Empirical Evaluation of Dividend Discounted Model in Equity

Valuation in India

SIP paper submitted in partial fulfillment of the requirements for the

MBA Program

Compiled By:

Rajat Gupta

01412303909

Internal Supervisors:

Prof. B. K. Chadha

External Supervisors:

Mr. Pronod Kumar Bharatiya

Delhi Institute of Advanced Studies

2009-2011

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 ABSTRACT

This paper demonstrates a method to forecast stock price using analyst earnings

forecasts as essential signals of firm valuation. The demonstrated method is based on

the Residual Income Model (RIM). The retain earning policy of a company determines

what proportion of earnings of the company are distributed to the shareholders by way

of dividends, and what proportion is ploughed back for reinvestment purposes. Since

the main objective of financial management is to maximize the market value of equity

shares, one key area of study is the relationship between the retained earnings or

residual income and market price of equity shares. Over the past few years, the RIM is

widely accepted as a theoretical framework for equity valuation based on fundamental

information from financial reports. The residual Income Model uses various factors like

growth ratio, retention ratio, and return on equity to find the residual income for

company in coming years and values the company on base of the disserted [Link]

paper shows how to implement the RIM for forecasting and check its applicability in

Indian Capital Market. The paper using hypothetico – deductive method concluded that

though Residual Income Model can value different regular dividend paying companies

to find the market price of the companies with accuracy. Overall, this paper provides a

method to forecast stock price that blends fundamental data.

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 CHAPTER 1

INTRODUCTION TO EQUITY VALUATION AND

VALUATION MODELS

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 2.1 Meaning

Valuation is the process of determining the intrinsic value of common stocks. It is the

process to determine the value of a stock or companies. There are various techniques

for valuation. Firstly, the commonly accepted theoretical principal for valuation is

discounted cash flow methodology. According to it, an asset is worth the amount of all

future cash flows to the owner of this asset discounted at an opportunity rate that

reflects the risk of the investment. This fundamental principal does not change and is

valid through time and place. A valuation model that best converts this theoretical

principal into practice should be most useful. Secondly valuation requires an estimate of

the present value of all expected future cash flows to shareholders, or we can say that it

involves uncertain future that is estimated through models and techniques in order to

reduce inaccuracy.

There are many variables that affect the future cash flows of a company and thus the

value of a stock. Variables are measurable, related but not necessarily quantitative, and

they affect the stock value either in combination or alone. The different combination of

various factors brings different and unique results. Given the complexity of analyzing

all factors in order to determine the value of stock at certain point of time and to deal

with this complexity comprehensive and systematic valuation model are to be used.

2.2 Importance of Stock Valuation

Valuation is useful in a wide range of task. Valuation plays a minimal role in portfolio

management for a passive investor, where as it plays a larger role for an active

investor .Even among active investors, the nature and the role of valuation is different

for different types of active investment. Market timers use valuation much less than

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 investors who pick stocks, and the focus is on market valuation rather than on firm-

specific valuation. Among security selectors, valuation plays a central role in portfolio

management for fundamental analysts and a peripheral role for technical analysts.

Valuation is the central focus in fundamental analysis. Investors using this approach

hold a large number of ‘undervalued’ stocks in their portfolios; their hope is that, on

average, these portfolios will do better than the market. Efficient marketers believe that

valuation exercise is useful to determine why a stock sells for the price that it does.

Since the underlying assumption is that the market price is the best estimate of the true

value of the company, the objective becomes determining what assumptions about

growth and risk implied in this market price, rather than on finding under or overvalued

firms.

2.3 Various Stock Valuation Techniques and their Relevance

Three major valuation model categories can be distinguished as follows:

 Asset based Valuation.

 Discounted Cash Flow Models

 Residual Income Models

 Dividend Discounted Models

 Absolute Valuation or Discounted Cash Flow models

 Relative Valuation

2.3.1 Asset based Valuation

Asset based valuation is closely associated with Value investing therefore Graham

suggested that value stocks first of all based on the market value of the existing tangible

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 as assets of a company. The second most reliable measure of a firm’s intrinsic value is

the value of the current earnings the company is able to generate with its assets. Graham

calls this ‘past performance value’. He assumes that the current earnings correspond to

the sustainable level of distribution cash flow and that this level remains constant over

the infinite future. Graham assumes though no growth and discounted earnings based

on the same belief that in a competitive economy growth usually does not create value

and therefore has no value.

The third is the value of growth, this element is the most difficult to estimate and is

accordingly highly uncertain in a competitive environment growth creates value only

when the firm is operating in a sustainable competitive advantage.

2.3.2 Discounted Cash Flow Models

A valuation method used to estimate the attractiveness of an investment opportunity.

Discounted cash flow (DCF) analysis uses future free cash flow projections and

discounts them (most often using the weighted average cost of capital) to arrive at a

present value, which is used to evaluate the potential for investment. If the value arrived

at through DCF analysis is higher than the current cost of the investment, the

opportunity may be a good one.  

Calculated as:

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 The value of common stocks in DFC models is determined by the stream of expected

future cash flow to investors in the nominator and their required rate of return in the

denominator. In the following, we take a closer look at the three most widely used

versions of DCF models:

 Residual income models

 Dividend discounted models

 Free cash flow discounted models

2.3.3 Residual Income Models

A residual income model values securities using a combination of book value of the

company (i.e. its NAV), and a present value based on accounting profits. The value of a

company is the sum of:

 The NAV at the time of valuation, and,

 The present value of the residual income: the amounts by which profits are

expected to exceed the required rate of return on equity.

The latter, like most present value calculations, ends with a terminal value which is

calculated on a different basis to the other future amounts.

The residual return is:

(R - r) × B

Where:

B = NAV

R = the return based on accounting profits and owners equity (net profit ÷ B), and

r = the required rate of return on equity. This can also be expressed as net profit - (r ×

B)

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 The terminal value is somewhat different from that used in an NPV. Rather than being

the actual value of the company at that time, it is the actual value minus the NAV at that

time.

The significance of the extra profit over the required rate of return is that it is a measure

of the wealth the company creates for shareholders. This is what the company adds to

the value of its assets, and what justifies a company being worth more than the value of

its assets. Therefore, the value of a company should be the sum of this and its assets.

The NAV will vary from year to year, which affects the calculation of the returns. The

change is the net profit, fewer dividends and other returns to shareholders, plus capital

rose. Basing valuation on wealth creation is conceptually similar to EVA. Residual

income models are better suited to securities valuation (whereas EVA is primarily

useful to management).

2.3.4 Dividend Discounted Models

A dividend discount model is a financial model that values shares at the discounted

value of future dividend payments. A share is worth the present value of all future

dividends. As it values shares on the actual cash flows received by investors, it is

theoretically the most correct valuation model. A dividend discount model would

typically be a discounted cash flow (DCF) using dividend forecasts over several stages.

