values of returns on the basis of ownership structure of sample companies, 2001−2014

Year Weighted average Mean Standard Variance Coefficient Minimum Maximum Skewness Kurtosis Lower Upper
annual returns returns deviation of variation returns returns quartile quartile
Family-owned
2001 −23.36 −10.67 36.93 1362.79 −346.11 −89.01 225.78 1.90 11.88 −27.96 0.00
2002 17.71 12.59 39.97 1597.31 317.47 −67.63 339.26 3.02 17.14 0.00 18.32
2003 −7.5 5.60 34.10 1162.60 608.93 −82.81 223.58 2.28 10.68 −0.67 9.53
2004 158.5 90.75 131.15 17199.70 144.52 −14.56 732.43 2.20 5.72 0.00 124.80
2005 61.75 72.36 255.30 65179.29 352.82 −31.53 708.55 13.55 210.13 0.00 85.61
2006 79.56 61.96 84.48 7136.83 136.35 −34.31 747.58 2.80 15.55 0.00 97.82
2007 41.88 15.57 113.94 12981.82 731.79 −68.61 802.61 11.37 151.61 −11.83 14.83
2008 39.96 25.66 69.40 4816.92 270.46 −68.62 636.77 3.77 24.30 −6.01 40.64
2009 −34.96 −41.12 28.20 795.49 −68.58 −87.03 54.01 0.54 −0.39 −63.85 −20.93
2010 129.25 154.85 116.36 13538.50 75.14 −46.03 642.00 1.30 2.75 75.51 205.42
2011 13.43 9.14 45.02 2026.38 492.56 −73.98 259.32 1.79 6.04 −18.38 29.00
2012 −0.88 −4.12 32.82 1077.43 −796.60 −77.25 130.25 0.79 1.35 −26.73 13.33
2013 12.84 −0.42 35.52 1261.96 −8457.14 −73.23 213.50 1.24 4.56 −26.93 19.80
2014 28.72 21.89 44.98 2023.05 205.48 −90.47 237.21 1.34 3.46 −5.30 42.00
Average 36.92 29.57 76.30 9440.01 −452.35 −64.65 425.20 3.42 33.20 −8.01 48.58
PSU
2001 8.83 5.61 28.14 791.89 501.60 −47.52 120.18 1.81 7.08 −5.36 15.44
2002 72.65 44.37 53.50 2862.51 120.58 −15.04 161.93 0.93 −0.45 0.00 80.97
2003 15.61 15.79 43.28 1873.22 274.10 −44.46 203.50 2.58 9.21 −3.53 19.59
2004 160.77 129.94 104.89 10855.50 80.72 0.00 386.44 0.50 −0.21 18.45 194.31
(continued)
5 Rates of Return—Disaggregative Analysis
Table 5.6 (continued)
Year Weighted average Mean Standard Variance Coefficient Minimum Maximum Skewness Kurtosis Lower Upper
annual returns returns deviation of variation returns returns quartile quartile
2005 15.07 26.60 47.65 2270.33 179.14 −36.97 196.61 1.75 3.56 0.00 38.05
2006 56.37 35.00 59.53 3543.34 170.09 −23.41 280.30 2.59 7.95 0.03 47.25
2007 3.74 −2.99 17.65 311.47 −590.30 −45.36 40.18 0.16 0.75 −16.23 4.19
Section V: Summary

2008 42.09 29.71 35.63 1269.51 119.93 −27.07 139.47 1.00 1.01 1.22 54.16
2009 −17.10 −21.55 19.72 388.73 −91.51 −66.78 7.51 −0.42 −0.59 −37.62 −6.06
2010 71.74 100.67 75.73 5734.32 75.23 0.00 327.40 0.83 0.99 42.17 149.17
2011 8.46 12.43 27.39 750.20 220.35 −34.15 62.98 0.11 −0.96 −11.40 34.28
2012 −11.88 −17.00 15.34 235.40 −90.24 −44.65 17.79 0.48 0.12 −28.16 −9.58
2013 −0.73 −13.23 18.35 336.59 −138.70 −75.80 19.09 −0.93 2.23 −27.41 1.33
2014 2.70 −1.30 25.96 674.04 −1996.92 −43.20 91.17 1.32 3.36 −20.56 9.49
Average 30.59 24.58 40.91 2278.36 −83.28 −36.03 146.75 0.91 2.43 −6.31 45.19
Non-family/non-PSU
2001 −42.48 −7.13 63.15 3987.38 −885.69 −91.44 530.09 6.83 58.56 −29.64 0.00
2002 1.98 19.58 66.09 4368.02 337.54 −31.78 560.33 6.39 50.16 −1.64 27.34
2003 −5.20 7.49 27.38 749.39 365.55 −55.19 79.10 0.49 0.42 −1.71 18.51
2004 80.50 92.71 104.06 10828.20 112.24 0.00 433.08 1.30 1.41 3.36 145.01
2005 43.28 54.65 76.56 5861.82 140.09 −13.71 467.47 2.58 9.31 1.52 73.44
2006 79.02 71.26 89.44 7999.62 125.51 −15.43 388.19 1.72 2.99 0.67 107.30
2007 14.95 −1.03 27.80 772.90 −2699.03 −58.50 95.34 0.93 1.46 −21.79 10.08
2008 24.58 22.12 47.10 2218.35 212.93 −73.84 248.22 1.95 6.88 0.00 43.12
2009 −26.43 −32.81 27.64 763.92 −84.24 −83.77 37.96 0.28 −0.77 −55.67 −10.68
2010 115.74 138.43 96.34 9281.81 69.59 0.00 455.87 0.73 0.35 68.73 190.25
(continued)
115
Table 5.6 (continued)
116

Year Weighted average Mean Standard Variance Coefficient Minimum Maximum Skewness Kurtosis Lower Upper
annual returns returns deviation of variation returns returns quartile quartile
2011 19.80 16.93 34.88 1216.89 206.02 −51.77 149.54 0.85 1.59 −4.15 40.43
2012 3.64 1.14 32.57 1060.64 2857.02 −54.05 160.91 1.94 7.35 −18.94 17.49
2013 14.87 1.61 31.09 966.83 1931.06 −58.19 131.75 1.20 3.06 −17.86 15.45
2014 22.20 24.17 38.98 1519.15 161.27 −52.36 160.79 1.14 2.05 1.81 45.51
Average 24.75 29.22 54.51 3685.35 203.56 −45.72 278.47 2.02 10.34 −5.38 51.66
5 Rates of Return—Disaggregative Analysis
Table 5.7 Weighted annual average returns and statistics of mean, standard deviation, variation, coefficient of variation, skewness, kurtosis and quartile
values of returns on the basis of underlying sector of sample companies, 2001−2014
Year Weighted average Mean Standard Variance Coefficient Minimum Maximum Skewness Kurtosis Lower Upper
annual returns returns deviation of variation returns returns quartile quartile
Commodities
2001 8.82 10.83 58.13 3379.36 536.75 −67.05 225.78 2.59 7.51 −13.91 12.17
Section V: Summary

2002 70.19 22.99 44.92 2018.14 195.39 −67.63 182.78 1.35 2.70 0.00 54.17
2003 12.69 22.05 53.38 2849.76 242.09 −54.67 223.58 1.93 4.32 0.00 22.05
2004 3.33 97.83 122.02 14887.71 124.73 0.00 549.40 1.65 3.40 1.08 173.63
2005 72.74 152.39 620.14 384574.40 406.94 −36.97 554.41 6.29 40.48 0.00 88.12
2006 39.31 34.97 59.10 3493.06 169.00 −34.31 291.81 2.45 8.17 0.00 51.56
2007 2.96 4.33 38.19 1458.83 881.99 −48.91 178.18 2.57 9.60 −17.90 18.04
2008 52.12 83.36 120.83 14599.28 144.95 −38.57 636.77 2.75 9.88 12.72 108.02
2009 −29.29 −44.28 26.68 711.90 −60.25 −85.83 6.96 0.47 −1.08 −65.36 −18.51
2010 120.71 174.82 123.68 15295.57 70.75 0.00 493.06 0.66 0.11 84.53 251.70
2011 4.06 −4.05 26.43 698.51 −652.59 −62.41 55.73 −0.11 −0.33 −24.27 14.54
2012 −10.55 −17.16 23.18 537.41 −135.08 −54.05 35.66 0.56 −0.45 −34.63 −4.49
2013 −2.06 −20.94 20.03 401.21 −95.65 −61.60 19.09 −0.01 −0.62 −35.35 −5.79
2014 12.19 13.62 35.50 1259.93 260.65 −56.46 107.98 0.57 0.68 −8.19 25.72
Average 25.52 37.91 98.02 31868.93 149.26 −47.75 254.37 1.69 6.03 −7.23 56.50
Consumer goods
2001 −2.35 −14.80 30.21 912.38 −204.12 −78.60 58.36 −0.47 0.36 −32.06 2.66
2002 −6.75 5.99 27.87 776.73 465.28 −45.35 109.82 1.77 5.04 −6.21 8.84
2003 −6.73 1.18 28.01 784.39 2373.73 −55.00 74.52 0.49 0.41 −16.91 14.49
2004 84.14 84.39 93.23 8692.21 110.48 0.00 485.21 2.54 9.45 4.47 118.02
2005 55.51 104.57 141.66 20067.52 135.47 0.00 708.55 2.64 9.00 4.98 136.57
(continued)
117
Table 5.7 (continued)
118

Year Weighted average Mean Standard Variance Coefficient Minimum Maximum Skewness Kurtosis Lower Upper
annual returns returns deviation of variation returns returns quartile quartile
2006 118.45 102.21 81.66 6668.22 79.89 0.00 259.15 0.26 −1.05 22.79 163.69
2007 9.61 35.01 280.73 78810.60 801.86 −68.81 67.58 5.82 34.18 −27.47 3.86
2008 51.17 31.70 69.38 4813.99 218.86 −30.31 385.93 4.17 20.72 0.00 40.37
2009 −17.06 −32.33 29.22 853.77 −90.38 −83.07 23.45 −0.03 −1.14 −58.89 −7.50
2010 98.21 180.30 153.00 23409.07 84.86 0.00 635.95 1.99 3.68 93.46 181.43
2011 37.87 36.87 64.89 4210.17 176.00 −45.89 259.32 1.69 3.22 −0.71 53.27
2012 20.39 5.94 42.47 1803.74 714.98 −53.47 129.51 0.76 0.91 −25.56 30.72
2013 40.78 15.81 49.93 2493.06 315.81 −45.09 213.50 1.96 6.16 −17.32 31.00
2014 17.28 13.71 34.71 1204.74 253.17 −90.47 98.26 −0.15 1.83 −7.56 27.78
Average 35.75 40.75 80.50 11107.19 388.28 −42.58 250.65 1.67 6.63 −4.79 57.51
Finance
2001 3.92 2.55 26.96 726.76 1057.25 −64.09 136.50 1.61 8.37 −1.27 6.39
2002 29.90 25.48 42.87 1838.08 168.25 −23.52 149.40 1.60 1.74 0.00 34.77
2003 18.83 15.86 33.24 1105.14 209.58 −14.89 203.50 3.23 14.18 0.00 15.21
2004 141.14 86.85 92.25 8509.78 106.22 0.00 357.56 1.06 0.71 0.00 138.07
2005 32.58 31.11 52.12 2716.36 167.53 −25.93 247.93 2.49 6.70 0.00 36.90
2006 50.75 25.94 49.16 2417.09 189.51 −40.69 215.89 1.91 3.65 0.00 39.28
2007 19.66 13.16 37.08 1374.90 281.76 −46.49 211.11 2.66 10.95 −3.95 27.09
2008 35.72 31.56 42.66 1819.86 135.17 −68.62 189.47 1.45 3.96 0.56 27.09
2009 −33.79 −34.60 24.74 612.26 −71.50 −84.45 9.52 0.01 −0.85 −53.29 −15.03
2010 129.71 128.18 93.26 8697.01 72.76 0.00 412.63 1.09 1.25 78.42 174.03
2011 28.36 26.59 34.36 1180.74 129.22 −37.59 149.37 0.94 2.03 2.16 43.07
2012 −7.45 −8.77 23.47 550.61 −267.62 −77.25 57.68 0.06 1.62 −22.19 7.37
(continued)
5 Rates of Return—Disaggregative Analysis
Table 5.7 (continued)
Year Weighted average Mean Standard Variance Coefficient Minimum Maximum Skewness Kurtosis Lower Upper
annual returns returns deviation of variation returns returns quartile quartile
2013 11.15 6.07 24.87 618.49 409.72 −47.50 70.45 0.20 −0.38 −13.49 23.83
2014 9.01 4.41 29.17 851.14 661.45 −57.24 121.06 1.10 3.24 −13.93 16.35
Average 33.54 25.31 43.30 2358.44 232.09 −42.02 180.86 1.39 4.08 −1.93 41.03
Section V: Summary

Health care
2001 −11.11 −14.36 34.96 1222.31 −243.45 −75.14 79.58 0.46 0.71 −42.41 0.83
2002 4.47 11.95 41.14 1692.55 344.27 −62.86 119.60 1.11 1.15 −8.91 26.14
2003 −14.77 −1.15 45.28 2050.14 −3937.39 −81.01 190.29 2.87 11.73 −20.59 0.00
2004 179.33 170.49 170.87 29196.40 100.22 0.00 701.22 1.37 2.17 28.11 268.21
2005 33.83 38.78 74.39 5533.81 191.83 −31.53 295.68 2.52 6.75 0.00 45.34
2006 84.31 60.92 46.08 2123.68 75.64 0.00 172.84 0.69 0.09 25.37 90.30
2007 11.71 9.29 39.42 1553.78 424.33 −33.85 112.16 1.37 1.11 −15.58 15.50
2008 13.28 −2.07 36.04 1298.65 −1741.06 −55.95 106.65 1.22 1.99 −24.29 10.53
2009 −8.96 −18.65 31.19 972.79 −167.24 −69.56 42.12 0.16 −0.85 −42.13 8.60
2010 127.52 155.56 118.03 13931.17 75.87 44.64 525.56 1.69 2.63 73.88 189.16
2011 17.50 12.57 31.11 968.06 247.49 −50.88 92.34 0.21 1.40 0.71 28.84
2012 13.12 1.70 29.10 847.06 1711.76 −53.31 69.14 0.23 0.24 −25.02 14.42
2013 25.15 11.63 35.66 1271.41 306.62 −70.25 58.70 −1.07 0.70 −1.78 32.92
2014 41.45 32.75 49.01 2402.30 149.65 −55.37 237.21 2.48 10.71 2.34 48.87
Average 36.92 33.53 55.88 4647.44 −175.82 −42.51 200.22 1.09 2.90 −3.59 55.69
ICT
2001 −62.10 −31.32 36.48 1330.84 −116.48 91.44 0.00 −0.53 −1.50 −69.97 0.00
2002 10.19 27.48 116.83 13649.70 425.15 −63.70 560.33 3.76 14.98 −3.84 0.55
2003 −12.17 −8.94 26.25 688.83 −293.62 −82.81 62.41 −0.57 2.28 −23.06 0.00
(continued)
119
Table 5.7 (continued)
120

Year Weighted average Mean Standard Variance Coefficient Minimum Maximum Skewness Kurtosis Lower Upper
annual returns returns deviation of variation returns returns quartile quartile
2004 141.11 86.99 181.57 32967.62 208.73 −14.56 32.43 2.72 7.02 0.00 80.12
2005 37.85 50.69 99.66 9931.39 196.61 −17.45 516.34 3.49 14.97 0.00 81.41
2006 61.94 46.17 71.71 5142.38 155.32 −1.93 301.52 2.07 4.47 0.00 71.00
2007 36.44 20.56 34.90 1218.08 169.75 −23.00 37.05 1.58 2.66 0.00 36.35
2008 −4.75 −7.56 41.68 1736.99 −551.32 −62.55 127.03 1.25 2.35 −42.90 8.34
2009 −25.85 −42.67 24.43 596.91 −57.25 −83.41 5.46 0.51 −0.73 −62.60 −23.63
2010 122.01 155.20 106.89 11424.73 68.87 −46.03 36.84 −0.15 −1.10 59.02 245.19
2011 23.86 7.78 49.20 2420.76 632.39 −48.88 195.63 2.06 5.75 −22.47 26.05
2012 0.05 −5.30 31.29 979.10 −590.38 −73.49 75.48 0.27 0.77 −21.39 9.30
2013 16.63 9.91 42.12 1774.39 425.03 −73.23 42.88 1.05 2.17 −14.99 36.37
2014 31.81 38.52 47.39 2245.72 123.03 −47.20 177.93 0.88 1.55 8.05 71.93
Average 26.93 24.82 65.03 6150.53 56.84 −39.06 155.10 1.31 3.97 −13.87 45.93
Infrastructure
2001 −16.67 −6.94 17.28 298.73 −248.99 −61.70 11.76 −2.10 3.63 −6.77 0.00
2002 21.94 5.48 16.04 257.37 292.70 −37.85 59.70 1.59 4.95 0.00 4.98
2003 −2.05 1.58 14.33 205.29 906.96 −38.42 43.63 0.29 3.76 0.00 2.50
2004 169.06 58.54 118.85 14124.45 203.02 0.00 482.75 2.41 5.20 0.00 85.42
2005 67.17 72.21 124.25 15437.33 172.07 0.00 467.47 1.81 2.60 0.00 136.12
2006 128.62 75.57 133.06 17704.79 176.08 0.00 747.58 3.11 12.86 0.00 115.69
2007 115.77 14.03 115.63 13371.03 824.16 −47.41 802.61 6.73 46.71 −0.84 2.98
2008 32.73 28.48 48.39 2341.89 169.91 −40.73 212.87 1.70 3.43 0.00 44.13
2009 −53.44 −51.92 29.25 855.36 −56.34 −87.03 0.00 0.71 −0.83 −76.52 −34.78
2010 115.17 146.51 117.47 13799.23 80.18 0.00 642.00 1.61 5.39 68.19 201.28
(continued)
5 Rates of Return—Disaggregative Analysis
Table 5.7 (continued)
Year Weighted average Mean Standard Variance Coefficient Minimum Maximum Skewness Kurtosis Lower Upper
annual returns returns deviation of variation returns returns quartile quartile
2011 −11.65 −15.86 31.77 1009.06 −200.32 −73.98 115.28 1.40 4.89 −37.99 0.23
2012 −0.48 −10.54 27.65 764.66 −262.33 −62.88 57.81 0.35 −0.40 −30.45 12.05
2013 3.43 −11.71 27.10 734.50 −231.43 −70.90 63.96 0.29 0.04 −32.15 6.71
Section V: Summary

