Predictability Of Stock Returns Using Valuation Ratios: Empirical Evidence From Nairobi Securities Exchange

Abstract

The use of valuation ratios as determinants of stock returns is widely being acknowledged. Seminal works present evidence of a return advantage on stocks with high earnings yield, book to market and dividend yield ratios. The objective of the study was to asses the ability of valuation ratios to predict stock returns at the Nairobi Securities Exchange (NSE). The study was also aimed at reviewing the growing body of theoretical and empirical literature that examines the range of magnitude and effects of the ability of valuation ratios to determine stock returns. The study employed a panel survey design with the target population being all the 57 firms listed at the NSE before 31st December 2013. The sample was represented by thirty-one firms, which had already listed as at January 2014 and was still listed at the end of 2018. The companies also needed to have issued dividends for at least three years of the study period. Secondary sources of data were employed, and data was collected on; the stock prices, net income, outstanding shares, dividends issued, and the book values. The unit period of analysis was annual, and data was collected for the period 2014 to 2018 comprising of five years. The study applied correlation analysis and multiple linear regression equation with the technique of estimation being Ordinary Least Squares (OLS) to establish the the predictive ability of stock returns using valuation ratios. The study findings were that valuation ratios have no predictive power over stock returns. The findings also established that the earnings yield, dividends yield, and book to market ratios do not have a significant association and relationship with stock returns. The study conclusion is that the Nairobi Securities Exchange is weak form efficient and recommends that the Capital Markets Authority (CMA) focus on creating policies that will strengthen the market to the semi strong and strong form of market efficiency. Further recommendations are that retail and institutional investors should focus on making investment decisions based on current public available information and firm fundamentals. It’s also recommended that firms trading in the NSE should strive to improve their fundamentals in order to enhance their market values because past information is already reflected in the share prices.