 If there are any dividends that have been announced but for which the share has not yet

gone ex –dividend, these are known amounts in the near future and do not require

forecasts.

 There are likely to be forecasts based on detailed financial model for the near future

(the next two to five years).

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  Beyond that, forecasts based on less detailed models (for example, assuming a gradual

reduction in profit growth and a fixed payout ratio) can be used.

 Assuming a fixed growth rate (typically equal to the long term growth rate of the

economy) beyond some point (say after five or ten years) allows a terminal value to be

calculated at that point.

2.3.5 Free Cash Flow Discounted Models

Free cash flow (FCF) measures how much money a company makes after deducting

maintenance capital expenditure, but before capital expenditure on expansion. This is

important as it allows valuation of the existing business without the harder to assess

value of investment in expansion and new ventures. The latter should be worth more

than the money that is being invested in them. How much more is hard to assess and

valuing companies using their free cash flow sidesteps the question.

This means that using free cash flow based valuations will undervalue companies which

have particularly good opportunities to invest. It will also mean that it will overvalue

companies which are sufficiently badly run to make investments that destroy

shareholder value. The latter is not as uncommon as it should be because managers

usually benefit by expanding more than is in the best interests of shareholders. The free

cash flow is the same as what the dividends would be if a company decided to pay out

as much as it could in dividends without either running down its operations or

increasing debt. Free cash flow (FCF) is often used in discounted cash flow valuations.

A rough free cash flow can be calculated from the cash flow statement:

FCF = operating cash flow - tax – capital expenditure

This free cash flow number would be used in a DCF. Free cash flow can also be used in

valuation ratios. Comparing it to EV is probably the most generally useful: EV/FCF. An

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 equity investor may prefer to also subtract net interest paid and use that number in a

DCF, or to calculate cash flow per share.

2.3.6 Relative Valuation

Relative valuation is a simple way to unearth low-priced companies with strong

fundamentals. As such, investors use comparative multiples like price-earnings

ratio (P/E), enterprise multiple (EV/EBITDA) and price-to-book ratio all the time to

assess the relative worth and performance of companies and to identify buy and sell

opportunities. The trouble is that while relative valuation is quick and easy to use, it can

be a trap for investors. The concept behind relative valuation is simple and easy to

understand: the value of a company is determined in relation to how similar companies

are priced in the market. Here is how to do a relative valuation on a publicly listed

company:

 Create a list of comparable companies, often industry peers and obtain their market

values.

 Convert these market values into comparable trading multiples, such as P/E.

 Compare the company's multiples with those of its peers to assess whether the firm is

over or undervalued.

2.4 Detailed discussion on residual income model

Conceptually, residual income is Shareholder cash flow less a charge for the cost of

shareholder capital (rE), or Firm cash flow less a charge for the cost of firm capital

(using WACC). Although Net Income includes a charge for debt capital (i.e., interest

expense), it does not include a charge for equity capital Residual income makes a

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 deduction for this missing charge Conceptually, residual income models view the

intrinsic value of a firm as the initial book (i.e., invested capital) plus the present value

of residual income (i.e., value created).

Example

Using Equity Capital Approach

Residual Income = NI – Equity Charge

Residual Income = NI – Equity Capital x rE(%)

Residual Income = (ROE – rE) x Equity Capital

ROE = Return on Equity

ROE = NI/Equity Capital

Residual Income = (ROE – rE) x Equity Capital

Using Invested Capital Approach

Residual Income = EBIT(1 – T) – Invested Capital Charge

Residual Income = NOPAT – Invested Capital Charge

Residual Income = NOPAT – Invested Capital x WACC(%)

NOPAT = Net Operating Profit After Tax

ROIC = Return on Invested Capital

ROIC = NOPAT/Invested Capital

Residual Income = (ROIC – WACC) x Invested Capital

These simple expressions show very clearly what creates and destroys value in a

company in general terms.

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 2.4.1 The RIM Model and Descriptive Equation

In economics and finance, the traditional approach to value a single firm is based on the

Dividend Discount Model (DDM), as described by Rubinstein (1976). This model

defines the value of a firm as the present value of its expected future dividends.

where Pt is stock price, rt is the discount rate, and dt is dividend at time t. This Equation

relates cum dividend price at time t to an infinite series of discounted dividends where

the series starts at time t. The idea of DDM implies that one should forecast dividends

in order to estimate stock price. The DDM has disadvantages because dividends are

arbitrarily determined, and many firms do not pay dividends. Moreover, market

participants tend to focus on accounting information, especially earnings. So, residual

income model is generally use for valuation which is given as:

Clean Surplus Equation is given as:

which states that book value of equity B is the sum of the book value of the preceding

period B plus current earnings x minus dividends paid D .

Solving the above given equations, we get

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 This is the basic valuation equation for the residual income valuation approach. It

explains current firm value Pt as the sum of book value of equity B0 plus the future

residual income which is the difference between net income xt and the required return

on equity (R-1)Bt-1 discounted by the firm's discount factor R .

2.4.2 Advantages and Disadvantages of Residual Income Model

 Advantages

 Terminal value i.e. the estimated life of company is a relatively smaller portion of

present value.

 Uses readily available accounting data which is easily available.

 Applies to both dividend and non-dividend paying companies.

 Can be used when cash flows are unpredictable because considers profit after tax and

book value of equity.

 Focuses on economic value of company so that shareholders can be most beneficial

from the model.

 Disadvantages

 Uses readily available accounting data which can be manipulated as happened in case

of Satyam Computers.

 Accounting data may need to be adjusted for distortions due to various methods used by

different companies.

 The model requires that the clean surplus relation holds (i.e., changes in book value

equals NI less dividends; that is, all changes to book value other than ownership

transactions flow through earnings).

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 The model cannot be used when there is huge difference between present book value

and company’s earnings.

Therefore, the model can also be useful when

 A company does not pay dividends or dividends are not predictable

 FCF is negative over a comfortable forecast horizon

 There is great uncertainty in estimating terminal values

Not useful when

 There are significant departures from clean surplus accounting. For example, Gains on

marketable securities are reflected in stockholder’s equity as “comprehensive income”

rather than as income on the income statement

 Wide use of employee stock options

 Foreign currency translations

 Some pension adjustments

 determinants of residual income (e.g., book value and ROE) are not predictable

2.4.3 Limitations of RIM Model

Residual Income Model (RIM), a widely used theoretical framework for equity

valuation based on accounting data. Despite its importance and wide acceptance, the

RIM yields large errors when applied for forecasting. Various researchers had used a

statistical approach to improve stock price forecasts based on the RIM, specifically by

showing that adjusting for serial correlation in the RIM’s model (autocorrelation) yields

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 more accurate price forecasts. Despite the statistical tools, this model can not be use

when there is huge difference between book value and present year’s earnings.