2014 3.99 −2.77 39.78 1582.13 −1436.10 −47.52 188.47 2.88 11.75 −29.55 8.82
Average 40.97 21.62 61.49 5891.84 27.83 −40.60 278.28 1.63 7.43 −10.43 41.87
Power and electricals
2001 14.24 −9.69 24.73 611.58 −255.21 −75.00 53.26 −0.32 0.80 −28.16 0.00
2002 6.13 19.76 47.37 2243.80 239.73 −62.86 161.93 1.75 2.98 0.00 22.14
2003 2.33 9.59 32.67 1067.47 340.67 −81.01 145.95 1.38 6.83 0.00 20.47
2004 139.27 107.43 117.26 13750.75 109.15 0.00 558.06 1.34 2.99 0.00 190.68
2005 14.76 46.85 69.63 4847.80 148.62 −29.71 326.50 2.01 4.94 0.00 73.04
2006 88.82 76.87 92.12 8486.01 119.84 −12.10 330.93 1.23 0.72 0.00 139.15
2007 31.42 9.93 37.00 1369.00 372.61 −45.36 157.07 1.83 4.87 −10.69 24.50
2008 57.30 33.59 49.72 2471.85 148.02 −46.49 153.61 0.77 −0.19 0.00 65.92
2009 −28.64 −37.41 23.97 574.48 −64.07 −84.93 1.01 0.23 −1.00 −56.65 −17.99
2010 69.18 134.58 111.61 12457.28 82.93 −5.03 525.56 1.04 1.64 49.20 221.26
2011 −7.07 −10.27 24.42 596.38 −237.78 −46.55 95.00 1.78 6.32 −25.95 0.83
2012 −18.77 −15.07 19.72 388.82 −130.86 −48.39 52.77 0.90 1.84 −28.91 −6.64
2013 −5.83 −16.70 21.98 482.99 −131.62 −75.80 49.50 0.21 1.20 −30.80 0.12
2014 22.83 28.47 39.93 1594.44 140.25 −45.47 125.94 0.57 −0.04 −5.03 54.22
Average 27.57 27.00 50.87 3638.76 63.02 −47.05 195.51 1.05 2.42 −9.79 56.26
Transport
2001 −11.40 −0.93 86.60 7499.74 −9311.83 −65.00 530.09 5.50 33.74 −35.76 0.00
(continued)
121
Table 5.7 (continued)
122

Year Weighted average Mean Standard Variance Coefficient Minimum Maximum Skewness Kurtosis Lower Upper
annual returns returns deviation of variation returns returns quartile quartile
2002 85.77 26.98 45.85 2102.26 169.94 −28.57 176.17 1.55 2.04 0.00 54.03
2003 4.48 7.68 28.95 837.97 376.95 −55.19 78.71 0.39 0.49 0.00 22.77
2004 161.82 95.06 102.77 10562.35 108.11 0.00 370.76 0.86 −0.22 1.33 163.34
2005 14.49 36.95 55.45 3074.57 150.07 −23.53 206.33 1.43 1.46 0.00 68.97
2006 91.29 58.04 56.35 3175.60 97.09 −3.63 186.11 0.59 −0.71 1.12 101.26
2007 2.49 1.28 23.84 568.53 1862.50 −56.17 64.11 0.31 1.48 −9.66 11.51
2008 3.58 5.77 40.97 1678.40 710.05 −73.84 187.74 2.15 8.27 −11.21 15.24
2009 −16.64 −38.78 27.99 783.53 −72.18 −85.62 54.01 0.96 1.20 −61.08 −15.90
2010 160.41 169.47 115.48 13336.14 68.14 0.00 455.87 0.65 −0.15 81.24 239.16
2011 26.27 16.39 35.25 1242.78 215.07 −49.46 104.36 0.29 −0.54 −8.68 47.55
2012 11.29 9.10 40.57 1646.22 445.82 −50.65 160.91 1.52 3.77 −15.45 26.13
2013 4.65 −3.25 26.71 713.38 −821.85 −51.28 88.30 1.18 2.17 −20.86 9.76
2014 44.04 48.01 52.92 2800.46 110.23 −52.36 205.35 1.12 1.51 16.54 76.49
Average 41.61 30.84 52.84 3573.00 −420.85 −42.52 204.92 1.32 3.89 −4.46 58.59
Textiles and chemicals
2001 −20.35 −20.33 30.69 941.91 −150.96 −85.93 80.88 0.62 2.10 −41.51 0.00
2002 22.60 21.34 34.74 1207.13 162.79 −52.05 128.60 0.88 1.79 −0.96 34.16
2003 16.61 13.63 29.62 877.52 217.31 −53.27 70.69 −0.11 −0.01 0.00 31.26
2004 118.07 114.53 108.03 11670.45 94.32 0.00 421.24 1.20 1.15 31.96 202.47
2005 58.25 65.01 64.08 4105.76 98.57 −18.40 223.51 1.04 0.36 14.76 88.59
2006 113.35 91.30 103.81 10777.36 113.70 −17.12 435.43 1.90 3.55 18.54 110.71
2007 4.67 −7.93 26.05 678.61 −328.50 −67.34 61.66 0.25 0.70 −24.32 5.39
2008 31.04 15.75 33.27 1106.63 211.24 −49.48 82.93 −0.08 −0.75 −9.17 44.03
(continued)
5 Rates of Return—Disaggregative Analysis
Table 5.7 (continued)
Year Weighted average Mean Standard Variance Coefficient Minimum Maximum Skewness Kurtosis Lower Upper
annual returns returns deviation of variation returns returns quartile quartile
2009 −30.56 −32.42 28.17 793.53 −86.89 −76.69 37.96 0.25 −0.33 −59.80 −11.57
2010 145.26 135.40 72.08 5195.05 53.23 0.00 337.98 0.56 0.31 81.82 190.39
2011 34.92 30.69 37.66 1418.49 122.71 −33.16 149.54 0.87 1.72 2.97 49.62
Section V: Summary

2012 16.22 5.05 25.09 629.49 496.83 −35.82 68.03 0.44 −0.31 −13.26 26.54
2013 26.40 3.14 34.14 1165.43 1087.26 −58.19 83.91 0.60 −0.23 −25.82 26.95
2014 18.69 24.32 41.14 1692.14 169.16 −38.65 160.79 1.40 2.18 −1.77 43.64
Average 39.66 32.82 47.76 3018.54 161.49 −41.86 167.37 0.70 0.87 −1.90 60.16
Miscellaneous
2001 −75.71 −13.08 32.63 1064.46 −249.46 −89.22 48.22 −1.04 0.57 −18.02 0.15
2002 7.96 0.41 23.54 553.94 5741.46 −50.06 83.53 1.03 4.31 0.00 4.88
2003 −31.33 −7.46 20.57 423.24 −275.74 −61.65 32.66 −0.91 0.84 −19.45 0.00
2004 31.89 72.03 110.87 12291.54 153.92 0.00 458.19 2.02 3.87 0.00 95.43
2005 18.61 43.25 68.62 4709.34 158.66 −11.28 270.93 1.88 3.18 0.00 53.96
2006 94.04 45.78 52.85 2793.35 115.44 0.00 203.00 0.98 0.54 0.00 89.75
2007 8.93 14.15 63.77 4067.11 450.67 −38.00 251.00 3.07 9.48 −18.25 5.07
2008 28.47 11.57 49.92 2492.29 431.46 −48.39 185.60 2.29 6.20 −15.63 20.36
2009 −16.36 −31.18 26.99 728.22 −86.56 −69.67 20.50 0.32 −1.38 −53.33 0.00
2010 107.27 95.04 76.00 5776.00 79.97 0.00 244.02 0.21 −1.01 12.85 154.57
2011 20.97 10.67 29.97 898.12 280.88 −53.81 68.04 −0.09 −0.09 −5.10 29.55
2012 13.03 5.66 42.71 1824.55 754.59 −70.72 130.25 1.11 1.70 −21.62 26.67
2013 16.25 6.86 34.58 1195.63 504.08 −39.76 131.75 1.56 4.11 −11.00 17.96
2014 29.26 16.27 31.60 998.63 194.22 −35.28 86.43 0.72 −0.31 −7.91 33.18
Average 18.09 19.28 47.47 2844.03 589.54 −40.56 158.15 0.94 2.29 −11.25 37.97
123
124 5 Rates of Return—Disaggregative Analysis

The overall returns emanating from all of the segregates have been commend-
able. However, as has also been indicated in other chapters, high volatility (risk) is
present in the returns at the segregated levels, as well.
Overall, the returns vary along with the various segregates, providing the
investors diversification opportunities, based on the same. A negative correlation
appears between the age of companies and returns. Further, small and medium-
sized companies yield higher returns compared to their large counterparts. The
findings are similar to the findings of Banz (1981), Wong and Lye (1990), Lau et al.
(2002) and Manjunatha and Mallikarjunappa (2012). The apparent ‘age’ and ‘size’
anomalies are also indicative of the status of market efficiency. The aspect of market
efficiency is explored further in Chap. 8.
Companies such as Aurobindo Pharma, Monsanto India, BF Utilities, Tata Elxsi,
Reliance Communications and BEML appear attractive investment choices for
equity investors. However, considering the substantial volatility present in all
segregates, investors would do well to analyse each company both fundamentally
and technically, for possible risk considerations, before investing.

References

Banz RW (1981) The relationship between return and market value of common stocks. J Financ
Econ 9(1):3–18
Beaver W, Kettler P, Scholes M (1970) The association between market determined and
accounting determined risk measures. Account Rev 45(4):654–682
Ben-Zion U, Shalit S (1975) Size, leverage, and dividend record as determinants of equity risk.
J Finance 30(4):1015–1026
Entrepreneur website (2015). http://www.entrepreneur.com/encyclopedia/family-businesses.
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Fama EF, French KR (1992) The cross-section of expected stock returns. J Finance 47(2):427–465
Fisher L (1959) Determinants of risk premium on corporate bonds. J Polit Econ 68(3):232–239
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evidence. J Econ Bus 49(3):211–221
Galai D, Masulis R (1976) The option pricing model and the risk factor of stock. J Financ Econ 3
(1–2):53–81
Gupta LC (1981) Rates of return on equities: the Indian experience. Oxford University Press, New
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stocks. J Finance 27(2):435–452
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family-business. Accessed on 7 July 2015
Ho RY, Strange R, Piesse J (2006) On the conditional pricing effects of beta, size, and
book-to-market equity in the Hong Kong market. J Int Financ Markets Inst Money 16(3):
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sales growth: evidence from Singapore and Malaysia. J Multinl Financ Manag 12(3):207–222
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capital market. AIMS Int J Manag 6(1):73–86
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cnx_500.htm. Accessed on 10 Mar 2014
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india/IndiaBrochure2012.pdf. Accessed on 5 July 2015
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Chapter 6
Analysis of Price Multiples

Introduction

This chapter has been devoted to the analysis of the price multiples, viz. the
price/earnings (P/E) ratio and the price/book value (P/B) ratio, for the sample
companies, over the period of the study. This part of the research study attempts to
build on the seminal work by Gupta et al. (1998) who reported the Indian P/E
ratios, perhaps, for the first time. Reference to their work and relationship with their
findings would find recurrence in this chapter.
Amongst the most practical ways of determining whether the prevailing share
prices are rational is through P/E ratios. The P/E ratio signifies the price being paid
by the buyer of equities for each rupee of annual earnings, whether distributed as
dividends or retained in the company. The P/E ratio is also a useful indicator of the
investors’ (market’s) mood and state. It measures the overall reasonableness or,
otherwise, the market’s valuation.
Theoretically, the P/E ratio is not a perfect measure. The reason is, whilst the
price which an investor pays for a share is really for buying the future stream of
earnings, the P/E ratios are actually computed from the past (latest available)
earnings per share (EPS). Despite their imperfect nature, the practical usefulness of
P/E ratios is widely recognized in the world of investments in stock markets. In
fact, analysis of equity investment and returns is incomplete without taking note of
the P/E ratio.
The computation of P/E and P/B ratios requires inputs of share price, EPS and
book value/price (net worth) per share.
For better exposition, this chapter has been divided into five sections. Section I
provides a brief literature review of studies related to price multiples. Section II is
devoted to presenting broad groups of P/E ratios as per Gupta’s work. This section
also enumerates guidelines for better interpretation of such ratios. Section III
contains the scope and methodology used behind calculating the P/E ratio, the P/B

© Springer Science+Business Media Singapore 2016 127

S. Singh et al., Equity Markets in India, India Studies
in Business and Economics, DOI 10.1007/978-981-10-0868-9_6
128 6 Analysis of Price Multiples

ratio and the EPS growth. Section IV presents the computed P/E ratios and its
analysis taking into consideration the P/B ratio and the EPS growth for the sample.
Section V contains the summary.

Section I: Literature Review

The literature review focuses on studies carried out/related to price-to-earnings

ratio/multiple and price-to-book value ratio as well as the factors affecting them.
Sivy (1996) reviewed the companies identified by T.J. Peters and R.H.
Waterman in their book, In Search of Excellence, in the early 1980s. The majority
of the excellent companies identified by them underperformed the market during
1981–1985. In marked contrast, Sivy noted that the majority of the non-excellent
companies beat the market, outperforming the Standard & Poor (S&P) index. This
could be possible because the investors had bought the shares of excellent com-
panies at non-excellent (too high) prices and the shares of non-excellent companies
at excellent (low) prices. For the buyers, the buying prices determine the returns.
Clearly, shares bought at low P/E ratio (in general) are likely to be more rewarding
to the investors vis-à-vis shares bought at higher P/E multiple.
Chen and Zhang (2007) have explained how accounting variables are related
with cross-sectional changes in stock returns. They noted returns as a function of
earnings yield, equity capital investment, changes in profitability, growth oppor-
tunities and discount rates. Ferreira and Santa-Clara (2011) studied data from 1927
to 2007 and attempted to forecast the components of stock market return. The
resultant significant components were dividend–price ratio, earnings growth and
price–earnings growth. Frankel and Lee (1998) used an analyst-based residual
income model and the resulting value-to-price (V/P) ratio to examine issues related
to market efficiency and the predictability of cross-sectional stock returns. They
proved that the value-to-price (V/P) ratio was a reliable predictor of cross-sectional
returns, particularly over longer time horizons.
Wong and Lye (1990) attempted to provide evidence on the relation between
stock returns and the effects of firm size and earnings-to-price ratio (E/P), with a
sample from the stock exchange of Singapore. They observed that stock returns
were significantly related to both size and E/P; between the two, the size effect
appeared to be of secondary importance. Lau et al. (2002) examined the relationship
between stock returns and beta, size, the earnings-to-price (E/P) ratio, the cash
flow-to-price ratio, the book-to-market equity ratio and sales growth (SG) by
studying the data of the Singapore and Malaysian stock markets for the period
1988–1996. They reported a negative size effect and a positive E/P effect on stock
returns.
Morelli (2007) examined the role of beta, size and book-to-market equity as
competing risk measurements in explaining the cross-sectional returns of UK
securities for the period July 1980 through June 2000. Size was not observed to be a
significant risk variable, whereas book-to-market equity was observed to be priced
Section I: Literature Review 129

by the market; in other words, it had been noted as a significant determinant of

security returns. Manjunatha and Mallikarjunappa (2012) examined the validity of
the five parameter model (the combination of five variables, viz. beta (β), size, E/P,
book value/market value (BV/MV) and market risk premium (Rm–Rf) on Indian
stock returns using cross-sectional regression. The results indicated that the com-
bination of β, size, E/P, BV/MV and (Rm–Rf) variables explained the variation in
security returns.

