Do fundamentals matter?

SPECIAL REPORT

A study of stock prices and key financial parameters of companies reveals that prices have a slender correlation with corporate fundamentals.

Here is something that goes against conventional wisdom. While it is commonly assumed that earnings growth (or the lack of it) of a company is an important element in the discovery of its stock price, a recent study tells a different story.

The study that covers the relationship between the stock prices and financial parameters of companies under the BSE 200 Index for the period between 1997 and 2004 (as on April 15, 2005), shows that earnings have a weak relationship with the stock prices.

In fact, it can be inferred from the study that stock prices do not have a very strong relationship with most financial parameters of companies, which means that they depend more on the market perception of a company.

But interestingly, the intrinsic worth of a company, exemplified by such parameters as net worth and total assets, has the strongest relationship with stock prices.

The study looked at the yearly growth as well as CAGR (compounded annual growth rate) growth over three-year and five-year periods for stock prices as well as 16 financial parameters.
 

How financial variables and stock prices relate
Parameter	1 year	3 year (CAGR)	5 year (CAGR)
Net worth	0.3065	0.418	0.31
Return on net worth	0.2621	0.047	0.093
Total assets	0.2464	0.373	0.362
Net value added	0.1706	0.338	0.226
Return on capital employed	0.1342	-0.063	0.106
PAT	0.0569	0.191	0.235
Operating profit	0.0063	0.119	0.214
PAT as % of sales	-0.0099	0.066	0.047
Net sales	-0.0122	0.356	0.501
Cash flow from operations	-0.0346	0.175	0.108
Debt-equity ratio	-0.1134	-0.046	0.139

The correlation between the stock prices and companies' financial variables was arrived through the correlation of the respective growth figures.

The study reveals that stock prices do not have a strong relationship with the financial variables of companies. Highest correlation that came out was only 0.3065 (between stock price and net worth) in the yearly study and 0.501 (between stock price and net sales) in the three-five year study.

In fact, the correlation is strongest between net worth and total assets of a company and its stock price.

While the highest correlation is 0.3065 between stock price and net worth as per the yearly study, the next best is the correlation between stock prices and return on net worth and total assets which are at 0.2621 and 0.2464 respectively.

Debt-to-equity ratio had the lowest relation with prices under this category.

The correlation between stock price and net worth was strongest for the one-year and three-year periods at 0.3065 and 0.418 respectively.

For the five-year period, the strongest correlation was between stock price and net sales at 0.501. Correlation between total assets and stock price also ranked quite high under all three time-frames.

For the five-year and three-year study, the top three variables are common. These are net sales, total assets and net worth.

Though net worth does have reasonably strong correlation with prices, interestingly, return on net worth doesn't figure quite high in the list for longer periods.

Return on net worth had a correlation of only 0.047 with stock prices for the three-year period; it is only slightly better at 0.093 for the five-year period.

However, earnings or net profit (PAT) of a company didn't play much of a role in the growth in the stock price of a company.

The correlation between PAT and stock price was relatively low at 0.0569 (one-year), 0.191 (three-year) and 0.235 (five-year). Stock prices had the lowest correlation with operating profits of a company.

The parameters used in the study included net sales, profit after tax, operating profit, cash flow, net worth, RoCE (return on capital employed) and margins. Stock prices were adjusted for bonus issues, buyback by the company, etc.

(This article is based on a project work titled 'A report on the study of stock prices and corporate financial data' by Manoj Kumar, an MBA student of ICFAI Business School.)

RESEARCH CALLS

JET AIRWAYS
(value buy)
Edelweiss Capital recommends a 'value buy' for Jet Airways, expecting a 25 per cent CAGR in EBITDA in FY05-07E.

It notes that Jet is the best long-term airlines play in India. It adds that the growth rate of domestic traffic has picked up significantly over the past three years from 8.5 per cent in FY03 to 24.5 per cent in FY05E.

Jet will also start flying to UK, USA, Singapore and Malaysia in FY06. It estimates a P/E of 15.8 for FY06 and 13.9 for FY07.

ALLSEC TECHNOLOGIES
(market outperformer)
Stratcap Securities views Allsec Technologies as a market outperformer. Beginning in 2000, the company has transformed itself into a focussed BPO company with over 1,400 employees.

It recently completed its IPO at Rs 135 and is set to expand its capacities by 2.5 times. According to Stratcap, the domestic BPO sector registered a growth of 44 per cent in 2004.

BPO revenues are expected to surge 40 per cent this year. The firm expects Allsec's revenues to increase from Rs 57.7 crore in FY05 to Rs 145.6 crore in FY07. EPS is also expected to go up to Rs 9.7 to Rs 25.9.

ZEE TELEFILMS
(target price: Rs 180)
Zee Telefilms is making a fresh attempt to revive its franchise. An Enam Securities' report mentions that the company's focus is on marketing and distribution of its content and a staggered launch of high profile new shows.

On the DTH front, the company claims a subscriber base of 2,00,000 and daily additions of 2,000. The report adds that the company is currently trading at a P/E of 20 (FY06E) on an EPS of Rs 8.2 and a P/E of 15 (FY07E) on an EPS of Rs 10.9.

The report states that the current DTH policy is beneficial to Zee. Moreover, the loss-leader strategy of Zee is being viewed as appropriate at this stage of the industry's life cycle.

Torrent Pharma
Edelweiss Capital has termed Torrent Pharmaceuticals as promising. Torrent Pharma has been investing in export markets like Brazil and Russia and these markets are expected to turn around in the years to come.

Moreover, the company's recent acquisition of Heumann in Germany will provide the necessary traction to its exports. Torrent has a strong presence in lifestyle segments like cardiovascular, central nervous system and gastro-intestinal.

The domestic market growth is also expected to outpace the industry in this segment. The company has also developed a pipeline of products for the US and is currently looking for marketing tie-ups and expects to start revenues in FY07.