2.5 Managerial Usefulness of Study

The Residual Income Model is a useful heuristic model that relates the present stock

price to the present value of its future residual incomes in the same way that a

Company’s fundamentals depend upon on the retained earnings and financial position

or leverage. The Residual Income Model, depends on projections about company

growth rate, future earnings, future dividend and future retained earnings with respect to

the remaining cash flows. Getting either the retained earnings or the growth rate wrong

will yield an incorrect intrinsic value for the stock, especially since even small changes

in either of these factors will greatly affect the calculated intrinsic value. Furthermore,

the greater the length of time considered, the more likely both factors will be wrong.

Hence, the true intrinsic value of a stock is unknowable, and, thus, it cannot be

determined whether a stock is undervalued or overvalued based on a calculated intrinsic

value, since different investors will have a different opinion about the company’s

future. But, still Residual Income Model gives satisfactory result for the intrinsic value

of the company and based upon this, the market position or market value of the

company can be estimated for the upcoming year.

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 CHAPTER 2

LITERATURE REVIEW

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 After giving the introduction to Residual Income Model there off in Section I, the

second step was the review of the literature pertaining to the Valuation through

Residual Income Models. The review of literature is required for various purposes like

determining the logic of the research work, objective of the study, and application of

analytical tools and the modules as operand of interpretation of research. The research

survey goes through the following paragraphs.

Higgins in his paper entitled ‘Forecasting Stock Price with the Residual Income

Model’ demonstrated a method to forecast stock price using analyst earnings forecasts

as essential signals of firm valuation. The demonstrated method was based on the

Residual Income Model (RIM), with adjustments for autocorrelation. The paper showed

how to implement the RIM for forecasting, and how to address autocorrelation to

improve forecast accuracy. The paper provided a method to forecast stock price that

blends fundamental data with mechanical analysis of past time series. His

demonstration was based on SP500 firms, using 22 years of data spanning 1982 – 2003

to estimate the prediction models, which he then used to predict stock prices in a

separate period spanning 2004 - 2005. The mean absolute percentage error obtained can

be as low as 18.12% in one-year-ahead forecasts, and 29.42% in two-year-ahead

forecasts.

Ashton, Peasnell and Wang (May, 2010) in their paper entitled ‘Residual Income

Valuation Models and Inflation’ explored that existing empirical evidence suggests

that residual income valuation models based on historical cost accounting considerably

underestimated equity values because of the use of historical cost accounting under

inflationary conditions. In the paper, they used a residual income framework to explore

theoretically how historical cost accounting numbers need to be adjusted for inflation in

forecasting and valuation. They also demonstrated that even in a simple setting where

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 inflation is running at a relatively low level, residual income models produced severe

under-valuations if inflation was not properly taken into account. They used sample of

250 company’s simulated data taken from I/B/E/S to reinforce their theoretical findings

and to illustrate the difficulties that empirical investigators may face while working

within the confines imposed by real data.

Henschke and Homburg (May, 2009) in their paper entitled ‘Equity Valuation Using

Multiples: Controlling for Differences Between Firms’ explored the problem of

differences between firms and the impact on valuations based on multiples. They

investigated the sample from 1986-2004 taken from I/B/E/S, the extent to which

industry-based multiples ignored additional firm-specific information and developed

measures for identifying peer groups that were not comparable with the target firm.

They find that differences between firms lead to systematic errors in the value estimates

of different multiples. Those errors were consistent with their hypotheses, statistically

significant, economically substantial, consistent between different value drivers and

robust over time. They showed that those errors were predicted very accurately by

comparing the financial ratios of the target firm with the financial ratios of its peer

group. They showed that when adequately controlling for differences between firms,

valuation accuracy was improved substantially and all considered value drivers perform

almost equally well.

Kim, Lee and Tiras (Jan, Aug, 2009) in their paper entitled ‘Residual Income

Valuation: A New Approach Based on the Value-to-Book Multiple’ explored a new

way to implement the residual income model (RIM) that improved the estimates of

fundamental equity value of the firm over those of existing valuation models. RIM had

been expressed as a form of the value-to-book (V/B) ratio. They decomposed a firm’s

V/B ratio into the industry V/B and firm-differential V/B, and then estimated separately

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 the two components using the industry P/B (price-to-book) ratio and analysts’ earnings

forecasts. They find that by incorporating the impact of both industry economic factors

and conservative accounting there was improved predictability of existing valuation

models, specifically that of Frankel and Lee (1998). They had taken the sample of

1976-2003 and find that their valuation measure predicts future returns more accurately

for firms with high level of accounting conservatism.

Drake in her paper entitled ‘A Study on Residual Income Model’ explored the various

concepts related to residual income model and the necessary inputs required for

forecasting of stock prices using Residual Income Model. She also explored the

forecasting technique with the help of book values, return on equity, retention rate, cost

of equity, number of years of economic profit and abnormal earnings. She also explored

that the values that comes out from valuation of different models are generally different

from each other, because each model requires rate of return on equity so that future

values can be discounted to the present values, but generally source of future values

differ from model to model, so the choice of the method is the trade off between the

distortion that takes place in book values and the errors in estimation of future rate of

return.

Fernández (Oct, 2008) in his paper entitled ‘Three Residual Income Valuation

Methods and Discounted Cash Flow Valuation’ explored that three Residual Income

Models always yield the same value as the Discounted Cash Flow Valuation models.

He used three different residual income measures: Economic Profit (EP), Economic

Value Added (EVA) and Cash Value Added (CVA). He had taken the arbitrary data for

a sample company and first showed that the present value of the EP discounted at the

required return to equity, plus the equity book value equals the value of equity (the

present value of the Equity cash flow discounted at the required return to equity). Then,

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 he showed that the present value of the EVA discounted at the WACC plus the

enterprise book value (equity plus debt) equals is the enterprise market value (the

present value of the free cash flow discounted at the WACC). Then, he showed that the

present value of the CVA discounted at the WACC plus the enterprise book value

(equity plus debt) equals is the enterprise market value (the present value of the Free

cash flow discounted at the WACC).

G. H. Wu (Oct, 2006) in his paper entitled ‘The Strategic Role of ‘Cost of Capital’ in

Residual Income measurement’ explored the strategic role of ‘cost of capital’ in

residual income measurement in an oligopoly. Because of imperfect competition in the

product market, firm market valuation and managerial performance evaluation based on

residual income measures or Economic Value Added (EVA®) were most closely

related to each other so that an interactive effect arisen. Facing a stochastic production-

technology with diminishing marginal returns in the decision context of capital

investment, firm owners used the ‘cost of capital’ in residual income measures as a

competitive tool for their managers. They also showed that the mode of competition had

a significant impact on the strategic role, and determined whether the firm owners levy

a lower or higher ‘cost of capital’ on their managers than their own opportunity cost of

capital. They considered three different sources of uncertainty: industry-wide demand,

firm-specific technological input and output. Their results proved that neither industry-

wide demand uncertainty nor firm specific input uncertainty affects the equilibrium

‘cost of capital.’ Furthermore, firm-specific output uncertainty moved the equilibrium

‘cost of capital’ closer to the firm owners’ own cost of capital, and hence, made the

strategic role less valuable, although its effect on the strategic role is of secondary

relative to that of imperfect competition.