Section II: P/E Ratios in India

India began to open up its stock market gradually to foreign portfolio investment in
the 1980s. This had the effect of raising the Indian P/E ratios to international levels.
Further, the Indian government provided fiscal incentives to domestic savers for
investing in equities. This pushed up the domestic demand for equities and led to
the popularization of equity investment amongst the investing community (in
particular the middle class). As a result of all these developments, India experienced
a strong and long bullish market for a decade and a half from the early 1980s to the
first half of the 1990s (Gupta et al. 1998). In their study, Gupta et al. classified the
state of the Indian stock market into four broad categories based on the market’s
average P/E ratio:
1. Dangerously high average P/E ratio—a P/E ratio of greater than 21—was a
symptom of a market bubble. This was a signal of exiting from the market
instead of entering into it.
2. High average P/E ratio—a P/E ratio between 18 and 20. Caution was required to
be exercised in entering into the market, if at all, in this situation.
3. Reasonable average P/E ratio—a P/E ratio between 13 and 17. The P/E ratio
was neither too high nor too low, but was just around an economically justifiable
or normal level.
4. Abnormally low market P/E ratio—a P/E ratio of less than 12. This offered a
rare opportunity of buying stocks at advantageous prices, an opportunity which
occurred once in many years.
The benchmarks suggested above did not apply to individual company P/E
ratios but to the market’s average P/E ratio only.
Over the past two decades, Indian investors have come to accept a substantially
reduced dividend yield, i.e. dividend as per cent of market price; it is, to a marked
extent, also a reflection of the rise in the P/E ratios, especially because the dividend
payout ratio has remained largely unchanged (Jain et al. 2013). The average divi-
dend yield for the actively traded shares in India declined from around 6.15 % at
the beginning of 1980s to less than 2 % for most of the 1900s (Gupta et al. 1998).
As a logical corollary of the above capital gains constitute relatively more
important component of equity returns (and dividends less important). Investors
cannot, therefore, expect a regular annual return from equity investments in most
130 6 Analysis of Price Multiples

cases because capital gains (or losses) due to equity price appreciation (or depre-
ciation) will always be uncertain in a volatile market like India (refer Chap. 4 on
returns). In fact, it is a built-in aspect of equity investments.
In India, the use of the P/E ratio was not very common till as late as 1990.

Interpreting the P/E Ratio: A Word of Caution

A high P/E ratio is suggested when the investors are confident about the company’s
future performance/prospects and have high expectations of future returns; high P/E
ratios reflect optimism. On the contrary, a low P/E ratio is suggested for shares of
firms in which investors have low confidence as well as expectations of low returns
in the future years; low P/E ratios reflect pessimism (Khan and Jain 2014).
Further, the future maintainable earnings/projected future earnings should also
be used to determine EPS. It makes economic sense in that the investors have
access to future earnings only. There is a financial and economic justification to
compute forward or projected P/E ratios with reference to projected future earnings,
apart from historic P/E ratios. This is especially true of present businesses that
operate in a highly volatile business environment. Witness in this context is the
following: ‘In a dynamic business world, a firm’s past earnings record may not be
an appropriate guide to its future earnings. For example, past earnings may have
been exceptional due to a period of rapid growth. This may not be sustainable in the
future…’ (Ramanujam 2000).
The P/E ratios should, however, be used with caution as the published P/E ratios
are normally based on the published financial statements of corporate enterprises.
Earnings are not adjusted for extraordinary items and, therefore, to that extent, may
be distorted. Besides, all financial fundamentals are often ignored in the published
data. Finally, they reflect market sentiments, moods and perceptions. Assuming
retail stocks have been overvalued/undervalued, this error could, in all probability,
be built into the valuation as well (Damodaran 1996).
In spite of these limitations attributed to the P/E ratio, it is the most widely used
measure of valuation. The major reasons are as follows: (i) it is intuitively appealing
in that it relates price to earnings; (ii) it is simple to compute and is conveniently
available in terms of published data; (iii) it can be a proxy for a number of other
characteristics of the firm, including risk and growth (Damodaran 1996).

Earnings Per Share (EPS)

According to corporate finance theory, the EPS is the ultimate source of share-
holders’ returns, whether by way of capital appreciation or dividends. In practice
also, the use of EPS is common amongst market analysts for the purpose of assessing
or estimating the future possibilities of returns from shares (Gupta et al. 1998).
Section II: P/E Ratios in India 131

The most important factor behind the growth of EPS is the ploughing back of
profits by Indian companies. Every rupee of retained profit represents reinvestment
on behalf of shareholders. In the case of sound investments, it should result in a
higher profit (higher EPS) without increasing the number of shares. The rate of EPS
growth will depend on how efficiently the management employs the retained
profits.
The EPS growth, to a marked extent, would depend on the extent to which a
company is able to take advantage of the following:
1. technological progress,
2. organizational improvements,
3. economies of scale and
4. profitable takeover/merger opportunities.

Relationship Between EPS and Prices

On a priori basis, there is expected to be positive relationship between EPS and

share prices as well as dividends. Of the two companies, other things being equal
(say, size, type of business, quality of management, etc.), the one having a higher
EPS will normally command a relatively higher market price. Likewise, as a
company’s EPS grows, the market value of its shares may also exhibit appreciation
(may not be in the same proportion).

P/B Ratio

The price-to-book value/net worth (P/B) ratio is an indication of how the market
values the company vis-à-vis its book value/net worth. Hence, a low P/B ratio
indicates an undervalued company which translates into a good investment
opportunity for the fundamental investor; a higher P/B ratio, prima facie, is reck-
oned as a signal of the undervaluation of the company (as well as of its shares). An
analysis of the P/B ratio would enable us to have insight whether Indian companies
have been undervalued/overvalued during the period of the study.

Section III: Scope, Data and Methodology

The research methodology adopted in the study to compute the P/E ratio, P/B ratio
and the EPS growth has been delineated in this section.
132 6 Analysis of Price Multiples

Scope

The sample comprises of the NSE 500 companies. The NSE 500 index of India
comprises of the top 500 companies listed on the NSE based on their market
capitalization representing 96.76 % of the free-float market capitalization and
97.01 % of the traded value of all stocks on NSE (Source: National Stock Exchange
(NSE) Website. http://www.nseindia.com/products/content/equities/indices/cnx_
500.htm).
The sample is representative in nature as the NSE 500 companies represent all
industry groups. The date of sample selection was 11 March 2013. The period of
the study for this chapter is 2001–2014.

NSE 500 Index Background

The company Standard & Poor’s (S&P) introduced its first stock-based index in
1923 in the United States of America (USA). The transition of the index from
market-value weighted to float weighted was made recently, in two steps, the first
on 18 March 2005 and the second on 16 September 2005 (Source: Wikipedia
Website. http://en.wikipedia.org/wiki/S%26P_CNX_500).
Its Indian counterpart, the CNX 500 (hereby referred to as NSE 500), is India’s
first broad-based benchmark of the Indian capital market. CNX stands for the Credit
Rating Information Services of India Limited (CRISIL) and the NSE. These two
bodies own and manage the index through a joint venture called the India Index
Services and Products Limited (IISL) (Investopedia 2013).

Secondary Data and Analysis

Definition of P/E Ratios

The numerator ‘P’ of the P/E ratio stands for the market price of a share and the
denominator ‘E’ for earnings per share (EPS). The P/E ratio signifies the price
being paid by the buyer of equities for each rupee of annual earnings, whether
distributed as dividends or retained in the company. Its inverse (i.e. E/P, known as
‘earnings yield’) measures corporate profitability in relation to the market value of
corporate equity. A company’s P/E ratio, although not the only factor, is important
for judging whether the prevailing market price of a share is reasonable, i.e. eco-
nomically justifiable. A market’s average P/E ratio (as distinct from the individual
company’s P/E ratio) is an important market indicator of the general state of the
share market.
Section III: Scope, Data and Methodology 133

Computation of P/E Ratios

The yearly P/E ratio of an individual company has been computed by using the
year’s average share price and the latest reported annual EPS. The year’s average
share price of a company has been derived by averaging the year’s high and low
prices. Such averaging has been proved to have high reliability.

Computation of P/B Ratios

The yearly P/B ratio of an individual company has been computed by using the
year’s average share price, and the latest reported total assets less the intangible
assets, fictitious assets and external liabilities.

P/B ratio ¼ Market Price/Book Value per Share

Computation of EPS Growth

The EPS growth data for each year for a company was taken and then averaged, using
their market capitalization as the weight, to arrive at the EPS growth for the sample.

Data Sources and Analysis

The relevant data (secondary) were collected from the Bloomberg® database, for
fourteen years (2001–2014). Descriptive statistical values/positional values, i.e.
mean, standard deviation, variance, coefficient of variation, minimum, maximum,
skewness, kurtosis and quartile values, have been computed for each year. The
period of the study has been divided into two phases, viz. prerecession (2001–2008)
and post-recession (2009–2014), to analyse whether there has been any impact on
the price multiples due to the recession which originated in the USA in 2008. The
paired t-test has been administered to test the same. The entire set of data has been
analysed using Microsoft Excel® spreadsheets and the statistics software SPSS®,
namely Statistical Package for Social Sciences.

Section IV: Price Multiples

It is a well-established economic proposition that a high P/E multiple reflects

optimism about the future earnings prospects of a corporate and a low P/E multiple
of pessimism, suggesting low earnings in future years. Given this premise,
Table 6.1 presents the interpretation of varying values of P/E ratios, in five broad
groups (on the pattern of Gupta’s work).
134 6 Analysis of Price Multiples

Table 6.1 Interpretation of P/E ratios

P/E ratio Interpretation
N/A A company with no earnings has an undefined P/E ratio. By convention,
companies with losses (negative earnings) are usually treated as having an
undefined P/E ratio, even though a negative P/E ratio can be mathematically
determined
0–10 Either the stock is undervalued, or the company’s earnings are perceived to be on
decline. Alternatively, current earnings may be substantially above historic trends
or the company may have profited from selling assets. An analysis into the growth
in earnings per share (EPS) can indicate whether the stock is a value stock or not
11–17 For many companies, a P/E ratio in this range may be considered fair value
18–25 Either the stock is overvalued, or the company’s earnings are expected to increase.
The stock may also be a growth stock
25+ A company whose shares have a very high P/E may have very high expected
future growth in earnings, or this year’s earnings may be considered exceptionally
low, or the stock may be the subject of a speculative bubble

Whilst the frequency distribution of the P/E ratio has been presented first
(Table 6.2), the descriptive statistics have been presented in Table 6.3.
The Indian economy appears to be led by more than six-tenths of the sample
companies, in terms of aggressive (high) P/E ratios of more than 10. These are the
growth stocks amongst the sample companies. Nearly 15 % of the sample compa-
nies have a P/E ratio of less than 5 as in 2014. This number has, however, come
down substantially from more than 50 % in 2001. Another revealing finding that
emerges from Table 6.2 is the fact that the Indian stock market (represented by the
sample companies) appears to be overvalued and could be in the state of a bubble, in
2014, with more than 40 % of the companies reporting P/E ratios of more than 20.
For computing the descriptive statistics of mean, standard deviation, coefficient
of variation, skewness, kurtosis, median and quartile values, the approach followed
treats P/E ratios of less than 5 and more than 25 as outliers. The valid number of
companies within the specified ranges has been indicated in column 2 of the table.
The paired t-test results have been provided after Table 6.3. Figure 6.1 shows the
average P/E ratios for the sample.

Paired t-test
Paired differences t df Significance
Mean Standard Standard 95 % (2-tailed)
deviation error mean confidence
interval of the
difference
Lower Upper
Phase 1–Phase 2 1.43 1.09 0.45 −2.58 −0.29 −3.22 5 0.02

The P/E ratio hovers around 13 for the sample companies, indicating reasonable
to high (aggressive) ratios. The coefficient of variation is moderate (40 % plus) and
 Section IV: Price Multiples

Table 6.2 Frequency distribution related to P/E ratio of sample companies, 2001–2014
P/E ratio 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
0–5 54.00 53.00 60.00 41.00 30.00 23.00 23.00 19.00 40.00 13.00 11.00 13.00 15.00 14.75
5–10 20.26 19.76 19.78 24.26 18.93 9.82 16.24 19.11 24.81 18.50 19.96 21.43 21.00 17.43
10–20 15.32 15.00 14.16 20.68 29.84 23.31 27.59 27.41 20.77 31.98 33.97 30.89 31.08 27.01
Above 20 9.35 11.71 5.84 13.50 20.37 43.15 32.49 34.36 14.23 36.03 34.93 34.36 32.05 40.23
Total 100 100 100 100 100 100 100 100 100 100 100 100 100 100
Total (100) may not tally due to rounding off
135
Table 6.3 Mean, standard deviation, coefficient of variation, skewness, kurtosis, median and quartile values related to P/E ratio of sample companies
136

2001–2014
Year endinga Number of companies Mean Standard Coefficient of Skewness Kurtosis Median Quartile 1 Quartile 3
with P/E ratio <25 and >5 deviation variation (%)
2001 146 10.67 4.71 44.14 0.93 0.10 9.25 6.86 13.16
2002 156 11.20 5.09 45.45 0.81 −0.41 9.81 6.85 14.39
2003 164 10.79 4.96 45.97 0.93 −0.03 9.37 6.70 13.76
2004 243 11.84 5.36 45.27 0.71 −0.49 10.42 7.53 15.46
2005 271 13.01 5.01 38.51 0.38 −0.82 12.75 8.79 16.20
2006 218 14.92 5.45 36.53 0.07 −1.22 14.34 10.28 19.99
2007 280 13.97 5.83 41.73 0.28 −1.11 13.41 9.00 18.52
2008 281 13.05 5.50 42.15 0.46 −0.89 12.10 8.30 17.60
2009 276 12.20 5.68 46.56 0.72 −0.65 10.63 7.50 15.91
2010 315 13.62 5.47 40.16 0.26 −1.00 13.04 8.82 17.60
2011 328 13.51 5.29 39.16 0.31 −0.91 13.06 8.88 17.44
2012 328 13.43 5.63 41.92 0.42 −0.96 12.53 8.82 17.73
2013 321 13.35 5.55 41.57 0.38 −0.95 12.63 8.73 17.81
2014 318 14.91 5.97 40.04 0.04 −1.28 15.24 9.51 20.62
2001–2014 260 12.89 5.39 42.08 0.48 −0.76 12.04 8.33 16.87
Phase 1 (2000–2001 220 12.43 5.24 42.47 0.57 −0.61 11.43 8.04 16.14
to 2007–2008)
Phase 2 (2008–2009 314 13.50 5.50 41.57 0.36 −0.96 12.86 8.71 17.85
to 2013–2014)
Figures are in percentages
(i) aThe Indian financial year begins on April 1 and ends on March 31 of the following year. The same holds true for all subsequent tables and notations
(ii) Values of more than 25 and less than 5 are excluded
6 Analysis of Price Multiples
Section IV: Price Multiples 137

Fig. 6.1 Mean values of P/E ratio for sample companies, 2001–2014

has displayed little deviation (the range being 36.53–45.97 %) over the period of
the study. The skewness and kurtosis values also indicate a near-normal distribution
of the P/E ratios, indicating that the values are spread equally in both directions
from the mean value. The quartile values have been stable as well throughout the
period of the study. However, in 2014, the quartile 3 is 20.62 indicating a possible
bubble in the stock market (Table 6.2). Further, there is a statistically significant
change in the P/E ratios pre- and post-recession, as per the paired t-test, probably
due to the lower P/E ratios in the first three years (2001–2003). The lower quartile
figure of 8.33, as well as the upper quartile figure of 16.87, reflects the presence of
both value stocks and growth stocks in the sample (Table 6.1).
On a priori basis, increase in EPS should yield to higher P/E multiple or vice
versa. What has been the experience of the shares of the sample companies in this
regard constitutes the subject matter of the remaining part of this section. Empirical
analysis shows that the market price usually responds to the growth in EPS at the
company level. The same is presented through Table 6.4. The paired t-test has also
been administered to ascertain whether there was any statistically significant dif-
ference between the EPS growth between the two phases.

