Valuation of securities and influence of value on financial decisions of a firm

Abstract

In this dissertation the price behavior of common stock of Indian private sector companies has been studied in two time perspectives, the short-run and the long-run. The study of day-to-day price behaviour has been undertaken to establish the efficiency of the market in assimilating new information into the price structure of securities. The study with longer time perspective has been undertaken to locate the determinants of market price and construct a model for valuation of securities. The influence of value of the financial decisions of a firm has been studied by estimating a simultaneous equations model for the decision making process. Methodology The independence of day-to-day price movements has been examined through runs test and autocorrelations test. These tests have been carried out on data comprising of daily closing quotations on twenty securities over a period of two years, July 1977 to June 1979. The empirical distributions of price changes have also been examined to conjecture about the distribution of generating process of price changes. The value of a firm’s security, as measured by the average price prevailing over a period of one year, is expressed as a linear function of expected earnings of the firm. The expected earnings has been determined by using a distributed lag model. The valuation model has been estimated for the engineering and the chemical industries. Data on fifty four engineering and about sixty chemical firms for a ten year period (1969-78) has been used to estimate and validate the proposed model. To complete the understanding of the valuation Process two more hypotheses: (a) Financial leverage is a measure of risk perception of investors, (b) unexpected change in dividends contain information about the future earnings of a company, have also been examined. Simultaneous equations model has been suggested to explain the decisions of a firm on investment, capital structure and dividends. Valuation ratio of (market price/book value) has been used as an independent variable in the equations to determine the influence of value on the decisions. Major Findings 1. The Indian capital market is efficient in assimilation of new information into the price structure of securities. The price appears to adjust to new information within a day or two. 2. The price movement of the securities shows a ‘Loader follower’ relationship. A rise in price of ‘Leader' securities is accompanied with a rise in price of ‘follower’ securities with a lag of one or two days. 3. The generating distribution of price changes is non-normal. It appears to follow a stable Pertain distribution with a characteristic exponent below two. 4. The expectation process can be captured by a geometric lag model. The average age of the data used for determining expected earnings is eight to nine years. 5. The valuation modal based on expected earnings has an excellent explanatory power for the price structure prevailing in the market. 6. Financial leverage is not a good measure of risk perception of Indian market operators. 7. Unexpected changes in dividends do not contain information about the future earnings of a company. 8. Dividends have an independent influence on the market price of a security. This indicates that the Indian capital market is imperfect. 9. The market price of a firm's security does not appear to play significant role in the financial and investment decision making process of firms.