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 Kahan (2006) in his paper entitled ‘Reconciliation of Residual Income and Free Cash

Flow Valuation Models’ explored the recounciliation of the residual income model.

Ohlson & Naworth (2005) show, using a ‘scheme’ developed in Ohlson 1998, 2000,

that one can derive the residual income model from the discounted dividend model.

However, their method involved the condition that an infinite sum (book value per

share) divided by the infinite sum of discount factors had converge towards zero (‘mild

transversality condition’). One can argue that economically, no firm will ever have

infinite book value, and thus the fraction will converge to zero as the discount factor

tends toward infinity. However this assumes that the firm will still be operating in

infinity, which is equally unlikely. Raphael Kahan theoretically showed the

reconciliation methods which are free from convergence assumptions.

Yee (July, 2006) in his paper entitled ‘Opportunities Knocking: Residual Income

Valuation of an Adaptive Firm’ explored that part of a firm's value resides in its ability

to exploit new opportunities. The paper incorporates adaptation into Ohlson's residual

income valuation framework and obtained an adaptation-adjusted valuation formula

which was based on the arbitrary sample data. Although parsimoniously cast, the model

makes two predictions which were consistent with phenomena reported in the empirical

literature: earnings convexity and complementarily. Moreover, he also introduced an

Equivalence Theorem relating Modigliani-Miller dividend invariance, complementarily,

and convexity.

Gode, Ohlson (Jan, Feb,2006) in their paper entitled ‘A Unified Valuation Framework

for Dividends, Free-Cash Flows, Residual Income, and Earnings Growth Based

Models’ explored and criticized the extant valuation approaches namely the discounted-

dividends model (DDM), the discounted free cash flows model (DCF), and the residual

income valuation model (RIV). They had not taken any data but theoretically presented

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 a framework to unify these extant models and to derive a model based on earnings and

earnings growth, which were the two most heavily watched metrics in the real world.

They also presented a parsimonious parameterization of the earnings-based model that

was easy to implement and yet provided powerful insights into a firm’s value and its

perceived risk.

Jamin (Aug, 2005) in his paper entitled ‘Investment Performance of Residual Income

Valuation Models on the German Stock Market’ explored value-investing strategies

based on the residual income valuation for the German stock market. Plenty of

empirical evidence showed that it is possible to earn positive abnormal returns by

investing in on the basis of simple fundamental ratios such as PE ratio, PB ratio, or

dividend yield undervalued stocks. A price-value (PV) ratio calculated with the residual

income approach was theoretically better founded than the simple ratios as it captures

all value-generating aspects. Four model specifications were developed and their

performance when using them for value-investing strategies was compared to the

performance of the simple ratios for German companies over a period of 1990 – 2002.

It turned out that fundamentally undervalued companies indeed earn higher returns but

the results were statistically weak and the theoretically superior models do not perform

significantly better than the simple ratios.

Brief (Feb, Mar, 2004) in his paper entitled ‘An Equivalent Form of the Residual

Income Valuation Model’ explored that Easton’s model (2004) model of earnings and

earnings growth to estimate the expected rate of return on equity capital can be viewed

as an equivalent form of the residual income valuation model (RIVM), if clean surplus

sweep was assumed. While Easton’s model does not required clean surplus and there

were problems with the clean surplus assumption (Ohlson, 2003), the fact that his

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 model can be derived directly from the RIVM was of interest and provides additional

understanding into the nature of these models theoretically.

Martin, Petty and Rich (May, 2003) in their paper entitled ‘An Analysis of EVA and

Other Measures of Firm Performance Based on Residual Income’ explored the

theoretical foundations of residual income as a tool for evaluation a firm's interim

performance for purpose of assigning incentive compensation. Consequently, paying

for performance using residual income to measure wealth creation had incentive effects

that were inconsistent with wealth creation. They had taken the work of various

forecaster’s work and showed that recent attempts to address the shortcomings of

residual income had effectively address the wealth measurement issue; however, they

give rose to serious implementation problems related to the necessity for forecasting

future firm performance. Furthermore, if internal forecasts of future firm performance

are used, it was a source of a potentially serious moral hazard problem as the same

managers whose performance was being evaluated provide the forecasts.

Hanlon and Peasnell (Nov, 2002) in their paper entitled ‘Residual income valuation:

Are inflation adjustments necessary?’ explored Residual income-based valuation using

forecasts of residual incomes that were derived from historical cost accounting numbers

taken from I/B/E/S and discount them at the nominal cost of equity that had lead to

undervaluation of firms, and recommended that residual income-based valuation should

be carried out using inflation adjusted residual income forecasts discounted at the real

cost of equity. The paper separately identifies the three types of inflation adjustment

contained within the Ritter-Warr model, and showed that none of the adjustments had

any effect on the theoretical value estimate obtained from the residual income-based

valuation procedure. They find that no theoretical basis for the argument that residual

income valuation needs to be carried out on the basis of inflation-adjusted residual

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 incomes.

Chen, Dong (Jun, 2001) in their paper entitled ‘Stock Valuation and Investment

Strategies’ explored relative performance of several stock valuation measures. The first

was mispricing based on the valuation model developed by Bakshi and Chen (1998).

The BCD model relates stock’s fair value to firm’s EPS, expected EPS growth and long

term interest rates. The second was Residual Income Model based on book value and

return on equity. The BCD model was found to be highly mean reverting. They had

used a sample data from 1979 to 1996 from I/B/E/S and found 3.18% return from the

sample and on the basis of result, concluded that the best investment strategy is to

combine the BCD mispricing with momentum rankings.

Tham (2001) in his paper entitled ‘Consistent Value Estimates from the Discounted

Cash Flow (DCF) and Residual Income (RI) Models in M & M worlds without and

with taxes’ explored, how we can obtain consistent value estimates from the DCF and

RI models in M & M worlds without and with taxes. Previously, Lundholm and

O'Keefe identified the estimation of the WACC as an important reason for the

discrepancy between the value estimates obtained from the Discounted Cash Flow

(DCF) and Residual Income (RI) models. He had taken the arbitrary data showed that

the distortion in valuation values from the two models can be minimized.