Paired t-test
Paired differences t df Significance
Mean Standard Standard 95 % (2-tailed)
deviation error mean confidence
interval of the
difference
Lower Upper
Phase 1–Phase 2 83.44 83.29 34.00 −3.98 170.85 2.45 5 0.58

In spite of the substantial drop in EPS (−144.58 %) in 2009, due to the impact of
the recession originating out of the financial crisis, the EPS has grown at an
impressive rate of 27.01 % over the period of the study for the sample companies,
indicating the robust and growing earnings capability of Indian companies
138 6 Analysis of Price Multiples

Table 6.4 Growth in EPS vis-à-vis P/E multiples for sample companies, 2001–2014
Year ending* Growth in EPS (%) P/E multiple
2001 22.04 10.67
2002 −8.06 11.20
2003 50.69 10.79
2004 55.41 11.84
2005 63.46 13.01
2006 176.39 14.92
2007 73.3 13.97
2008 85.55 13.05
2009 −144.58 12.20
2010 41.68 13.62
2011 3.99 13.51
2012 −29.45 13.43
2013 −12.41 13.35
2014 0.08 14.91
2001–2014 27.01 12.89
Phase 1 (2000–2001 to 2007–2008) 64.85 12.43
Phase 2 (2008–2009 to 2013–2014) −23.45 13.50

(Table 6.4). Further, the paired t-test results also indicate that the change in the EPS
over the two phases has not been statistically significant. The P/E ratio increased
(albeit gradually, from 12.43 to 13.50) in spite of the fluctuating EPS growth
(ranging from –144.58 to 176.39), through the period of the study. Hence, empirical
evidence indicates that in cases where the portfolio was acquired at relatively low
P/E ratios, the returns were commendable (refer Chap. 4 on returns). The oppor-
tunity for this was provided by a prolonged rise in P/E ratios so that the earlier
period purchases benefitted immensely.
In continuation of the analysis of price multiples, whilst the P/E ratios indicate
growth stocks, it is the P/B ratios that provide a further insight into value stocks. For
the purpose, the P/B ratios for the sample companies were computed, for the period
of the study. Frequency distribution of the P/B ratios for the sample is presented in
Table 6.5. For computing the descriptive statistics of mean, standard deviation,
coefficient of variation, skewness, kurtosis, median and quartile values, the
approach followed treats P/B ratios of less than 0 and more than 5 as outliers. The
valid number of companies within the specified ranges has been indicated in col-
umn 2 of Table 6.6. The paired t-test results have been provided after Table 6.6.
Figure 6.2 shows the average P/B ratios for the sample companies.
The impact of the recession is clearly brought forth in 2009, with more than
one-fifth of the sample companies reporting P/B ratios of less than 0.5. Nearly 30 %
of the sample companies are undervalued in 2014 (Table 6.5). This figure has come
down drastically from more than 70 % of undervalued companies in the beginning
of the study period, 2001. This gradual decline in the undervalued companies,
 Section IV: Price Multiples

Table 6.5 Frequency distribution related to P/B ratio of sample companies, 2001–2014
P/B ratio 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
0–0.5 37.00 36.00 40.00 26.00 21.00 19.00 15.00 10.00 22.00 7.00 4.00 6.00 8.00 9.20
0.5–0.8 12.00 13.00 12.00 7.00 3.00 2.00 3.00 3.00 17.00 3.00 6.00 12.00 18.00 12.80
0.8–1.0 4.00 5.00 7.00 5.00 3.00 1.00 4.00 4.00 6.00 5.00 6.00 9.00 5.00 6.80
1.0–2.0 11.00 16.00 16.00 22.00 22.00 16.00 22.00 25.00 26.00 26.00 33.00 27.00 26.00 25.20
2.0–3.0 5.00 4.00 4.00 11.00 15.00 12.00 12.00 15.00 12.00 21.00 18.00 16.00 14.00 13.00
3.0–5.0 3.00 3.00 6.00 10.00 16.00 19.00 18.00 20.00 9.00 19.00 17.00 16.00 14.00 14.00
Above 5 27.00 21.80 13.80 15.80 18.20 30.20 25.20 20.00 6.60 17.40 15.00 12.00 13.00 18.00
Total 100 100 100 100 100 100 100 100 100 100 100 100 100 100
Total (100) may not tally due to rounding off
139
Table 6.6 Mean, standard deviation, coefficient of variation, skewness, kurtosis, median and quartile values related to P/B ratio of sample companies
140

2001–2014
Year endinga Number of companies Mean Standard Coefficient of Skewness Kurtosis Median Quartile 1 Quartile 3
with P/B ratio of >0 and <5 deviation variation (%)
2001 359 0.80 0.95 118.75 2.14 5.02 0.48 0.23 1.03
2002 384 0.83 0.92 110.84 1.82 3.66 0.53 0.20 1.20
2003 423 0.88 1.02 115.91 1.75 2.80 0.54 0.14 1.18
2004 410 1.29 1.22 94.57 0.86 −0.05 1.07 0.00 2.03
2005 400 1.74 1.45 83.33 0.44 −0.78 1.62 0.00 2.78
2006 343 1.90 1.57 82.63 0.32 −1.07 1.72 0.00 3.18
2007 370 1.85 1.42 76.76 0.38 −0.85 1.61 0.86 2.95
2008 397 1.99 1.34 67.34 0.38 −0.69 1.82 1.08 3.00
2009 465 1.31 1.09 83.21 1.12 0.73 1.03 0.51 1.86
2010 410 2.08 1.22 58.65 0.25 −0.68 1.97 1.14 2.93
2011 421 2.00 1.18 59.00 0.66 −0.22 1.79 1.11 2.70
2012 435 1.83 1.19 65.03 0.79 −0.23 1.55 0.87 2.54
2013 435 1.71 1.20 70.18 0.90 −0.06 1.38 0.71 2.41
2014 408 1.75 1.21 69.14 0.90 −0.11 1.41 0.77 2.54
2001–2014 404 1.57 1.21 82.52 0.91 0.53 1.32 0.54 2.31
Phase 1 (2000–2001 386 1.41 1.24 93.77 1.01 1.01 1.17 0.31 2.17
to 2007–2008)
Phase 2 (2008–2009 429 1.78 1.18 67.53 0.77 −0.10 1.52 0.85 2.50
to 2013–2014)
Figures are in percentages
(i) aThe Indian financial year begins on April 1 and ends on March 31 of the following year. The same holds true for all subsequent tables and notations
(ii) Values of more than 5 and less than 0 are excluded
6 Analysis of Price Multiples
Section IV: Price Multiples 141

Fig. 6.2 Mean values of P/B ratio for sample companies, 2001–2014

representing value stocks, is an indication of the market responding to the invest-

ment opportunities presented. It is useful to bear in mind that not all undervalued
companies have good growth potential; sometimes, there could be something
drastically wrong with the company, preventing the market not to value it close to
its asset base. According to Table 6.6, the average P/B ratio has been rising
gradually from under 1 in 2001. However, the average of 1.57 still appears to be on
the lower side. The measures of dispersion (standard deviation, coefficient of
variation, skewness and kurtosis) exhibit a lot of variation, an indication of the
volatility in the market. Lower quartile (quartile 1) values have been as low as 0,
whilst the upper quartile value (quartile 3) has recorded a maximum of 3.18 during
the period of the study, an indication towards lower P/B ratios, overall.
In prerecession years of 2005–2008, one-third of the sample companies were
having P/B ratio of about 3, reflecting that the market price per share (MPS) is three
times the book value (BV)/net worth of their shares; there has been a considerable
decline in the P/B ratio in subsequent years. For instance, except in 2010, when the
P/B ratio was 2.93, in the other years, the value ranged from 1.86 to 2.70. Hence, the
Indian stock market presents positive investment potential in such companies where
the P/B ratio is on the lower side, provided of course, they are fundamentally strong.
Changes in the pre- and post-recession P/B values are not statistically significant.

Paired t-test
Paired differences t df Significance
Mean Standard Standard 95 % (2-tailed)
deviation error mean confidence
interval of the
difference
Lower Upper
Phase 1–Phase 2 −0.54 0.57 0.23 −1.14 0.06 −2.31 5 0.07
142 6 Analysis of Price Multiples

Section V: Summary

The Indian economy appears to be led by more than six-tenths of the sample
companies, in terms of aggressive (high) P/E ratios of more than 10. These are the
growth stocks amongst the sample companies. Nearly 15 % of the sample com-
panies have a P/E ratio of less than 5 as in 2014. This number has, however, come
down substantially from more than 50 % in 2001. Further, the market response to
EPS growth is evident. This can be regarded as a testimony of fundamentals
applying in the Indian economy. Fundamental investors are doing and are likely to
do well to identify the companies which are better than average performers in terms
of EPS growth over long periods and map them against their P/E ratios. The equity
research should particularly focus on EPS growth of companies, both at individual
company level and portfolio level.
Another revealing finding of the analysis is the fact that the Indian stock market
(represented by the sample companies) appears to be overvalued and could be in the
state of a bubble, in 2014, with more than 40 % of the companies reporting
P/E ratios of more than 20.
However, the aspect that the sample companies also represent value stocks is
brought forth by the P/B ratios. Lower P/B ratios through the period of the study are
indicative of undervalued companies.
In sum, when seen along with the findings of Chap. 4 on returns, it appears that
the Indian stock market provides returns to both fundamental (long-term) and
technical (short-term) investors. It is an indication of the breadth of the Indian stock
market, in terms of presenting opportunities of investment to both kinds of inves-
tors. This is perhaps why the Indian stock market continues to attract domestic as
well as foreign capital market investments.

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than the whole. J Financ Econ 100(3):514–537
Frankel R, Lee C (1998) Accounting valuation, market expectation, and cross-sectional stock
returns. J Acc Econ 25(3):283–319
Gupta LC, Jain PK, Gupta CP (1998) Indian stock market P/E ratios. Society for Capital Market
Research and Development, New Delhi
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Dec 2013
Jain PK, Singh S, Yadav SS (2013) Financial management practices: an empirical study of Indian
corporates. Springer, New Delhi/New York. ISBN 978-81-322-0989-8
Khan MY, Jain PK (2014) Financial management: text, problems and cases, 7th edn. McGraw Hill
Education (India) Private Limited, New Delhi, p 32.11
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Sivy M (1996) Rules of investing. Warner Books Inc., New York, p 26
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Singapore. J Bank Financ 14(2/3):311–326
Chapter 7
Volatility in Stock Returns

Introduction

Although volatility in returns on equity stocks/shares is inherent, the presence of

excessive volatility may not be preferred by a large number of equity investors (in
particular, genuine long-term investors). Given the fact that there is an increasing
number of investors willing to cross borders to diversify their portfolios, it becomes
important for them to know the level/magnitude of volatility present/associated with
Indian equity markets. For these reasons, it is useful to undertake a study that
examines the volatility in stock returns in India. This constitutes the rationale of the
present chapter.
For better exposition, this chapter has been divided into four sections. Section I
provides the literature review of studies focusing on behaviour of returns. Section II
contains the scope and methodology used to study volatility/behaviour of returns.
Section III presents the specific characteristics exhibited by the returns along with
the statistics deployed to determine the same. Section IV contains the summary.
Annexure 7.1 contains a glossary of technical terms used in the chapter, with their
meaning.

Section I: Literature Review

Earlier stock market theories centred on the random walk behaviour of stock prices
asserting that neither prices have any predictable time pattern, nor they offer any
insight for speculating on future movements (Kendall 1953; Fama 1965; Granger
and Morgenstern 1963; Sharma and Kennedy 1977). Eventually, evidences against
the random behaviour of stock prices began to gain ground. Since the application of
statistical techniques by Mandelbrot (1963) and Fama (1965) on stock returns,

© Springer Science+Business Media Singapore 2016 145

S. Singh et al., Equity Markets in India, India Studies
in Business and Economics, DOI 10.1007/978-981-10-0868-9_7
146 7 Volatility in Stock Returns

researchers have documented the presence of patterns in the time series of prices,
returns and volatilities.

International Studies on Behaviour of Returns

Roberts (1959) analysed American data for indices as well as individual companies,
taking data points at both small and large intervals; he reported that both the index
price levels and changes in the individual company’s price levels behaved as if they
were derived from a chance model. Gordon (1959) explained the variation in the
price of the stock by developing a model; the model aimed at identifying the
parameters that investors considered and the weights they assigned to these
parameters in buying common stocks. Praetz (1972) presented both theoretical and
empirical evidence about a probability distribution which described the behaviour
of share price changes.
Lynch and Mendenhall (1997) analysed price and volume data for firms added to
and deleted from the Standard & Poor’s (S&P) 500 index since 1989 for a distinct
pattern of stock price movements. The price reversal after addition and deletion
strongly suggested the existence of temporary price effects, caused by index-fund
trading associated with S&P 500 composition changes. Frankel and Lee (1998)
deployed an ‘analyst-based residual income’ model to examine issues related to the
predictability of cross-sectional stock returns. The index returns were found to be
leptokurtic. Saatcioglu and Starks (1998) examined the stock price–volume relation.
Using monthly index data, they documented a positive relation between volume and
the magnitude of price change as well as the price change itself.
Handa et al. (1989) examined the behaviour of beta as a function of the return
measurement interval. It was observed that betas of high-risk securities increased
with the return interval, whereas betas of low-risk securities decreased with the
return interval. Francis et al. (2000) compared the reliability of the value estimates
from the three models—the discounted dividend model, the discounted free cash
model and the discounted abnormal earnings model. It was observed that the dis-
counted abnormal earnings (AE) model was more accurate and reliable than the
other two models.
Parisi and Vasquez (2000) studied the stock market returns of Chile from 1987
to 1998. Xinga and Howe (2003) applied the general autoregressive conditional
heteroscedasticity—mean (GARCH-M) model to the weekly stock index returns
from the United Kingdom (UK); they documented a significant positive relationship
between stock returns and the variance of returns. The study by Trueman et al.
(2003) analysed the pricing of Internet firms around their earnings announcements.
The stock prices of Internet firms rose during the 5 days prior to the earnings
announcement and fell in the 5 days following the announcement. Berger (2003)
extended this study and focused on the major concerns raised by the price pressure
explanation offered.
Section I: Literature Review 147

Goyal and Welch (2003) observed that the primary source of poor predictive
ability is parameter instability. Belter et al. (2005) presented a new
dividend-adjusted blue chip index for the Danish stock market covering the period
1985–2002. Jeyanthi (2010) studied the stock markets of the emerging economies
(India, China, Indonesia, Kuala Lumpur, Korea and Taiwan) from 1998 to 2009 to
test for the weak form of market efficiency. Mixed results were observed using
different tools. Coutts (2010) revisited the work of Coutts and Cheung (2000) to test
the predictive capabilities of the technical trading rules in the Hong Kong stock
market. It was concluded that the strategies that could yield profitable results at one
point of time could not always be relied upon (as their potentials to outperform
market returns were not the same at all points of time).
Liu et al. (2010) studied the sources of multifractality over time for the Shenzhen
stock market. Chordia et al. (2011) explored the sharp uptrend in the trading activity
and the accompanying changes in market efficiency, using sample data consisting
of the New York Stock Exchange (NYSE) listed equity stocks for the sample period
1993–2008. Alagidede (2011) examined the stock-return predictability in Africa’s
emerging equity markets. Majumder (2011) devised a model which incorporated
the market sentiments for the ‘less than’ efficient market. He contended that the
equity price was an outcome of the combined effect of news/information released in
the market and subsequent sentiments cultivated by them.
Maher and Parikh (2011) examined the short-term price behaviour of three
market parameters (market capitalization, crisis versus non-crisis periods and
magnitude of shocks) in response to informational shocks. They concluded that the
market, in general, reacted more towards positive events. Majumder (2012) anal-
ysed the Brazil, Russia, India and China (BRIC) equity markets and compared them
with markets in the USA. The findings suggested that it would be difficult to
segregate an ‘efficient’ set of markets from their ‘inefficient’ counterparts. Johnson
and So (2012) examined the information content of option and equity volumes
when the agents were privately informed and the trade direction was unobserved.
Golez (2012) showed that the S&P 500 futures were pulled towards ‘at-the-money
strike price’ on days when the serial options on the S&P 500 futures expired and
were pushed away from the ‘cost-of-carry adjusted at-the-money strike’ price right
before the expiration of options on the S&P 500 index.
Savor (2012) studied how information presence affected the post-event perfor-
mance of stocks experiencing large price changes, using regression analysis. The
results indicated that investors under-reacted to news about fundamentals and
over-reacted to other ‘shocks’ that moved stock prices down. Lai et al. (2012)
examined the day-of-the-week effect on the Shenzhen stock market. They concluded
that there was a significant Thursday effect. Wahal and Yavuz (2013) analysed the
role of ‘style investing’ on asset-level return predictability. ‘Style investing’ refers to
an investment approach in which rotation amongst different ‘styles’ is supposed
to be important for successful investing, for example, placing money in broad
category of assets, such as ‘growth’ or ‘emerging markets’. They based their
analysis on the prediction framework provided by Barberis and Shleifer (2003);
148 7 Volatility in Stock Returns

the framework emphasized that under certain conditions, ‘style investing’ could
generate predictability in returns.

Indian Studies on Behaviour of Returns

Studies focusing on the behaviour of returns in India have started only in recent
years.
Dicle et al. (2010) evaluated the Indian equity market for its efficiency and its
potential to offer diversification benefits to international investors. The Indian
equity market was found to be integrated with the international equity markets, a
characteristic that lowered international diversification benefits. Mishra et al. (2011)
focused on the issue of nonlinearities in stock price data. They concluded that the
Indian stock market exhibited ‘random walk’. Gahlot and Datta (2011) studied the
impact of futures trading on the weak form of efficiency and volatility of the Indian
equity market. They used the exponential general autoregressive conditional
heteroscedasticity (EGARCH) model to capture the asymmetric nature of the
volatility. The findings suggested that future trading did not have any significant
effect on equity market volatility.
It is evident from the literature reviewed that a comprehensive study on the
behaviour/pattern of Indian equity returns, for such a large sample and period, has
perhaps not been undertaken, so far. This chapter is an attempt to fill this gap.

Section II: Scope, Data and Methodology

The research methodology adopted to study the characteristics/behaviour of returns

has been delineated hereunder.

Scope

The sample comprises the NSE 500 companies. The NSE 500 index of India
comprises the top 500 companies listed on the NSE based on their market capi-
talization (Source: National Stock Exchange (NSE) Website. http://www.nseindia.
com/products/content/equities/indices/cnx_500.htm).
The sample is representative in nature as the NSE 500 companies represent all
industry groups. The date of sample selection was 11 March 2013. The period of
the study is 1999–2014. This universe was chosen on the assumption that it would
be an accurate representation of the equity returns in India.
Section II: Scope, Data and Methodology 149

NSE 500 Index Background

The company Standard & Poor’s (S&P) introduced its first stock-based index in
1923 in the USA. The index had traditionally been market-value weighted.
However, the index is now float weighted. That is, S&P now calculates the market
capitalizations relevant to the index using only the number of shares (called ‘float’)
available for public trading (Source: Wikipedia Website. http://en.wikipedia.org/
wiki/S%26P_CNX_500).
Its Indian counterpart, the CNX 500 (hereby referred to as NSE 500), is India’s
first broad-based benchmark of the Indian capital market. CNX stands for the Credit
Rating Information Services of India Limited (CRISIL) and the NSE; these are the
two bodies which own and manage the index through a joint venture called the
India Index Services and Products Limited (IISL). Without the additional abbre-
viation to S&P CNX, the index name would be S&P CRISIL NSE index
(Investopedia Website, 2014).
The NSE 500 companies are disaggregated into 72 industry indices, viz., CNX
industry indices (as on the date of sample selection). Industry weightages in the
index reflect the industry weightages in the market. For example, if the consumer
goods sector has a 5 % weightage in the universe of stocks traded on the NSE, the
consumer goods stocks in the index would also have a representation of 5 % in the
index (Source: National Stock Exchange (NSE) Website. http://www.nseindia.com/
products/content/equities/indices/cnx_500.htm).

Secondary Data and Analysis

Daily closing price data of the NSE 500 index have been used to understand
volatility/behaviour of returns and were collected from the Bloomberg® database.
The other secondary data sources used to substantiate any missing data were the
NSE’s Website, Capitaline® and AceEquity® databases. The study period is from
1999 to 2014 and consists of 3749 daily observations.
Stock returns, defined as continuously compounded log returns, were computed
as log of closing price of the NSE 500 on day t over closing price on day t − 1 (the
index value on the previous day the NSE was open). The return for each day was
calculated with reference to the last working day. Weekends and public holidays
were excluded from the sample of observations.
The returns were then subjected to various statistical tools and techniques which
are detailed in the following section. The software EViews 8®, a dedicated financial
statistics software, was used to run the tests for the variants of the GARCH family
(both symmetric and asymmetric models) for different lag lengths.
150 7 Volatility in Stock Returns

Methodology

This section describes the rationale for the deployment of particular statistical tools
in the analysis for the purpose of this paper. It starts from the basic return equation
and then moves on to more complex equations to mirror the related complexity
inherent in the financial returns series, viz., auto-regression, nonlinearity, volatility.
Volatility has several financial applications, one being the improvement in the
efficiency in parameter estimation and the accuracy in interval forecast. Volatility is
not directly observable, but its behaviour can be seen in asset returns. Volatility
exists in clusters and evolves over time in a continuous manner.
The return equation in a financial series is typically estimated as follows:

X
i¼p
Rt ¼ c0 þ ci Rti þ ut ð7:1Þ
i¼1

where Rt is referred to as the return in time t which is a summation of the returns

over the time series i to t and ‘i = p’ indicates the order (degree) of auto-regression
evident in prices; ut is referred to as the Gaussian innovation with zero mean and a
time varying variance ht. The autoregressive order of p is chosen based on the
Akaike information criteria (AIC) or the Schwarz information criteria (SIC). This
model is typically a linear equation assuming zero or very little volatility. However,
as has been stated earlier, the returns series typically exhibit nonlinearity or
volatility.
Engle (1982) proposed the first ever model to provide a systematic framework
for volatility modelling. It is commonly known as ARCH (autoregressive condi-
tional heteroscedasticity) model. Put simply, heteroscedasticity refers to the cir-
cumstance in which the volatility (variability) of a variable is unequal across the
range of values of a second variable that predicts it. ARCH Eq. (7.2) is provided as
follows:

X
i¼m
ht ¼ h o þ hi u2ti þ et ð7:2Þ
i¼1

The ARCH model is based on the assumption that the shock ht of an asset return
is serially uncorrelated, but dependent and hence this dependence can be repre-
sented using a simple quadratic function of its lagged values. These parameters are
estimated by maximizing the maximum likelihood function. The order ‘m’ can be
determined by AIC or SIC.
Though this is a simple approach, it suffers from some weaknesses. It does not
distinguish between the effect of positive and negative shocks. The model is
restrictive and limits the ability of ARCH models with Gaussian innovations to
capture excess kurtosis. It usually overpredicts as it responds slowly to large iso-
lated shocks to the return series. To overcome some shortcomings of ARCH model,
Section II: Scope, Data and Methodology 151

Engle and Bollerslev (1986) proposed the GARCH model. GARCH (m, s) model
can be written as follows:

X
i¼s X
j¼m
ht ¼ ho þ h1i u2ti þ h2j htj þ et ð7:3Þ
i¼1 j¼1

Equation (7.3) is estimated using quasi-maximum likelihood estimation (QMLE)

similar to Eq. (7.2). There are two restrictions imposed on Eq. (7.3). Whereas
higher values of ARCH coefficients indicated conditional volatility showing large
reaction and low persistence, the value of GARCH coefficients indicates the per-
sistence of volatility. AIC or SIC can be used to determine the order of m and s.
The integrated generalized autoregressive conditional heteroscedasticity
(IGARCH) is a restricted version of the GARCH model, where the persistent
parameters sum up to one, and therefore, there is a unit root in the GARCH process.
A variant of the same is the IGARCH-M (IGARCH-Mean); it assumes infinite
variance. Both the GARCH and the IGARCH models belong to the family of
symmetric GARCH models.
Campbell and Hentschel (1992) and Engle and Ng (1993) observed that
volatility reacted differently to positive and negative shocks referred to as the
‘leverage effect’. Symmetric GARCH-type models discussed in Eq. (7.3) cannot
capture this effect. Hence, to overcome this weakness of GARCH-type models,
Nelson (1991) proposed the asymmetric GARCH model called the exponential
GARCH (EGARCH) model. EGARCH (m, s) process can be specified as follows:
 rffiffiffi !
X
i¼m X
j¼s  u
 tj 2 utj
logðht Þ ¼ ho þ h1i logðhti Þ þ h2j pffiffiffiffiffiffiffiffi   þ cj pffiffiffiffiffiffiffiffi ð7:4Þ
i¼1 j¼1
 htj p htj

In simple words, the left-hand side term of Eq. (7.4) is the natural logarithm of
the conditional variance. This ensures that even if the parameters are negative, the
estimated variance will always be positive. The ‘leverage effect’ is captured by c.
The impact is asymmetric if c 6¼ 0. If c\0, good news generates less volatility than
bad news.
Glosten et al. (1993) and Zakoian (1994) developed an alternative asymmetric
model to handle ‘leverage effect’ known as the threshold ARCH (TARCH) model.
A general TARCH (m, s) model can be described as per Eq. (7.5):

X
i¼s X
j¼m
ht ¼ h o þ ðh1i þ ci Nti Þu2ti þ h2j htj ð7:5Þ
i¼1 j¼1

where, Nt−i = 1 if ut−i < 0 and 0 otherwise.

A more generalized model was introduced by Ding et al. in 1993. It is known as
asymmetric power ARCH (APARCH) model. It is more widely used as it includes
the Taylor effect. The Taylor effect (by now well-established aspect in financial
152 7 Volatility in Stock Returns

literature) states that high-frequency time series of financial returns are often
uncorrelated but not independent as there are nonlinear transformations which are
positively correlated (Taylor 1993). APARCH is represented as follows:

X
i¼m X
j¼s
hdt ¼ ho þ h1i hdti þ h2j ðjutj j þ cj utj Þd ð7:6Þ
i¼1 j¼1

The return of a security may also depend on its volatility. To model this scenario,
Engle et al. (1987) suggested the ARCH-M model, where ‘M’ stands for ‘in the
mean’. The variance equation remains the same for all the above-discussed models;
however in ARCH-M, a volatility term is introduced in the mean equation.
The APARCH model also yields the long-memory property of returns. The mean
equation is given as follows:

X
i¼p
Rt ¼ co þ ci Rti þ kht1 þ ut ð7:7Þ
i¼1

In Eq. (7.7), k represents the risk. If k is positive, the investors are risk averse
and are compensated for assuming higher risk. Glosten et al. (1993) presented that
positive and negative relationships between price and volatility are consistent with
theory. The IGARCH-M, EGARCH, TARCH and APARCH models belong to the
family of asymmetric GARCH models.

Formulation of Hypotheses

The overall null hypothesis (H0) could be stated as:

H0 = Changes in index returns have been constant over the period of the study.
For the purpose of analysis of returns and based on the literature reviewed, the
alternative hypotheses (Hn) constructed around the objectives (ii), (iii) and (iv) are:
(i) H1 = There is evidence of volatility in the index returns over the time period
of the study;
(ii) H2 = There is evidence of ‘volatility clustering’ in the index returns over the
time period of the study;
(iii) H3 = There is evidence of ‘leverage effect’ in the index returns over the time
period of the study;
(iv) H4 = There is evidence of ‘stationarity’ in the index returns over the time
period of the study.
Section III: Index Returns and Their Statistical Treatment 153

Section III: Index Returns and Their Statistical Treatment

The objectives of this section are twofold. First, it sets out to present the descriptive
statistics of the NSE 500 index returns. Secondly, it aimed at exhibiting the patterns
(if any) and/or trends evident in the return series.
Table 7.1 provides a summary of the descriptive statistics of the NSE 500 index
returns. Positive mean return is an indication of the fact that the returns have been
positive over the time period studied. The high value of the range is indicative of a
substantial difference between the minimum and maximum values of the data. The
given time series distribution is marked by negative skewness and leptokurtosis,
manifesting wide variations in the return values. Further, the significant value of the
JarqueBera statistics (at 1 % level of significance) provides clear evidence to reject
the null hypothesis of a Gaussian standard normal distribution of daily returns on
the NSE 500 index. In operational terms, it implies that there is volatility in the
returns. Further, the existence of conditional heteroscedasticity is also supported by
the estimates of skewness and kurtosis. Figure 7.1 portraying the histogram of daily

Table 7.1 Mean, standard Descriptive statistic Statistic value

deviation, variance, kurtosis,
skewness and range in daily Mean (log) 0.000511249
returns of the NSE 500, Standard deviation 0.01515395
1999–2014 Variance 0.000229642
Kurtosis 9.937031049
Skewness −0.819859183
Range 0.278867383
Minimum −0.14281113
Maximum 0.136056253
JarqueBera 14695.24

Fig. 7.1 Histogram of the NSE 500 daily returns, 1999–2014

154 7 Volatility in Stock Returns

returns depicts the distribution of the returns being characterized by a high peak at
the centre. In sum, the returns exhibit volatility. Hence, the null hypothesis (H0)
stands rejected.
Having established the presence of conditional heteroscedasticity in the returns,
hypothesis H1 is accepted.
Figure 7.2 presents the time path of the NSE 500 index daily returns. It
graphically indicates that the periods of low returns are followed by periods of low
returns and that of high returns are followed by periods of high returns, respec-
tively. Thus, ‘volatility clustering’ is evident, validating the acceptance of
hypothesis H2. The same is further tested by employing the Ljung-Box Q2 statistic
(Annexure 7.2) for different lag values to test the null hypothesis of no autocor-
relation in the standardized squared residuals. The rejection of null hypothesis (due
to a p-value of 0.000 which is less than the required value of 0.05 for significance)
statistically establishes the presence of ‘volatility clustering’ in the return series.
Further, Fig. 7.3 corroborates the same through the depiction of volatility patterns in
the daily stock returns. In application terms, this indicates that positive returns were
typically followed by further positive returns (signalling the presence of bullish
phase) and negative returns were followed by further negative returns (indicating
the presence of a bearish phase) in the stock market over the period of the study.

Fig. 7.2 Time Path of the NSE 500 daily closing prices, 1999–2014

Fig. 7.3 Volatility patterns (deviations) of the NSE 500 index based on daily closing prices,
1999–2014
Section III: Index Returns and Their Statistical Treatment 155

Fig. 7.4 Q–Q plot of daily

closing prices of the NSE 500
index, 1999–2014

To test hypothesis H3, the Quantile–Quantile (Q–Q) plot (Fig. 7.4) is deployed to
check whether the empirical distribution of the NSE 500 index returns and the
simulated Gaussian (normal) distribution returns were of the same type. The non-
linear plot provides evidence that the NSE 500 index returns’ distribution tails are
heavier than the tails of the Gaussian distribution as there is a substantial deviation
from the 45°. The plot further indicates that the impact of negative shocks is much
greater than the positive shocks in driving the departure from normality. This is an
indication of the ‘leverage effect’; such an impact is also visible/evident in the
returns. The Q–Q plot coupled with the JarqueBera test for normality confirms that
daily returns have thick tails and a non-Gaussian distribution. Further, the
deployment of Lagrangian multiplier test (Annexure 7.3) also indicates the presence
of ARCH effects which is significant (due to a p-value of 0.000 which is less than
0.05). Hence, hypothesis H3 indicating ‘leverage effect’ is accepted. In operational
terms, it indicates that the market returns fell at a steeper rate following negative
news in the market compared to the rise in returns following positive news, during
the period of the study under reference.
Having witnessed the ‘volatility clustering’ and the ‘leverage effect’, the ‘sta-
tionarity’ of the returns has been explored through the Augmented Dickey–Fuller
(ADF), Philips–Perron (PP) and the Kwiatkowski–Phillips–Schmidt–Shin (KPSS)
statistics (Annexure 7.4). The results indicate the presence of ‘stationarity’ as the
statistic values of all three tests are less than 0, (which is the significance criteria)
establishing ‘stationarity’ in the returns.
156 7 Volatility in Stock Returns

Section IV: Summary

The findings of the chapter are important from the following viewpoints. It
undertakes an examination, perhaps for the first time in the Indian context, of the
behaviour of returns and their volatility patterns (if any) for the NSE 500 index.
Also, the analysis presents the behaviour of returns in the Indian stock market in a
comprehensive manner bringing forth evidences of ‘volatility clustering’, ‘sta-
tionarity’ and the ‘leverage effect’ in the volatility exhibited in the return series.
Put simply, the NSE 500 index returns are volatile and behave in the following
manner:
– Whenever volatility is observed, it appears in a cluster; that is, the variations
appear together indicating that the market goes through a volatile ‘phase’.
Technical investors may use this ‘phase’ to book returns and fundamental
investors may need to wait out this volatile cluster, in order to book returns; they
may even exit the market if the prices exhibit a relatively upward trend.
– Further, there is evidence of ‘stationarity’ (referring to a sort of lag in the
volatility cluster) indicating that the volatility cluster provides a window for
aggressive trading to be able to book returns especially for technical investors.
– The ‘leverage effect’ indicates that investors react more strongly to negative
information or news; their behaviour is pessimistic and they bring prices down
sometimes by a larger extent that what is expected. On the other hand, when
compared to positive or good news, the optimism reflected in increasing prices
is of a lesser degree.
The findings are in accordance with the findings of Campbell and Hentschel
(1992) and Engle and Ng (1993) with regard to the presence of ‘volatility clus-
tering’ and to the findings of Black (1976), Christie (1982) and Rabemananjara and
Zakoian (1993) pertaining to the ‘leverage effect’ being evident in the return series.

Annexure 7.1: Glossary of Terms

S. no. Terms Meaning

1 Heteroscedasticity A collection of random variables is heteroscedastic if there are
subpopulations that have different variabilities from others
2 Leptokurtosis Leptokurtosis deals with distributions having fatter tails and
narrower and higher ‘peakedness’ at the mean compared to a
normal distribution
3 Leverage effect The condition where the impact of negative shocks is much
greater than the positive shocks in driving the departure from
normality or vice versa
(continued)
Annexure 7.1: Glossary of Terms 157

(continued)
S. no. Terms Meaning
4 Mean-reverting ‘Mean-reverting’ behaviour of volatility suggests there is a
normal level of volatility and deviations from that level are
eventually cleared
5 Stationarity The overall condition wherein the time series appears to have
been drawn from a ‘stationary’ process, that is, a stochastic
process where the joint probability distribution does not
change when shifted in time and space
6 Volatility A statistical measure of the dispersion of returns for a given
security or a market index
7 Volatility The phrase ‘volatility clustering’ implies that periods of high
clustering (low) volatility are followed by periods of high (low) volatility,
suggesting the presence of strong clustering of high and low
fluctuations of the variable concerned

Annexure 7.2: Ljung-Box Q2 Statistics

Ljung-box statistics Test statistic p-value

Q, 12 209.02 0.000
Q, 24 248.64 0.000
Q, 36 260.42 0.000
Q, 48 296.31 0.000
Q, 72 332.09 0.000
Q, 96 352.51 0.000
Q, 120 382.83 0.000
Q, 144 433.08 0.000
Q, 168 483.08 0.000
Q, 192 483.08 0.000
Q, 200 500.59 0.000

Annexure 7.3: Lagrange Multiplier Test

Lagrange multiplier test Test statistic p-value

LM, 5 40.51826 0.000
LM, 10 23.10503 0.000
LM, 20 13.26816 0.000
LM, 30 9.091963 0.000
(continued)
158 7 Volatility in Stock Returns

(continued)
Lagrange multiplier test Test statistic p-value
LM, 40 7.006252 0.000
LM, 50 5.976162 0.000
LM, 60 5.184236 0.000
LM, 70 4.73443 0.000
LM, 80 4.238505 0.000
LM, 90 3.867223 0.000
LM, 100 3.627176 0.000

Annexure 7.4: Stationarity Test Statistics

Tests Statistic value

ADF test for 1 lag (intercept and trend) −39.04482
Philips–Perron (PP) test (intercept and trend) −47.04032
Kwiatkowski–Phillips–Schmidt–Shin (KPSS) test statistics 0.076364

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Chapter 8
Level of Market Efficiency Using
‘Rational Bubbles’ Approach

Warren Buffett, the legendary investor and fund manager, was quoted as stating:
When the price of a stock can be influenced by a ‘herd’ on Wall Street, with prices set at the
margin by the most emotional person or the most depressed person, it is hard to argue that
the market always prices rationally. In fact, market prices are frequently nonsensical”
(Hagstrom 2000). This quote puts forth, in simple yet succinct terms, the aspect of market
inefficiency.