Rees and Sivaramakrishnan (Jun, 2001) in their paper ‘valuation implication of

Revenue Forecasts’ explored the importance attached to revenue forecasts by firms and

the market, and whether the forecasts were value-relevant conditional on earnings

forecasts. They had taken a sample of 4192 companies for the year 1998-1999 from

I/B/E/S and indicated that revenue forecasts errors bear a significantly positive, but a

non- linear association with the announcement-period market returns. They also showed

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 that association was stronger for high growth firms relative low growth firms but does

not depends upon earning stability, profitability of the firm.

Abukari, Vijay, McConomy (Nov, 2000) in their paper entitled ‘The Role and the

Relative Importance of Financial Statements in Equity Valuation’ explored relative

rankings of various valuation models and test the relative importance of the financial

statement variables in explaining equity valuation. In this paper they evaluated the role

and relative importance of financial statement variables used in various models of

equity valuation using data from Canadian public companies from [Link],

book value, dividends and other financial statement variables had been used in

theoretical and empirical research as important factors in models of equity valuation.

They indicated that book value and earnings related variables were the most important

variables for Canadian equity valuation. In addition, dividend levels were found to be

relevant in equity valuation; and valuation formulas that incorporate industry relatives,

such as certain court accepted models, perform well.

Halsley (Dec, 2000) in his paper entitled ‘using the residual income stock price

valuation model to teach and learn ratio analysis’ explored residual income stock

price valuation model and demonstrated its use in interpreting the DuPont return on

equity (ROE) decomposition. His paper supports DuPont ROE and aided in

understanding the implications of the price-to-book and price earnings ratios. He also

showed the valuation of Nordstrom Inc. as an example whose data had been taken from

I/B/E/S.

Ohlson (2000) in his paper entitled ‘Residual Income Valuation: The Problems’

explored three problems that persists during valuation through Residual Income Model.

First, on a per share basis that clean surplus will not generally hold if there are expected

changes in shares outstanding. Second, an all equity approach will not work if the firm

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Rajat Gupta 9555487746
 plans to bring in new shareholders. Third, GAAP violated clean surplus because some

capital contributions were not accounted for in market value terms. The paper

theoretically demonstrated the alternative method to Residual Income Valuation based

on expected EPS minus expected DPS instead of book values of equity.

Penman and Sougiannis (1998) in their paper entitled ‘forecasting methods with

alternatives’ demonstrated that the Residual Income Model forecasts are more accurate

than the alternatives like Dividend Discount Model and Free Cash Flow Model. They

had taken the sample of 150 companies from 1990 to 1996 and showed that errors are

large with out-of-sample forecasts, because the forecasted values were farther from the

center of the sample.

Hess and Sievers in their paper entitled ‘Extended Dividend, Cash Flow and Residual

Income Valuation Models ‘explored the Standard equity valuation approaches (i.e.,

DDM, RIM, and DCF) were derived under the assumption of ideal conditions, such as

infinite payoffs and clean surplus accounting. Since these conditions were hardly ever

met, they provided extensions of the standard approaches based on the fundamental

principle of integrated financial planning. Empirically, their extended models yield

considerably smaller valuation errors. Moreover, by construction, identical value

estimates were obtained across the extended models. Re-establishing empirical

equivalence under non-ideal conditions, their approach provided a benchmark that

allows them to quantify the errors resulting from individual deviations from ideal

conditions, and thus, to analyze the robustness of the standard approaches.

Zhang in his paper entitled ‘Conservative accounting and equity valuation’ explored

the link between accounting data and firm value under conservative accounting. By

using a sample of 12 groups of companies ,he showed that conservative accounting had

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Rajat Gupta 9555487746
 been characterized equivalently in terms of book value, earnings, or book rate of return.

The paper contributed to the accounting literature in three ways. First, it provided a

unifying framework that integrated different aspects of conservative accounting.

Second, in addition to the various economic reasons given in the literature regarding the

complementarily between earnings and book value in firm valuation, the study

demonstrated that conservatism in accounting also caused capitalized earnings to differ

from book value asymptotically. Third, under conservative accounting, firm growth was

shown to play an important role in combining book value and earnings in equity

valuation. The results were useful because they provided a benchmark for research that

relates earnings, book value and dividends to market value. One extension of the paper

was to analyze non-steady state situations by explicitly modelling firm transactions and

accounting policies.

Valuation is one of the main topics of the capital market research (KOTHARI,

2001).Bodie and Merton (2002) and Damodaran (1999) emphasized that the ability to

precisely valuate assets is the core of finance theory since many personal and corporate

decisions may be done through choice of alternatives that maximize value. The research

shows that valuation may be used for several purposes and among them, it can be used:

to determine the IPO initial share value (Initial Public Offering); to serve as a

comparison parameter for the negotiation of shares in the stock market; to quantify

value creation that is attributable to corporate businessman (for bonuses purposes), to

help in the strategic decision making (decision to continue in business, to sell, to

expand, to merge or to acquire other companies). The review of literature made in the

paper reveals a series of relevant issues that may be taken into account on an investment

valuation: market efficiency, analyst forecast and opportunity cost are among them. In

some models, there were attempts to understand the interaction of these issues in

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Rajat Gupta 9555487746
 valuation formula, with methodological approaches that vary in terms of level

complexity.

Gosta Jamin (2005) presented formulae that derived from these classic conceptions and

that used accounting variables in the valuation function mainly using Residual Income

Valuation by Ohlson (1995). In the review Residual Model (OM) had great impact in

the capital market academic research. Moreover, the present research work is helpful in

full sense that it dwells upon one more new aspect of impediments before the equity

players in the market. The review given above helped the researcher to determine the

objectives of the present study.

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 CHAPTER 4

RESEARCH METHODOLOGY

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 4.1 Research Design

The various phases of the paper are depicted in the following flow diagram.

Setting the objective, viz, the variables to study

Collection of the relevant data for the study

Removing inconsistency & standardizing data

Residual Income Model- Literature Review

Specification of Residual Income Model

Specify the Mean Equation

Specify the variables to be tested

Test the variables on data

Obtain result

Goodness of Fit of test

Excess Kurtosis Coefficient Values Insignificant Parameters

Draw Conclusion

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 4.2 Research Objective

The main objective of paper is to test the validity of the Residual Income Model in

valuing the companies listed over Indian stock exchange in general and to find the

applicability of Residual Income Model in the valuations of regular dividend paying

companies in particular. For this purpose the following is tested in the paper by

applying a hypothetico – deductive method:

 Profit after tax, dividend and book value are better estimates for growth ratio and return

on equity

 The growth ratio and return on equity in turn are better estimate for retention ratio/

residual income calculation which in turn can be effectively used to paper the value of

the equity.

4.3 Collection of Data

Data for the paper was obtained from capital-line data source. Statistic for 1313

companies was arranged year wise over the period of study and for the variables needed

for the studied. A detailed list of variables studied is being discussed in the preceding

section.

The stock specific data thus collected were grouped into 13 major sectors pertaining in

the market. The list of all sectors is given in Appendix I. Among them it was found that

Pharma and IT companies were following regular dividend payout from last few

quarters among the others. Thus these two sectors were considered most appropriate for

the present study.

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 In Pharma sector 296 companies were listed among which 149 were found paying

dividend regularly in recent past out of which a random sample of 20 companies were

selected for the study which was almost 10% of the population. On normalizing the

collected data for Pharma sector, it was found suitable for the study. Similarly, In IT

sector 113 companies were listed among which 49 were found paying dividend

regularly in recent past out of which a random sample of 20 companies were selected

for the study which was almost 40% of the population. On normalizing the collected

data for IT sector was also found suitable for the study. The list of all initially selected

companies is given in Appendix II. After that it was found that data of some companies

was not adequate enough to be tested or data is missing for some years in between the

data. So, data was again normalized according the variables required and the period of

study, and accordingly companies were selected on the basis of data.

Then a set of random samples of 8, 8 companies using cluster sampling model were

taken in pharmaceuticals and Information Technology Sectors. The samples taken were

homogenous and are highly correlated with the index. The list of the finally selected

companies is given in Appendix III. The finally selected sample companies were tested

with Residual Income Model for the last three years for its validity in India. The results

thus, forecasted were compared, analyzed and tested empirically with the actual

performance.

4.4 Period of Study

The test is applied on various companies valuation based on data from 2002-2010.

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4.5 Area of Study

Pharmaceuticals and Information Technology were considered for testing the model.

4.6 Hypothesis

Null Hypothesis, H0: Residual Income is better estimate of valuations of regular

dividend paying companies with near accuracy.

Alternative Hypothesis, H1: Residual Income is not better estimate of valuations of

regular dividend paying companies with near accuracy.

4.7 Sampling

The paper uses the cluster sampling technique. Under cluster sampling technique the

sample drawn from the population constitute a homogeneous group. From among

around 1313 listed companies over NSE, 417 companies were found paying regular

dividend over the years in the selected time period of the study, i.e., between 2002 and

2010. Two samples of 8 companies were taken from two sectors. Sector break up is

given in Appendix I.

4.8 Model Specification

The following model as explained by Gosta Jamin (2005) based on Ohlson (1995), is

being used to test the above mentioned null hypothesis.

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 Where,

Pt as the current firm value

B0 is the book value of equity

xt is the net income

(R-1)Bt-1 is the required return on equity

Rt is the firm's discount factor

4.9 Variable Studied

Variables used in Residual Income Model are:-

Pt is the market price per share,

rt is the discount rate,

dt is the dividend per share,

bvt is the book value of equity at time t,

xt is the earning forecasts,

xat is the abnormal earnings.

4.10 Steps involved during Valuation

1. Find the retention ratio by subtracting dividend from Net Profit and then dividing the

solution by Profit for corresponding years.

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2. Find the growth ratio by multiplying ROE and retention ratio for corresponding years.

3. Take the average growth ratio, retention ratio and ROE.

4. Consider the current Net Profit as current year’s earnings and based on it forecast the

earning for next year by multiplying book value by growth ratio.

5. Take the present book value and forecast the next year return on equity by multiplying

book value by average ROE.

6. Subtract the value comes from 4th and 5th step and the subtracted value will be the residual

income for the corresponding year.

7. Forecast the next year dividend by multiplying next year’s earnings and (1-retention ratio).

8. Further next year’s book value would become next year’s book value plus earning minus

the dividends.

9. Repeat the above steps for 10 years and find corresponding residual income.

10. Take the Net Present Value of forecasted residual incomes for 10 years. During present

study, the discount factor is considered to be 16%.

11. The current value of the firm will be present value of Residual Incomes plus the current

book value.

12. Divide the result of previous step by no. of outstanding shares and the forecasted value per

share will come out.

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4.11 Software Used and Source of Data

Data relating to Net Profit, dividends, book value and other data relating to financials of

the sample companies are compiled from Capital Line software. Through tabulation till

analysis of data is conducted over excel. Statistical test is carried over SPSS 17.0.

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 CHAPTER 5

RESULT AND ANALYSIS

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 5.1 Background

The information and the data pertaining stocks were collected through secondary

sources. The collection of information was made in the backdrop of objectives of the

study. The collected information was classified, tabulated and analyzed stepwise. On

the basis of the analytical tools the results were obtained, tested and explained. The

results and the explanation thereof are delineated in the following pages.

5.2 Variables Calculated

The following variables were calculated before the empirical testing of the Residual

Income Model for their applicability in Indian companies for their valuations.

Calculation details of each variables in given under each sub-headings.

5.2.1 Return On Equity (ROE)

Return on Equity stands for the return that the investor gets in a year after investing in a

particular stock. ROE can be calculated by dividing the Net Income of the company

after tax and preferential dividend in a particular year by the total equity share capital of

the company outstanding in the market at a particular time. ROE for each company was

calculated for the time frame 2002-2010, and the result is shown in Appendix VI.

5.2.2 Retention Ratio

Retention Ratio defines the retention money that the company retains with it after

giving the dividend from the Net Profit for a particular year.

Retention Ratio is calculated by subtracting the amount of dividend from the Net Profit

for a particular year and then dividing the result with the Net Profit of the same year.

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 5.2.3 Shares Outstanding

Numbers of shares outstanding are required to find the intrinsic value of the firm per

share or to find the market value of one share in the market. No. of shares outstanding

comprises of all shares pertaining with the company (promoter’s shares as well as

general public holdings).

5.3 Forecasted Result

The Residual Income Model was successfully applied to the selected sample of

companies in two sectors, i.e. Pharmaceuticals Sector and Information Technology

Sector, and the forecasted values for the financial year 2011 were found with the model

were listed and shown below:

Selected Companies Forecasted Values Present value as % change

for the year 2011 on 15/11/2010

Aurobindo pharma 1968.5 1056.1 86.39
Cadila health 542.18 697.2 -22.23
Dr Reddy 1610.1 1476.3 9.07
FDC 94.38 101.15 -6.69
IPCA 327.97 308.95 6.16
Lupin 363.19 396.75 -8.46
Piramal Health 511.18 520.55 -1.80
Torrent Pharma 589.36 570.4 3.32

CMC 2335
1954.9 19.49
Infosys 3087.5
3103.4 -0.51
Oracle 2707.5
2238.4 20.96
Polaris 154.37
169.95 -9.17
TCS 918.76
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 Tech Mahindra 1278. 960.2 -4.32
Unichem 556. 767.2 66.59
Wipro 547.95 513.4 8.34
460.95 18.87

The valuations of different companies using Residual Income Model is shown in

Appendix IX.