In an efficient market, the stock prices contain all the publically available
information and insider information, and the changes in stock prices can only be in
response to new publically available information. The objective of this chapter is to
test the presence of ‘rational bubbles’ (in the Indian stock market), in order to assess
the level of stock market efficiency, using both linear and nonlinear threshold
approaches.
The last two decades (1994–2014) have seen a paradigm shift in the attitude of
investors towards investing in emerging equity markets. Emerging markets like
India provide a plethora of new opportunities to the investors vis-a-vis developed
markets. Given this attitudinal shift, it is important to assess the market efficiency in
the emerging markets (like India).
There exist two groups of investors in the market. Whilst the first set of investors
is interested in future payoffs (dividends), the other category is interested in
profit-making by continuously buying and selling of shares (capital gains). If the
first group dominates the market, the stock prices are by and large, driven by
fundamentals. In case the second group dominates, the stock prices diverge from
their fundamental values; these are driven, by and large, by non-fundamental
speculative factors. It is these non-fundamental speculative factors that lead to a
‘bubble’. In the context of this study, ‘rational bubbles’ are defined on the lines of
Blanchard and Watson (1982). The presence of ‘rational bubbles’ is an indication of
market inefficiency.
This chapter is organized into six sections. Section I contains the introduction;
Section II is devoted to the literature review. Whilst Section III enumerates the
methodology used for analysis, Section IV presents the statistical models adopted to

© Springer Science+Business Media Singapore 2016 161

S. Singh et al., Equity Markets in India, India Studies
in Business and Economics, DOI 10.1007/978-981-10-0868-9_8
162 8 Level of Market Efficiency Using ‘Rational Bubbles’ Approach

test the existence of ‘rational bubbles’. The calculations based on the models and
their interpretation form the subject matter of Section V. The summary is presented
in Section VI.

Section I: Introduction

‘Rational bubbles’ in the stock markets have assumed significance, especially, after
the subprime crises of 2007. They can be defined as ‘self-fulfilling expectations that
push stock prices towards a level, which is unrelated to the change in the market
fundamentals’. It is usually characterized by a rapid increase in prices followed by a
drastic fall, after which the prices return back to their mean level (Blanchard and
Watson 1982).
However, ‘bubbles’ are not a very recent phenomenon. The earliest documented
record of the existence of price bubbles dates back to the ‘Tulip mania’ that
occurred in Holland in the early 1600s. Since then, the ‘South Sea company’ and
the ‘Railway mania’ price bubbles in Britain in 1720–1721 and in the 1840s,
respectively, were witnessed. The first ‘stock market bubble’ was observed in the
USA around the 1920s, followed by the ‘asset price’ bubble in Japan in the 1980s
and during the ‘Asian crises’ of 1997.
The methodologies to test the presence of ‘rational bubbles’ consist of a range of
linear (symmetric adjustment) and nonlinear (asymmetric adjustment) cointegration
approaches.

Section II: Literature Review

The literature review can broadly be divided into ‘rational bubbles’ and share price
changes.

Rational Bubbles

Topol (1991) suggested that the common partial assumption for bubble formation
was a weak-financial policy and excessive monetary liquidity in the financial
system, implying low interest rates and excessive leverage. Topol’s assumption can
be regarded as a necessary condition for the existence of a bubble, but it does not
appear to be a sufficient condition. Several other theoretical reasons have also been
attributed to the existence of ‘rational bubbles’ in the market. Most of these theories
have their genesis in the field of ‘Behavioural Finance’. The ‘greater fool’ theory,
the ‘herding’ theory, the ‘extrapolation’ theory and the ‘moral hazard’ theories are
four major theories; these theories (taken together) have potentials to explain the
Section II: Literature Review 163

existence of ‘rational bubbles’ in the market. These are based on the existence of
‘animal spirits’ in the market as explained by Keynes (1935). For the brief defi-
nitions of the mentioned theories and terms, please refer to Annexure 8.1.
A substantial amount of empirical research has been devoted to detect the
presence of ‘rational bubbles’ in the stock market. The results have been mixed.
The study conducted by Campbell and Shiller (1987) detected the presence of a
‘bubble’ in the United States (US) stock market, whilst the one conducted by Diba
and Grossman (1988) rejected it. Froot and Obstfeld (1991) observed evidence of
over-reaction in the stock prices due to changes in the dividends using the Standard
& Poor’s (S&P) stock prices and the dividend indices from 1900 to 1988. Yangru
(1997) reported evidence for the existence of ‘bubbles’ in certain time periods using
S&P 500 index over the period of 1871–1992. Several other studies in this area
have been done by Timmermann (1995), Crowder and Wohar (1998), Bohl (2003),
Nasseh and Strauss (2004), Cunado et al. (2005), Mokhtar et al. (2006) and Chang
et al. (2007).
Most of these studies were based on the assumption of the presence of a linear
cointegrating (symmetric adjustment) relationship between stock prices and divi-
dends. However, there appears to be no justification to assume that the economic
systems are linear (Barnett and Serletis 2000). ‘It seems to be generally accepted
that economics is nonlinear’ (Granger and Terasvirta 1993). Researchers like Hsieh
(1991) and Abhyankar et al. (1997) empirically demonstrated that the financial time
series were nonlinear. Bierens (1997) provided evidence that when the actual
direction of adjustment was nonlinear in the cointegrated relationship, using the
conventional linear cointegration framework led to the misspecification problem.
Balke and Fomby (1997) noted a loss in power in conventional cointegration tests
when the underlying process was threshold autoregressive in nature.
Ahmed et al. (1998) reported the presence of ‘bubbles’ in the ten Pacific-rim
countries using the ‘regime-switching’ model. Boucher (2007) reported evidence of
mispricing due to cognitive errors or sentiments. Liu and Chang (2008) deduced the
absence of ‘rational bubbles’ in the Korean stock market using nonlinear and
nonparametric tests. Onour (2009) supported the presence of ‘rational bubbles’ at
the Bombay stock exchange (BSE).
Apart from the psychological theories, several other researchers explained the
existence of ‘bubbles’ based on the technological and economic development and
market inefficiency. Other theories described ‘rational bubbles’ a result of market
manipulation in the presence of an ‘informal monopoly’, ‘informational oligopo-
lies’, ‘rational government induced policy’, ‘imminent revolution’, and the ‘ruling
elite’ (Thompson and Hickson 2006).
Chang et al. (2014) rejected the existence of ‘rational bubbles’ using the
supremum augmented Dickey–Fuller (SADF) test, but noted their presence based
on the generalized supremum augmented Dickey–Fuller (GSADF) test (both tests
were suggested by Philips et al. (2011, 2013), respectively). However, the existence
of ‘rational bubbles’ in India, on a priori basis, seems impossible as India has high
164 8 Level of Market Efficiency Using ‘Rational Bubbles’ Approach

interest rates, implying that the necessary condition for the existence of bubbles as
suggested by Topol (1991) is not present in the Indian stock market.

Share Price Changes

Gordon (1959) measured the relative valuation of dividends and capital gains in the
stock market, using a variant of the capital asset pricing model (CAPM). They
observed that dividends were not valued differently from capital gains. This finding
was consistent with the objective of share price maximization by firms. Miller and
Modigliani (1961) documented that the effect of a firm’s dividend policy on the
current price of its shares was important not only to the corporate managers but also
to investors planning portfolios, and further to the economists seeking to understand
and appraise the functioning of the capital markets. Similar findings were also
reported by Penman and Sougiannis (1997) and Harris et al. (2001).
Praetz (1972) presented both theoretical and empirical evidence about a prob-
ability distribution which described the behaviour of share price changes. Schipper
and Smith (1986) analysed the share price reactions of the parent firms to the
announcements of public offerings of the stock of wholly owned subsidiaries. The
average abnormal gains associated with ‘equity carve-out’ announcements con-
trasted with the average abnormal losses documented upon announcements of
public offerings of parent equity. Blume et al. (1989) observed that the price of a
typical stock that was added to or deleted from the index and required maximum
trading did not adjust fully immediately after the announcement nor had it fully
adjusted by the opening on the change date. This finding suggested that an indexer
could enhance the realized returns by buying at the opening date following the
announcement rather than waiting until the close on the change date.
Greig (1992) re-examined the Ou and Penman (1989) conclusion that funda-
mental analysis identified equity values not currently reflected in stock prices, and
thus systematically predicted abnormal returns. Bernheim and Wantz (1995) pro-
posed and implemented a new dividend signalling hypothesis. It implied that an
increase in the dividend taxation increased the share price response per dollar of
dividend; it was referred to as ‘bang-for-the-buck’. Their findings were in
tune/conformity with the signalling hypothesis. Lynch and Mendenhall (1997)
analysed price and volume data for firms added to and deleted from the S&P 500
index since 1989 for a distinct pattern of stock price movements. The price reversal
after addition and deletion strongly suggested the existence of temporary price
effects, caused by index-fund trading associated with S&P 500 composition
changes.
Trueman et al. (2003) studied the pricing of Internet firms around their earnings
announcements. The stock prices of Internet firms increased during 5 days prior to
the earnings announcement and decreased in the 5 days following the announce-
ment. On considering several potential explanations for the observed price patterns,
it was concluded that price pressure (due to investor optimism and share demand)
Section II: Literature Review 165

was the only parameter that received some support. Berger (2003) extended this
study and focused on the major concerns raised by the price pressure explanation
offered.
Goyal and Welch (2003) observed that the primary source of poor predictive
ability was parameter instability; for example, the dividend yield (as a parameter)
failed to forecast annual returns or dividend growth rates. Annaert et al. (2012)
introduced a new monthly return series for the Belgian owned equity based on the
Brussels stock market data for the period 1832–1914. Dividend income was
observed to constitute the major part of total returns and the dividend distributions
had a clear seasonal pattern.
Savor (2012) studied how information presence affected the post-event perfor-
mance of stocks experiencing large price changes, using regression analysis. He
focused on stocks that experienced major price changes. Using analyst reports as a
proxy, he observed that price events accompanied by information were followed by
drift, whilst no-information ones resulted in reversals. Thus, the results implied that
investors under-reacted to news about fundamentals and over-reacted to other
‘shocks’ that moved stock prices.
Wahal and Yavuz (2013) analysed the role of style-based investing on
asset-level return predictability. ‘Style’ investing refers to an investment approach
in which the rotation amongst different ‘styles’ is supposed to be important for
successful investing, for example, placing money in the broad category of assets,
such as ‘growth’ or ‘emerging markets’. They based their paper on the prediction
provided by Barberis and Shleifer (2003) that under certain conditions, style
investing could generate predictability in returns. They concluded that investing
behaviour in which investors chased style returns amplified the waves in asset
returns.
Singh et al. (2015) studied Indian equity returns and their characteristics, for the
past two decades (1994–2014) and observed the presence of ‘volatility clustering’,
‘leveraged effect’ and ‘stationarity’ in their behaviour. The findings are also
reported in Chap. 7.

Section III: Methodology

The research methodology adopted in this chapter to analyse the presence of ‘ra-
tional bubbles’ in the Indian stock market has been delineated in this section.

Scope

The NSE 500 index of India comprises of the top 500 companies listed on the NSE
based on their market capitalization. The total traded value for the last six months
ending December 2013, of all Index constituents, was approximately 97.01 % of the
166 8 Level of Market Efficiency Using ‘Rational Bubbles’ Approach

traded value of all stocks on NSE (Source: National Stock Exchange (NSE) Website.
http://www.nseindia.com/products/content/equities/indices/cnx_500.htm).
The sample is representative in nature as the NSE 500 companies represent all
industry groups. The period of the study is 1996–2014. This universe has been
chosen as it is most likely to be an accurate representation of the Indian stock
market (given the above facts).

NSE 500 Index Background

The company Standard & Poor’s (S&P) introduced its first stock-based index in
1923 in the United States of America (USA). Its Indian counterpart, the CNX 500
(hereby referred to as NSE 500), is India’s first broad-based benchmark of the
Indian capital market. The index has traditionally been market-value weighted,
stocks with higher market capitalizations have a greater effect on the index than
companies with smaller market capitalizations. However, the index is now float
weighted. That is, S&P now calculates the market capitalizations relevant to the
index using only the number of shares (called ‘float’) available for public trading.
This transition was made in two steps, the first on 18 March 2005 and the second on
16 September 2005 (Source: Wikipedia Website. http://en.wikipedia.org/wiki/S%
26P_CNX_500).

Secondary Data and Analysis

The basic computation of returns is for individual companies.

Share Prices

The share prices used in the computations are the average of the respective month’s
high and low prices. It is useful to mention here that the use of the month’s
‘average’ price has important advantages over the alternatives of using share prices
at some fixed date, say, the month-end. As a large proportion of the listed shares in
India are the shares of small- and medium-sized companies and are not traded daily,
the use of share prices on a fixed date would have resulted in exclusion of such
shares from the study. Also, prices at any particular point of time are liable to be
affected by chance factors. Tests conducted by Gupta and Choudhary (2000) have
shown that the average of the high and low prices quite closely approximate the
average based on more frequently collected price quotations, such as daily, weekly
or monthly prices.
Section III: Methodology 167

Dividends

The cash dividends are taken into account in the respective months and are not
assumed to be reinvested.

Transaction Costs and Taxes

Brokerage, other transaction costs and personal income tax have not been factored
in the computation of returns. Whilst the reason for excluding brokerage and other
transaction costs is logistic convenience, the reasons for income tax are two: first is
that the personal income tax rates vary from investor to investor and second is that
dividends were free of tax during the major period of the study under reference.

Tests for Existence of Rational Bubbles

For the purpose of this study, the existence of ‘rational bubbles’ is checked by
identifying the presence of a cointegrating relationship between stock prices and
dividends. Cointegration is a statistical property of time series variables. Two or
more time series are cointegrated if they share a common stochastic drift. For
example, if two or more series are individually integrated (in the time series sense)
but some linear combination of them has a lower order of integration, this signifies
an equilibrium relationship between the original series, which are then said to be
cointegrated (Source: Wikipedia Website). For the purpose of the analysis, ‘rational
bubbles’ would exist if the stock prices and dividends are not cointegrated.

Data Analysis

The Indian stock market has already entered into the trillion dollar club as on 20
May 2014 forming around 2.2 % of the world market capitalization (Source:
National Stock Exchange (NSE) Website. http://www.nseindia.com/products/
content/equites/indices/cnx_500.htm). The analysis is based on monthly stock
prices and dividends data for the NSE-based CNX-500 index from January 1996 to
April 2014. For computation, the financial statistics software R® version 2.15.3
package ‘apt’ has been used. The descriptive statistics of the data is as presented in
Table 8.1. Natural logarithm of stock prices and dividends are used in the analysis
to minimize the heteroscedasticity.
It is evident from Table 8.1 that the mean log stock price is more than twice the
mean log dividends. The standard deviation in both the variables is low and the
skewness is nearly zero. The kurtosis indicates that both prices and dividends have
hovered around the low mean value. The same is also corroborated by the low
168 8 Level of Market Efficiency Using ‘Rational Bubbles’ Approach

Table 8.1 Descriptive Statistic Ln (price) Ln (dividend)

statistics of log (price) and log
(dividends) Mean 7.74 3.62
Standard error 0.05 0.04
Median 7.63 3.66
Standard deviation 0.72 0.56
Kurtosis −1.67 −1.26
Skewness 0.08 −0.03
Minimum 6.71 2.58
Maximum 8.81 4.56
Count 220.00 220.00

difference between the minimum and maximum prices. This implies that prices
have been much higher than the amount of dividends. Further, it is reasonable to
infer than prices dominate the returns vis-à-vis dividends as the source of income
for the investors.

Section IV: Statistical Models Used to Test the Presence

of ‘Rational Bubbles’

The model for net returns is formed on the lines of Campbell et al. (1997), Cunado
et al. (2005) and Koustas and Serletis (2005). The simple stock return is defined as
the summation of capital gain and the payouts in form of dividends relative to the
initial investment (as shown in Eq. 8.1).

Pt þ 1  Pt þ Dt þ 1 Pt þ 1 þ Dt þ 1
Rt þ 1 ¼ ¼ 1 ð8:1Þ
Pt Pt

where Rt þ 1 ; Pt þ 1 and Dt þ 1 denote the stock return, stock price and dividend in the
period t + 1, respectively. Taking the mathematical expectation of Eq. (8.1), based
on all the information at time t, it can be rewritten as follows:


Pt þ 1 þ Dt þ 1
Pt ¼ Et ð8:2Þ
1 þ Rt

Solving Eq. (8.2) forward for k periods, the reduced form is obtained as follows:
" # " #
i¼k 
X i k
1 1
Pt ¼ Et Dt þ i þ Et Pt þ ki ð8:3Þ
i¼1
1 þ Rt þ i 1 þ Rt þ k
Section IV: Statistical Models Used to Test the Presence … 169

Equation (8.3) in its indefinite form can be written as follows:

" # " #
i¼k 
X i k
1 1
Pt ¼ lim Et Dt þ i þ lim Et Pt þ ki ð8:4Þ
k!1
i¼1
1 þ Rt þ i k!1 1 þ Rt þ k

If positive returns are assumed at the end period, it can be assumed that the
expected discounted value of the stock in the indefinite future converges to zero,
and Eq. (8.4) can be rewritten as follows:
" #
X  1 i
i¼1
P1t ¼ Et Dt þ i ð8:5Þ
i¼1
1 þ Rt þ i

Equation (8.5) can be described as the fundamental value of the stock as expected
present value of future dividends.
In the absence of convergence assumption, Eq. (8.3) can lead to an infinite
number of solutions, and any of them can be written in the form:


Bt þ 1
Pt ¼ P1t þ Bt ; where Bt ¼ Et ð8:6Þ
1 þ Rt þ 1

The extra term Bt is described as ‘rational bubbles’, as it denotes the amount of

deviation in the price of a stock from its fundamental value as denoted in Eq. (8.5)
in response to extraneous factor(s) and is consistent with the rational expectations
and the time path of expected returns. If the non-stationarity of stock prices can be
accounted for by the non-stationarity in dividends, then the stock prices and divi-
dends are said to be cointegrated.
The null hypothesis of ‘rational bubbles’ can either be checked by testing for the
cointegrating relationship between dividends and stock prices or by checking if the
stock dividend–price ratio is a stationary series. The presence of the stationarity of
dividend–price ratio or the cointegration of stock prices and dividends is incon-
sistent with the presence of ‘rational bubbles’ as discussed earlier.