5.4 Descriptive Statistics

Data was divided in two subsets i.e. Pharmaceuticals Sector & Information Technology

Sector and descriptive statistics was calculated for these two sets separately for each of

the eight scripts for the previous two years, i.e. 2009 and 2008. The results are provided

in Appendix IV and Appendix V respectively.

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 Analysis of Descriptive Statistics

 Through the Skewness figures of the return series, it can be satisfactorily assumed that

the selected scripts can be use for valuation as their values lie within the critical range

which is 1.415 for rejection region of .05 means the acceptance region can be taken as

95%, which is essential for estimation using Residual Income Model. Similarly, through

the kurtosis figures of the return series, it can be satisfactorily assumed that the

selected scripts can be use for valuation as their values lie within the critical range of

-1.96 to 3.69 for rejection region of .05 means the acceptance region can be taken as

95%, which is essential for estimation using Residual Income Model. So, the taken

sample was successful for application for Residual Income Model or to tell the

behaviour of overall sector or market.

 One can also observe the normal behaviour of return series from mean, range,

standard deviation and variance values. For a normal equation all the descriptive

values for expected and actual values lie on the same plane. Here also, it was found that

mean, range, standard deviation and variance values are almost equal for both the years

2008 as well as 2009, given few variations due to volatile behaviour of the market.

 Casually estimating the volatility using standard deviation, it was found that volatility is

high for different scripts in the year 2009 as compared to the year 2008. However,

comparing the values of standard deviation between actual and expected values, it was

found there isn’t any significant difference.

5.5 Empirical Analysis

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 The Residual Income Model is fitted for the given data series by sequentially following

the procedure mentioned earlier, Refer chapter IV. For the analysis, the model is fitted

to collected data series of each of the sixteen scripts separately for the time frame of

two years, i.e. 2009 and 2008. Hence, to arrive at any conclusion, sixteen market values

for two years were estimated and compared with the actual value pertaining in the

market. After checking for inter relationship of the return series for each script, it was

found that maximum number of scripts had given the related values to actual data. The

two values, i.e. expected values were actual values are plotted against each other to find

the similarity between the values and the graphs are shown in Appendix VIII.

The statistical interdependency between expected and actual values for two years, i.e.

2009 and 2008, was calculated with the help of chi-square test using SPSS 17.0. The

result of the chi-square test is shown in appendix VII. In the result, it was found that

likelihood ratio and linear by linear association are lie within the critical range defined

for specified degree of freedom. The value of Pearson chi-square test was found to be

little bit above then the critical value for 5% rejection region, but this value can be

accepted keeping the view of volatility of market and other external factors that also

affects the prices of scripts in the market.

For checking the consistency between expected values and actual values, the correlation

between actual values and expected values valued on the basis of Residual Income

Model was calculated separately for both the years, the correlations values were shown

in Appendix VII and were found to be positive and near to one, justifying that Residual

Income Model values and the actual values are nearly equal, and some discrepancies

occur due to other factors like sampling error or noise errors. So, the correlation values

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 justify that Residual Income Model can be suitably use to estimate of forecast the

market prices or intrinsic value of the company. Thus, it can be safely concluded that

the models passed in valuing different regular dividend paying companies listed over

Indian exchange with accuracy. Hence, the Null Hypothesis justifies.

5.6 Scope of further study

The results enunciated above and in the appendix stress on the need of development,

testing and validation of some modified version of the existing Residual Income Model

using other statistical tools and methods for further removal of discrepancies so that it

can best suits the Indian capital market completely.

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 CHAPTER 6

REFERENCES

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 Research papers

1. David Ashton, Ken Peasnell and Pengguo Wang (May, 2010), ‘Residual Income

Valuation Models and Inflation’, Bristol University, Bristol BS8 1TN, UK, Lancaster

University Management School, Lancaster LA1 4YX, Bristol University, Bristol BS8

1TN, UK. Available at [Link]

2. Kwon-Jung Kim, Cheol Lee and Samuel L. Tiras (Aug, 2009), ‘Residual Income

Valuation: A New Approach Based on the Value-to-Book Multiple’, Kyung Hee

University, Korea, Wayne State University, E.J. Ourso College of Business Louisiana

State University. Available at [Link]

3. Stefan Henschkeand Carsten Homburg (May, 2009), ‘Equity Valuation Using

Multiples: Controlling for Differences Between Firms’, Stefan Henschke, University

of Cologne, Accounting Department, Albertus-Magnus-Platz, D-50923 Cologne,

Germany. Available at [Link]

4. Pablo Fernández (Oct, 2008),’ Three Residual Income Valuation Methods and

Discounted Cash Flow Valuation’, PriceWaterhouseCoopers Professor of Corporate

Finance Camino del Cerro del Águila 3. 28023 Madrid, Spain. Available at

[Link]

5. Dan Gode and James A. Ohlson (Feb, 2006),’ A Unified Valuation Framework for

Dividends, Free-Cash Flows, Residual Income, and Earnings Growth Based Models’

Stern School of Business New York University, W. P. Carey School of Busines.

Available at [Link]

6. Gösta Jamin (Aug, 2005), ‘Investment Performance of Residual Income Valuation

Models on the German Stock Market’, Forschungsberichte of the Institute for Business

Management, Italy. Working paper No./Nr. 08/2005

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Rajat Gupta 9555487746
7. Raphaël Kahan (2005), ‘Reconciliation of Residual Income and Free Cash-flow

Valuation Models’. Available at [Link]

8. Richard P. Brief (Feb, 2004), ‘An Equivalent Form of the Residual Income Valuation

Model’ Department of Information, Operations and Management Sciences, Stern

School of Business New York University. Working paper (March).

9. John D. Martin*, J. William Petty, and Steven P. Rich (May, 2003), ‘An Analysis of

EVA and Other Measures of Firm Performance Based on Residual Income’,

Hankamer School of Business, Baylor University, Waco. Working paper no 76798-

8004

10. John O'Hanlon and Ken Peasnell (Nov, 2002), ‘Residual income valuation: Are

inflation adjustments necessary?’, Management School, Lancaster University,

Lancaster LA1 4YX, UK. Available at [Link]

11. Lynn Rees and K. Sivaramakrishnan (June, 2001), ‘Valuation Implications of Revenue

Forecasts’, Lowry Mays College & Graduate School of Business, Texas A&M

University, College Station, TX. Working paper no. 77843-4353

12. Tham (2001), ‘Consistent Value Estimates from the Discounted Cash Flow (DCF)

and Residual Income (RI) Models in M & M worlds without and with taxes’,

Fulbright Economics Teaching Program (FETP) in Ho Chi Minh City, Vietnam.