Unit Root Test

Before checking for cointegration, it is important to test the order of integration of

both the series; the reason is that if both the series are of the order 0, there cannot
exist a cointegrating relationship between them. In other words, cointegration in
this context would mean that the dividend payments series and the stock prices’
series would move in tandem over time. To check for the order of integration the
augmented Dickey–Fuller (ADF) test is applied. The ADF test was presented by
Dickey and Fuller (1981) as an improvement over the traditional Dickey–Fuller
(DF) test. The ADF test, tests for the null hypothesis of presence of unit root in the
given time series Y via the following three specifications:
170 8 Level of Market Efficiency Using ‘Rational Bubbles’ Approach

(i) Without drift and linear time trend:

X
m
Dyt ¼ ðdÞyt1 þ bi Dyti þ ut ð8:7Þ
i¼1

(ii) With drift:

X
m
Dyt ¼ a þ ðdÞyt1 þ bi Dyti þ ut ð8:8Þ
i¼1

(iii) With drift and linear time trend:

X
m
Dyt ¼ a þ ct þ ðdÞyt1 þ bi Dyti þ ut ð8:9Þ
i¼1

The value of ‘m’ is chosen based on information criteria such as the Akaike
information criteria (AIC) or the Schwarz–Bayesian information criteria (SIC). In
Eqs. (8.8) and (8.9), we check for the null hypothesis Ho : d ¼ 0, against the
alternative Ha : d\0. The rejection of the null hypothesis implies that the residual
series has no unit root and is stationary. Hence, the series X and Y are cointegrated
and have a long-run relationship.

Tests for Cointegration

There are five methods for testing cointegration. These methods have now been
described:
1. Engle–Granger Two-Step Test
If two time series xt and yt are cointegrated, a linear combination of them must be
stationary. In other words,

yt  bxt ¼ ut ð8:10Þ

where ut is stationary.
If ut was known, it could be tested for stationarity using the Dickey–Fuller test,
for example. Also, β is not known and it is possible to estimate by using the method
of ordinary least squares (OLS). After calculating beta, the stationarity test can be
applied on the estimated ut series.
2. Phillips–Ouliaris Test
Multicointegration extends the cointegration technique beyond two variables, and
occasionally to variables integrated at different orders. Further, cointegration
Section IV: Statistical Models Used to Test the Presence … 171

assumes that the cointegrating vector is constant during the period of study.
However, it is possible that the long-run relationship between the underlying
variables changes.
In the context of this chapter, however, this test is not applied as here only two
variables are considered, viz., stock price and dividend.
3. Autoregressive Distributed Lag (ARDL) Test
The ARDL tests of Pesaran and Smith (1998) and Pesaran et al. (2001) estimate the
presence of long-run relationships between economic time series. It is a better
approach than Engle–Granger (1987) test as it does not assume that all the variables
have to be I(1). Some of the variables under consideration can be stationary under
ARDL approach; however, none of the variables can have an order of integration
greater than one. It is a one-step procedure and involves formulating the following
regression model:

X
i¼p X
i¼q
DYt ¼ a0 þ a1i DYti þ a2i DXti þ b1 Yt1 þ b2 Xt1 þ ut ð8:11Þ
i¼1 i¼1

To investigate the presence of cointegration between X and Y, bound testing as

specified by Pesaran et al. (2001) is used. The null hypothesis is tested as follows:

Ho : b1 ¼ b2 ¼ 0 ð8:12Þ

The ARDL bound test is based on the Wald test (F-statistic). When the com-
puted F-statistic is greater than the upper-bound critical value, the null hypothesis is
rejected and vice versa. When the computed F-statistic falls between the lower and
the upper bounds, the result is inconclusive.
4. Johansen–Juselius (JJ) Test
JJ test presented by Johansen and Juselius (1990) is a better approach than ARDL in
the sense that it is effective even if the order of integration of variables is greater
than 1. Secondly, it can also test if there are more than one cointegrating rela-
tionships present between the variables.
5. Threshold Autoregression (TAR) Test
Threshold-based cointegration test is an advanced nonlinear methodology that does
not assume a symmetric adjustment between the variables. It was proposed by
Enders and Siklos (2001). It is a two-step procedure. In the first step, we estimate
the following long-run relationship between X and Y:

Yt ¼ a þ bXt þ ut ð8:13Þ

where ut is the normally distributed error term.

172 8 Level of Market Efficiency Using ‘Rational Bubbles’ Approach

In the second step, we obtain the OLS estimates of ρ1 and ρ2 as per the following
equation:

X
i¼k
D^ut ¼ It q1 ^ut1 þ ð1  It Þq2 ^ut1 þ ci D^uti þ mt ð8:14Þ
i¼1

where νt is a white-noise disturbance.

The residuals in Eq. (8.13) are substituted in Eq. (8.14). The necessary condition
for ut to be stationary is −2 < (ρ1, ρ2) < 0. Enders and Granger (1998) and Enders
and Siklos (2001) agree on the fact that in either case, under the null hypothesis of
ρ1 = ρ2 = 0, the series has a non-standard distribution. The rejection of both the
hypotheses indicates the existence of threshold cointegration with asymmetric
adjustments.
Further, this model is important when the adjustment is asymmetric with the
series exhibiting more ‘momentum’ in one direction than in the other (Enders and
Granger 1998). This class of threshold models is referred to as momentum-
threshold autoregression (M-TAR) models. The TAR model can capture the deep
cycle process and M-TAR representation is able to capture sharp movements in a
sequence. The value of threshold is generally unknown a priori and is obtained by
Chan’s (1993) method to search amongst possible threshold values to minimize the
residual sum of squares from the fitted model.

Section V: Results and Discussion

This section presents the tests applied and their results along with their
interpretation.
All calculations and models are run on the financial statistics software R® ver-
sion 2.15.3 package ‘apt’. Since the detailed statistical calculations behind each test
have already been outlined in the previous section, this section focuses only on the
results and their interpretation. The detailed calculations are presented through
Annexures 8.2–8.9.

Unit Root Test

As highlighted earlier in the text, the first step in determining the existence of
‘rational bubbles’ is to compute the order of integration between the time series of
stock prices and dividends. The unit root tests for stock price and dividend for
different specifications of the ADF test are presented in Annexure 8.2. Both the
natural log of stock prices and dividends are I(1) and not 0; hence, there could be a
case for ‘rational bubbles’ here.
Section V: Results and Discussion 173

Threshold Autoregressive (TAR) Test

The results of the TAR model are presented in Annexure 8.3. It rejects the null
hypothesis of symmetric adjustments.
However, along with the rejection of the null hypothesis of symmetric adjust-
ment, it is important to note that equity returns in India over the past two decades
have exhibited evidence of ‘volatility clustering’, ‘leverage effect’ and ‘stationarity’
(Singh et al. 2015) indicating the presence of sharp asymmetric movements (for
details, please refer to Chap. 7 on ‘Volatility in Stock Returns’). Hence, it was
considered useful to apply the momentum-threshold autoregressive (M-TAR) test
for cointegration to check for asymmetric adjustments (if any).

Momentum-Threshold Autoregressive (M-TAR) Test

The M-TAR model (results presented in Table 8.2) has greater power than linear
tests and TAR-based cointegration test, especially in the presence of sharp
movements.
10,000 Monte Carlo simulations were performed to generate 5 and 10 % critical
values as in Enders and Siklos (2001). Based on the results of M-TAR tests, it may
be concluded that there is a long-run asymmetric relationship between stock prices
and dividends at 10 % level of significance. Hence, based on the evidence of an
asymmetric cointegration relationship, the existence of ‘rational bubbles’ may be
rejected within the 90 % confidence interval. The probable reason behind the
evidence of cointegration using the M-TAR model vis-à-vis the TAR model could
be the aspect that there might exist sharp movements in the time series of stock
prices and dividends instead of deep cycle movements and, the M-TAR model is
better in capturing such movements.

M-TAR Error Correction Model

Next, the M-TAR-based error correction model (ECM) was deployed to confirm the
findings. It was established that the speed of adjustment for deviations below the
threshold value is faster than the speed of adjustment above the threshold value.

Table 8.2 Results of M-TAR cointegration test

Null hypothesis Statistic Critical value* Critical value**
Presence of symmetric adjustment 4.364** 8.130 2.718
There is no cointegration 6.238** 8.016 5.384
*, ** denote simulated critical values for 5 and 10 % significance level
174 8 Level of Market Efficiency Using ‘Rational Bubbles’ Approach

The results of M-TAR ECM are presented in Annexure 8.4. The estimated coef-
ficients of the error correction terms in the two regimes determine the speed of
adjustment for positive and negative deviations from the fundamental value. The
coefficients of the error correction term in the lower regime are greater in magnitude
than the coefficients of the error correction term in the lower regime, in both Models
1 and 2. This implies that the speed of adjustment for negative deviations is faster;
that is, negative deviations from the fundamental values are eliminated faster than
the positive deviations. In simple terms, this means that the stock market is able to
revert back to the average return values faster from negative or lower deviations,
and it takes longer to revert back to average values when the deviations are positive.
In the long run, it is perhaps safe to assume that such a behaviour is an indication of
a bullish stock market.
The summaries of diagnostic tests for M-TAR model estimated in Annexure 8.4
are presented in Annexure 8.5. Next, the Granger causality and equilibrium path
asymmetry was checked for. The results are reported in Annexure 8.6.
Based on results of Annexure 8.6, a unilateral causality running from stock
prices to dividends may be established. Also, an equilibrium adjustment path
asymmetry for dividends may be observed. Hence, it may be safe to conclude that
the adjustments in dividends to their equilibrium level follow an asymmetric path;
and, the stock price is responsible for most of the adjustments. The results are
indicative of the important role played by price adjustment in the Indian stock
market. They are also indicative of the status of the market efficiency.
Since conventionally the linear approaches are also applied before the nonlinear
approaches, the linear approaches, viz., the Engle–Granger two-step test, autore-
gressive distributed lag (ARDL) test and the Johansen–Juselius (JJ) test, were also
applied and their results presented in Annexures 8.7–8.9, respectively. Though
these tests did indicate a possible presence of ‘rational bubbles’, only the JJ test did
so conclusively. However, by and large, the tests based on asymmetric relationship
reject the presence of ‘rational bubbles’ in the Indian stock market.

Section VI: Summary

There are two notable findings that emerge as a result of the analysis. First, ‘rational
bubbles’ do not exist in the Indian stock market. Second, a cointegrating rela-
tionship between the prices and the dividends, with an asymmetric adjustment
characterized by sharp movements, is established.
The first finding finds basis in the assumption made by Topol (1991) indicating
that the common partial assumption for bubble formation is a weak-financial policy
and excessive monetary liquidity in the financial system, implying low interest rates
and excessive leverage. There is, however, a prevalence of high interest rates in the
Indian capital markets, thus rendering this assumption true.
The nonlinear M-TAR approach was able to reject the null hypothesis of
cointegration; it is being flexible enough to identify nonlinear adjustment patterns
Section VI: Summary 175

with sharp movements. Further, the results indicate that the negative deviations
from the fundamental values are adjusted faster as against positive deviations and
the price (and not the dividend) is responsible for most of the adjustments. This is
an evidence of the ‘leverage effect’ which was also reported in of Chap. 7.
The above discussion could make the case for a semi-strong form of efficiency,
considering the price-adjusting nature of the stock market. However, the chapter on
price multiples (Chap. 6) indicates that most stocks in the market are either over-
valued or undervalued; this indicates inefficiency in pricing. The findings of Chap. 5
(Disaggregative Analysis of Returns) also contain indications of ‘age’ and ‘size’
anomalies existing in the Indian stock market returns. Finally, the substantial
volatility present in the Indian stock market weakens the case for ‘semi-strong’ level
of efficiency. Hence, to conclude, the status of market efficiency for the Indian stock
market, based on the findings, is not only from the deployment of the ‘rational
bubbles’ methodology but also from the other aspects studied (as a part of this
research effort) appears to be of the ‘weak’ form.

Annexure 8.1: Brief Definition of Theories and Terms

Name of theory Definition

‘Greater fool’ A theory that states it is possible to make money by buying securities,
theory whether overvalued or not, and later selling them at a profit because there
will always be someone (a bigger or greater fool) who is willing to pay the
higher price
‘Herding’ theory A mentality characterized by a lack of individual decision-making or
thoughtfulness, causing people to think and act in the same way as the
majority of those around them
‘Extrapolation’ Extrapolation is the process of estimating, beyond the original observation
theory range, the value of a variable on the basis of its relationship with another
variable
‘Moral hazard’ The risk that a party to a transaction has not entered into the contract in
theory good faith; has provided misleading information about its assets, liabilities
or credit capacity; or has an incentive to take unusual risks in a desperate
attempt to earn a profit before the contract settles
‘Animal spirits’ A term used by John Maynard Keynes used in one of his economics
books. In his 1935 publication, ‘The General Theory of Employment,
Interest and Money’, the term ‘animal spirits’ is used to describe human
emotion that drives consumer confidence. According to Keynes, animal
spirits also generate human trust
Source The Investopedia and Wikipedia Websites
176 8 Level of Market Efficiency Using ‘Rational Bubbles’ Approach

Annexure 8.2: Augmented Dickey–Fuller (ADF) Test

Results

Specification Test at level data Test at first differenced data

Dependent None Intercept Intercept None Intercept Intercept
variable and trend and trend
Log 2.762 −0.892 −3.063 −14.089* −14.590* −14.561*
(dividend)
Log (price) 1.804 −0.673 −2.204 −14.385* −14.546* −14.518*
*Denotes significance at 99 % level of significance

Annexure 8.3: Results of TAR Cointegration Test

Null hypothesis Statistic Critical value* Critical value**

There is no cointegration 4.168 7.044 6.008
Presence of symmetric adjustment 0.371 6.296 4.917
*, **Denote simulated critical values for 5 and 10 % significance levels

Annexure 8.4: Estimation Results of M-TAR Error

Correction Model (ECM)

Dependent variable Independent variable Estimate t-value p-value

D(LN_DIV): Model 1 C 0.010* 3.188 0.002
D(LN_DIV(-1)) 0.030 0.438 0.662
D(LN_PRICE(-1)) −0.069*** −1.659 0.099
ECT (above threshold) 0.006 0.485 0.628
ECT (below threshold) 0.050** 2.306 0.022
D(LN_PRICE): Model 2 C 0.006 1.219 0.224
D(LN_DIV(-1)) 0.134 1.208 0.228
D(LN_PRICE(-1)) 0.046 0.683 0.495
ECT (above threshold) −0.030 −1.396 0.164
ECT (below threshold) −0.080** −2.290 0.023
*, **, ***Denote significance at 1, 5 and 10 % significance levels; ECT error correction term
Annexure 8.5: Summary and Diagnostic Checking for M-TAR Models (1 and 2) 177

Annexure 8.5: Summary and Diagnostic Checking

for M-TAR Models (1 and 2)

Item Model 1 Model 2

R-squared 0.040 0.050
Adj-R2 0.020 0.030
F-stat 1.940 2.530
Durbin–Watson statistic 2.030 2.020
AIC −725.920 −515.880
BIC −705.610 −495.570
LB(4) 0.910 0.820
LB(8) 0.630 0.780
LB(12) 0.220 0.900
Note LB(j) denotes p-values for Ljung–Box statistic at jth lag

Annexure 8.6: Granger Causality and Path

Asymmetry Test

Null hypothesis F-statistic Pr(>F)

Equilibrium adjustment path symmetry in dividends 2.942* 0.088
Equilibrium adjustment path symmetry in stock prices 1.502 0.222
Dividends does not Granger cause stock price 1.460 0.228
Stock price does not Granger cause dividends 2.752* 0.099
*Significant at 10 % level of significance

Annexure 8.7: Engle–Granger Test Results

Dependent Tau-statistic Probability Z-statistic Probability

Log_Price −2.664736 0.2164 −13.43712 0.1917
Log_Dividend −2.725527 0.1946 −13.51506 0.1889
178 8 Level of Market Efficiency Using ‘Rational Bubbles’ Approach

Annexure 8.8: ARDL Bound Test Results

Variable Coefficient Standard error t-statistic Probability

C 0.142* 0.071 1.997 0.047
Ln_Price(-1) −0.044* 0.018 −2.380 0.018
Ln_Dividend(-1) 0.056* 0.024 2.375 0.018
D(Ln_Price(-1)) 0.046 0.067 0.684 0.495
D(Ln_Dividend(-1)) 0.153 0.110 1.390 0.166
*Denotes significance at 5 % level of significance

Annexure 8.9: Johansen–Juselius Test Results

Hypothesized number of Trace Probability Max-Eigen Probability

cointegrating equation(s) statistic statistic
None 8.827 0.382 8.625 0.319
At most 1 0.203 0.653 0.203 0.653

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Chapter 9
Concluding Observations

The objective of this chapter is to provide a bird’s-eye view of virtually all the
major aspects of returns in the Indian equity markets and their implications. The
study is perhaps the first (in India) having the largest sample size consisting of the
National Stock Exchange’s (NSE) 500 index companies (representing almost 97 %
of the market capitalization). Hence, the chosen sample virtually presents a census
on equity market returns in India. The period of the study is spread over two
decades (1994–2014) tracking returns right from the inception of the index till
March 31, 2014. The period of the study has been subdivided into two phases to
study the impact (if any) of recession.
Equity markets constitute the most important segment of stock exchanges; in
fact, status of equity returns is, by and large, reckoned as a barometer of the state of
the economy of a country. Returns earned by equity investors on their funds
invested in equity markets would be a decisive factor in the growth of such markets.
What has been the experience of Indian equity markets constitutes the subject
matter of the present research monograph.
It would be useful for equity investors to know the expected returns (on a
rational basis) and actual returns earned on their equity investments; equally
important would be to have insight related to the risk–return trade-off involved in
equity investment and the parameters that may affect the same. There are four major
aspects of Indian equity markets which have been our primary focus in the present
research work, namely returns on equity, price multiples, risk and the level of
market efficiency.
In brief, the study focuses on the following:
• Rates of return on equity funds, from the corporates’ perspective
• Expected rates of return on equity
• Market rates of return on equities from the investors’ perspective
• Rates of return: disaggregative analysis

© Springer Science+Business Media Singapore 2016 181

S. Singh et al., Equity Markets in India, India Studies
in Business and Economics, DOI 10.1007/978-981-10-0868-9_9
182 9 Concluding Observations

• Analysis of price multiples

• Risk/volatility in stock returns
• Level of market efficiency using the ‘rational bubbles’ approach.
For better exposition, this chapter is divided into five sections. Section I presents
the concluding observations on the different variants of the returns on equity.
Section II summarizes the findings related to price multiples. Observations
regarding risk/volatility in returns form the subject matter of Sect. III. Section IV
assesses the level of market efficiency of the Indian equity market. Section V
provides (in nutshell) the findings of this research work, its limitations and the
scope of future work.

Section I: Returns on Equity

This is perhaps the first study in India that links the three aspects of returns in detail
(viz., the returns that the companies actually earn, the returns the investors expect
and the returns the markets provide). It is heartening to observe empirically that
these three aspects are closely aligned in the Indian equity markets, making it an
attractive investment destination.
It appears safe to postulate that the Indian equity markets provide, prima facie,
adequate returns to the technical (short-term) investors and also allow returns over
the long run to the fundamental (long-term) investors. However, in the presence of
volatility in the short run which increases the risk, it would perhaps be wiser to
invest in the long run in the Indian stock market. Such a strategy should result in
relatively less risky and stable returns vis-à-vis the short-run returns.
The major findings related to all significant variants of rates of return on equity
have been presented in this section.
(i) Returns Earned on Equity Funds (ROEF) from the Corporates’
Perspective—The sample companies appear to be providing adequate returns
to their owners adhering to the primary objective of maximizing the wealth of
shareholders. Nearly seven-tenths of the sample companies report a ROEF of
greater than 10 %, for the entire period of the study. Given the current interest
rates prevailing in the capital market and social responsibilities the companies
are to perform mandatorily, the average return on equity funds (ROEF) of
19.10 %, prima facie, can be considered satisfactory. It would perhaps be
useful to note here that even though there was a drop in the ROEF,
post-recession, the sample companies were still able to record the return of
16.86 %. The statistic of adequate returns can be construed as good
news/signal for further growth of equity markets in years to come; in other
words, the companies are in a comfortable position to meet cost of equity.
Section I: Returns on Equity 183

(ii) Expected Returns—Expected returns are a reflection of cost of equity and are
conditional on the fundamental strength and financial performance of the
underlying company whose shares the investors’ purchase. Further, they are
also dependent on the company’s relative performance vis-à-vis the underly-
ing market. We have used two measures to determine expected returns which
consider both the aforementioned aspects: (i) return for the risk undertaken
(ke = rf + b + f) and (ii) the capital asset pricing model (CAPM).
With regard to the aspect of being compensated for the risk undertaken, would
an investor in India be satisfied with 8–10 % return on equity investment? The
answer is likely to be in the negative; this rate of return can be easily earned by
investing in debt instruments such as the public provident fund (PPF), the
Indira Vikas Patra (IVP) and long-term deposit with commercial banks (with
virtually full safety of investments). Obviously, the investors would like to be
compensated for the extra risk they are assuming by investing in the equity
shares of a corporate enterprise.
The risk undertaken was measured through the ratios of degree of operating
leverage (DOL) and the degree of financial leverage (DFL). The average cost
of equity over the period of the study (2001–2014) for the sample companies,
computed via this measure, has been nearly 14 %, assuming the average
risk-free rate to be 7.75 %. Obviously, the individual company’s cost of equity
would be dependent on its relative risk complexion, vis-à-vis the other
securities available in the market. The same is also substantiated by the
average expected returns computed via the CAPM.
The expected returns and the actual market index returns, by and large, appear
to follow the same pattern. The average expected returns for the period are
13.47 % compared to average market index returns of 16.46 %. The standard
deviations, coefficient of variation and variance figures are also similar,
indicating that expected returns mirror the volatility present in the market.
Further, the Pearson’s correlation coefficient between expected and actual
market index returns was 0.98. Hence, the CAPM model emerges to be an
appropriate model to estimate expected returns in the Indian stock market.
However, expectedly, the market index presents a volatility that is substan-
tially higher than the expectations.
(iii) Market Returns or Actual Returns (rates of return earned by equity
shareholders)—Market returns on equity perforce substantially surpass the
other relatively less risky investment avenues (debt) available in India. The
best annual interest rates available on 15, 10 and 5-year fixed deposits (to
compare with the 15, 10 and 5-year equity holding periods) have been 10 %
on an average over the study period. The average returns for the equity
portfolios of these durations were 18.41, 19.62 and 17.33 %, respectively.
It is to be noted that interest earned on deposits is taxed in the hands of the
investor in India, and so are the capital gains. At the time of writing this
chapter, the interest income (taxed at the personal income tax slab of the
individual) could attract a maximum tax rate of 30 %, whereas the long-term
184 9 Concluding Observations

capital gains tax was 20 %. It is evident from the tax rates that the after-tax
computation of equity returns would be greater than the after-tax computation
of interest income (assuming the highest tax slab rate of 30 %). The other
advantage that accrues to equity investment is the liquidity (in terms of
transaction and the entry/exit into/from the market). On both the counts of
taxes and liquidity, equity investment appears a better alternative than debt.
However, it is important to consider the volatility present in equity investment.
For the risk-averse investor, debt instruments provide attractive return with
low risk. Assuming debt instruments to be nearly risk-free, the ‘risk premium’
on equity appears to be approximately 8 % in India. Overall, it appears that
India continues to be an attractive investment destination for both equity and
debt instruments as it caters to the requirements of both the risk-assuming and
risk-averse investors.
(iv) Rates of Return: Disaggregative Analysis—Overall, the returns vary along
with the various segregates (age, size, ownership structure and underlying
sector/industry affiliation), thus providing the investors’ diversification
opportunities, based on the same.
There appears to be a negative correlation between age and returns. The
‘young’ companies with mean returns of 43.33 % fare far better than their
‘middle-aged’ and ‘old’ counterparts with mean returns of 33.72 and 31.09 %,
respectively. This is perhaps to be expected, as the companies in the ‘young’
segment have been observed to be affiliated with emerging and important
sectors for India, such as power and infrastructure. Additionally, being new,
these companies are equipped with new technologies, with new production
processes and perhaps also with skilled labour force. On the other hand, the
old companies seem to be saddled with ‘old’ technologies, old machines, more
labour force (and that too relatively less skilled) and so on. Nevertheless, the
equity returns for all 3 segments are commendable, though, with high degree
of volatility.
In terms of size, the small and medium capitalization (cap) companies lead the
returns compared to large cap companies. This could be attributed to the aspect
that they are growth companies with increasing market share, whilst the large
companies are mature companies with low further growth or expansion
opportunities. The ‘small’ and ‘medium’-sized companies fare better (at robust
returns of 40 %) than their ‘large’ counterparts by 10 % points. Volatility
remains evident in these segments as well.
The findings are similar to the findings of Banz (1981), Wong and Lye (1990),
Lau et al. (2002) and Manjunatha and Mallikarjunappa (2012). These apparent
‘age’ and ‘size’ anomalies are also indicative of the weak form of market
efficiency.
The ownership structure of the Indian corporates is dominated by
‘family-owned’ businesses, and their mean returns at more than 35 % (36.92)
are also the highest amongst the three segments. The volatility is the highest
for the ‘non-PSU/non-family’ segment, and at the same time, their returns are
Section I: Returns on Equity 185

also the lowest, amongst them. Therefore, an investment choice, they appear
unattractive. The ‘family-owned’ and ‘PSU’ segments thus, not surprisingly,
continue to be popular choices for equity investors.
Amongst the underlying sectors, the ‘transport’ and ‘infrastructure’ sectors
recorded high returns of more than 40 %. There is evidence of high volatility
amongst the sectors.

Section II: Analysis of Price Multiples

The P/E ratio signifies the price being paid by the buyer of equities for each rupee
of annual earnings whether distributed as dividends or retained in the company.
Despite their imperfect nature, the practical usefulness of P/E ratios is widely
recognized in the world of investments in stock markets. It is a useful indicator of
the investors’ (market’s) mood and measures the overall reasonableness or other-
wise of the market’s valuation.
The Indian economy appears to be led by more than six-tenths (300) of the
sample companies, in terms of aggressive (high) P/E ratios of more than 10. These
are the growth stocks amongst the sample companies. Hence, empirical evidence
indicates that in cases where the portfolio was acquired at relatively low P/E ratios,
the returns were commendable. The opportunity for this was provided by a pro-
longed rise in P/E ratios so that the earlier period purchases benefitted immensely.
Nearly 15 % of the sample companies have a P/E ratio of less than 5 as in 2014.
This number has, however, come down substantially from more than 50 % in 2001.
Notwithstanding the significant decrease, nearly one-sixth of the sample companies
have very low P/E ratio, suggesting the presence of still a large number of
undervalued companies in the Indian equity market. In marked contrast, the Indian
stock market (represented by the sample companies) also appears to be overvalued
(at the same time) and could be in the state of a bubble (in 2014).
In spite of the substantial drop in EPS (−144.58 %) in 2009, due to the impact of
the recession originating out of the financial crisis in USA, the EPS has grown at an
impressive rate of 27.01 % over the period of the study for the sample companies,
indicating the robust and growing earnings capability of Indian companies.
As a result, the P/E ratio increased [albeit gradually, from 12.43 in phase 1
(2001–2008) to 13.50 in phase 2 (2009–2014)].
In continuation of the analysis of price multiples, whereas the P/E ratios indicate
growth stocks, it is the P/B ratios that provide a further insight into value stocks. In
prerecession years of 2005–2008, one-third of the sample companies were having
P/B ratio of about 3, reflecting that the market price per share (MPS) is three times
the book value (BV)/net worth of their shares; there has been a considerable decline
in the P/B ratio in subsequent years. For instance, except in 2010, when the P/B ratio
186 9 Concluding Observations

was 2.93, in the other years, the value ranged from 1.86 to 2.70. Hence, the Indian
stock market presents positive investment potential in such companies where the P/B
ratio is on the lower side, provided of course, they are fundamentally strong.

Section III: Risk/Volatility in Returns

Although volatility in returns on equity stocks/shares is inherent, the presence of

excessive volatility may not be preferred by a large number of equity investors (in
particular, genuine long-term investors). Given the fact that there are an increasing
number of investors willing to cross borders to diversify their portfolios, it becomes
important for them to know the level/magnitude of volatility present/associated with
Indian equity markets. The profile of volatility is summarized as follows:
– Whenever volatility is observed, it appears in a cluster, indicating that the
market goes through a volatile ‘phase’. Technical investors may use this ‘phase’
to book returns; likewise, fundamental investors may need to wait out this
volatile cluster; at the near ‘peak’ state of equity prices, they may exit the
market.
– There is evidence of ‘stationarity’ (referring to a sort of lag in the volatility
cluster), indicating that the volatility cluster provides a window for aggressive
trading to be able to book returns especially for technical investors.
– There is presence of the ‘leverage effect’ which indicates that investors react
more strongly to negative information or news; their behaviour is pessimistic;
being so, they bring (sometimes) prices down to a larger extent than expected.
On the other hand, the optimism reflected in increasing prices, due to positive or
good news, is of a lesser degree. In other words, prices of shares do not increase
to the desired extent. Good news (by and large) does not yield as much salutary
impact in terms of increase in equity prices, as is expected of good news.
The findings are in conformity with the findings of Campbell and Hentschel
(1992) and Engle and Ng (1993) with regard to the presence of ‘volatility clus-
tering’ and to the findings of Black (1976), Christie (1982) and Rabemananjara and
Zakoian (1993) pertaining to the ‘leverage effect’.

Section IV: Level of Market Efficiency

The last two decades (1994–2014) have seen a paradigm shift in the attitude of
investors towards investing in emerging equity markets. Emerging markets like
India provide a plethora of new opportunities to the investors vis-à-vis developed
markets. Given this attitudinal shift, it was important to assess the level of market
efficiency in the emerging markets (like India).
Section IV: Level of Market Efficiency 187

There exist two groups of investors in the market. Whilst the first set of investors
is interested in future pay-offs (dividends), the other category is interested in
profit-making by continuously buying and selling of shares (capital gains). If the
first group dominates the market, the stock prices are, by and large, driven by
fundamentals. In case the second group dominates, the stock prices diverge from
their fundamental values; these are driven, by and large, by non-fundamental
speculative factors. It is these non-fundamental speculative factors that lead to a
‘bubble’. In the context of this study, market efficiency was analysed using ‘rational
bubbles’ which are defined on the lines of Blanchard and Watson (1982) as
‘self-fulfilling expectations that push stock prices towards a level, which is unre-
lated to the change in the market fundamentals’. It is usually characterized by a
rapid increase in prices followed by a drastic fall, after which the prices return back
to their mean level. The presence of ‘rational bubbles’ is an indication of market
inefficiency.
There are two notable findings that emerge as a result of the analysis. First,
‘rational bubbles’ do not exist in the Indian stock market. Second, a cointegrating
relationship between the prices and the dividends, with an asymmetric adjustment
characterized by sharp movements, is established.
The first finding can be traced to the assumption made by Topol (1991) for bubble
formation, being a weak financial policy and excessive monetary liquidity in the
financial system, implying low interest rates and excessive leverage. There is,
however, a prevalence of high interest rates in the Indian capital markets. In other
words, assumptions requiring bubble formation do not exist in Indian equity mar-
kets. Further, excessive leverage is not present in Indian companies (Jain et al. 2013).
Second, the market returns evince nonlinear adjustment patterns with sharp
movements. Further, the results indicate that the negative deviations from the
fundamental value are adjusted faster vis-à-vis positive deviations and the price
(and not the dividend) is responsible for most of the adjustments (evidence of the
‘leverage effect’).
The above discussion could make the case for a semi-strong form of efficiency,
considering the price-adjusting nature of the stock market. However, the findings on
price multiples indicate that most stocks in the market are either overvalued or
undervalued; this indicates inefficiency in pricing. The findings of the disag-
gregative analysis also contain indications of ‘age’ and ‘size’ anomalies existing in
the Indian stock market returns. Finally, the substantial volatility (present in the
Indian stock market) weakens the case for ‘semi-strong’ level of efficiency. Hence,
to conclude, the status of market efficiency for the Indian stock market, based on the
findings, not only from the deployment of the ‘rational bubbles’ methodology but
also from the other aspects studied (as a part of this research effort), appears to be of
the ‘weak’ form.
188 9 Concluding Observations

Section V: Summary

This section summarizes the major findings of this study. It also provides the
limitations of this research effort and the scope for future work.
Summary—In summary, the main conclusions emanating from the research
undertaken are as follows:
1. Close alignment has been observed amongst actual, expected and market equity
returns.
2. Companies, on an average, have been noted to have earned higher returns on
equity funds deployed than the expected ROE.
3. Equity risk premium in India is around 8 %.
4. Buy-and-hold strategy for longer terms yields higher and safer returns vis-à-vis
returns earned on shorter-span periods.
5. Equity investment yields higher returns (in terms of both after-tax returns and
liquidity) compared to debt securities, albeit with significantly higher risk
(particularly in the short term).
6. The capital asset pricing model (CAPM) has emerged as an appropriate tool to
forecast market returns in India.
7. Factors such as age, size, ownership structure and underlying sector affect
returns.
8. Indian economy is dominated by large business entities which are typically
either large family-owned businesses or subsidiaries of multinational compa-
nies or public sector undertakings.
9. There is a presence of both overvalued (measured through the price/earnings
(P/E) ratios) and undervalued companies (measured through price/book value
(P/B) ratios) in the market.
10. High share prices in the market are supported by growth in the underlying
earnings per share (EPS).
11. Volatility is present in the returns. Further, it exhibits behaviour such as ‘sta-
tionarity’, ‘volatility clustering’ and ‘leverage effect’.
12. Overall, the status of market efficiency is that of the ‘weak’ form.
Limitations—This study has the following limitations:
(i) It is focused only on the Indian equity markets—a study comprising the equity
markets of more than one country could have provided an international
perspective.
(ii) It focuses only on equity returns—a study analysing other investment avenues
in detail, in addition to equity returns, would be more insightful.
(iii) It is focused only on NSE 500 companies—even though the sample size
allows us to present a virtual census of Indian equity market returns, there are
still a sizeable number of companies (in the Indian equity market) which are
not considered.
Section V: Summary 189

(iv) It has focused only on four segregates in the disaggregative analysis—there

are many other aspects such as foreign holding and geographical location
which could also be considered in the analysis.
Scope for future work—Overcoming one or more of the aforementioned lim-
itations could provide scope for future work. Various studies, for example, a study
analysing investment returns (across both equity and debt securities), one analysing
equity returns across countries, another comprising a larger sample of companies
and organizations and another analysing various other parameters (in the disag-
gregative section), could also be conducted. Researchers across the world would do
well to extend this research effort, treating the present work as a base.

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