Available at [Link]

13. Robert F. Halsley (Dec, 2000), ‘Using the Residual Income Stock Price Valuation

Model to teach and learn ration analysis’, Babson College, 302 Luksic Hall, Babson

Park, MA. Issues in Accounting Education, 104-132.

14. Kobana Abukari, Vijay Jog, Bruce J. McConomy (Nov, 2000), ‘The Role and the

Relative Importance of Financial Statements in Equity Valuation’, School of

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 Business & Economics, Wilfrid Laurier University, Waterloo, Ontario, Canada. SSRN

working paper no 254972

15. Martin G. H. Wu (Oct, 2000), ‘The Strategic role of ‘Cost of Capital’ in Residual

Income Measurement’, University of British Columbia, 2053 Main Mall Vancouver,

BC Canada. Available at [Link]

16. Kenton K. Yee (July, 2000), ‘Opportunities Knocking: Residual Income Valuation of

an Adaptive Firm’, GSB and Law School, Stanford University, Journal of Accounting,

Auditing, and Finance, vol15.3 page 225

17. James A. Ohlson (Mar, 2000), ‘Residual Income Valuation: The Problems’, Stern

School of Business, New York University, New York City. Available at

[Link]

18. Xiao-Jun Zhang, ‘Conservative accounting and equity valuation’, Haas School of

Business, University of California at Berkeley, Berkeley, CA 94720-1900, US.

Available at [Link]

19. Wilcox, J.W. (1984), ‘The P/B-ROE Valuation Model,’ Financial Analysts Journal,

40, pp. 58-66.

20. Bennett Stewart, ‘The Quest for Value III’, Harper Business, 1991, pg 102-148.

Books

1. Cusatis,Patrick.J and Woolridge, [Link] a Stock: ‘The Savvy Investor's Key to Beat

the [Link] York’ :McGraw-Hill,2004

2. Damodaran, Aswath . ‘Applied Corporate Finance: A User's Manual’, New York: John Wiley

& Sons, 2005

3. Damodaran, Aswath . Investment Valuation. New York: John Wiley & Sons,2003
4. Damodaran, Aswath. Corporate Finance. New York: John Wiley & Sons, 2001
5. Damodaran, Aswath. Study Guide for Damodaran on Valuation: Security Analysis for

Investment and Corporate Finance. New York: Wiley, 1994. A supporting learning resource

for the main book

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Rajat Gupta 9555487746
 6. Hitchner, James R. Financial Valuations: Applications and Models. Georgia: Wiley, 2006
7. Koller, Tim and Goedhart, Marc .Valuation Measuring and Managing the Value of

Companies. Canada: Wiley, 2005

8. Palepu, Krishna.G. Business Analysis and Valuation: Using Financial Statements, South-

Western Educational Publishing, 1999

9. Whitehurst,David. Investment :Body, Kane [Link] York: McGraw-Hill

10. Whitehurst,David. Investment :Body, Kane [Link] York: McGraw-Hill

Websites

 [Link]

 [Link]

 [Link]

 [Link]

 [Link]

 [Link]

 [Link]

 [Link]

 [Link]

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 APPENDIX I: Selection of sector for present study

Auto Sector comprises of Automobile, Auto Component, Auto Ancillary, Tyre, Battery and other
Auto Sector
automotive components Companies.
Bank Sector Bank Sector holds only Private and Public sector Banks.
Capital Goods Sector consists of Heavy Machine manufacturers, Engineering firms, Electronics and
Capital Goods
Electric components Companies, Cables and Wire Companies, motor manufacturer ,Heavy Infra-
Sector
structure Companies, Infrastructure components companies, Defence Supply.
Consumer
In this sector all the Appliances Companies, Watch and Jewelry companies, Diamond, Plastic and Wood
Durables
Furniture Companies are included.
Sector
Cement

Sector In Cement Sector all the Cement and Cement Product manufacturing Companies are included.

Chemical
In this sector any type of Chemical manufacturer, Paint and Varnish Companies and other Chemical
Sector
related Companies are included.

Finance &

Investment This sector comprise of Housing and Auto Finance Companies, also Holdings and Investments

Sector Companies which invest especially in Equities.

FMCG Sector This sector include companies from Cigarette manufacture to Biscuit, Detergent, Oil, Mineral water and

Leather Products Companies

Health-care
Health Care Sector comprises of Drugs and Pharmaceuticals Companies, Medial related research
Sector
companies, Medical Equipment Manufacturer and Hospitals.

In this Sector Software services and solution Companies, BPOs, and IT Marketing and Outsourcing
IT Sector
companies it also includes, Communication, Teleservices, and Technical firms.
Metal Sector In this sector all the Steel, Copper and Aluminum Companies are included.
Oil & Gas
In this sector Oil Refineries, Petroleum, Engine Oil manufacturers are included.
Sector
Power Sector Power Sector comprises of Power Generation Companies through any means.
Textile Sector This sector includes Cloth mills, Cotton Yarn and Retailing firms.
This sector includes all the Construction and Sales & Purchase Companies, Shipping firms, Spirit,

Other Sector Alcohol and Breweries firms, Sugar& Paper Mills, fertilizer companies, Hotels Organization, Logistics

and Transport Companies, Telefilm Production Companies, Entertainment and News Channels

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 50
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 APPENDIX II : List of initially selected companies

Pharma Sector IT Sector

aurobindo pharma Cmc
cadila healthcare
Financial Technology
cipla
dr reddy HCL
Fdc Infosys
Oracle
Glenmark
Ipca Patni
lupin Polaris

Mindtree Rolta
Tcs
Morepan Techmahindra
unichem
Natco Pharma wipro
piramal health

Sunpharma
torrent pharma

Wockhardt

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 APPENDIX III: List of final Selected Companies

Pharma Sector IT Sector

aurobindo pharma Cmc
cadila healthcare Infosys
dr reddy Oracle
Fdc Polaris
Ipca Tcs
lupin techmahindra
piramal health unichem
torrent pharma wipro

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 APPENDIX IV

Descriptive Statistics for Pharmaceuticals sector year 2009

Minimu Maximu Std.
N Range m m Mean Deviation Variance Skewness Kurtosis
Statisti Statisti Statisti Std. Statisti Std.
c c Statistic Statistic Statistic Statistic Statistic c Error c Error
expected 8 1290.4 61.92 1352.39 696.228 468.5814 219568.53 .306 .752 -1.155 1.481
7 8 1 4
actual 8 1546.8 80.55 1627.35 751.281 524.0350 274612.70 .487 .752 -.646 1.481
0 3 2 3
Valid N 8
(listwise)

Descriptive Statistics for IT sector for year 2009

Minimu Maximu Std.
N Range m m Mean Deviation Variance Skewness Kurtosis
Statisti Statisti Std. Statisti Std.
c Statistic Statistic Statistic Statistic Statistic Statistic c Error c Error
expected 8 2330.5 123.05 2453.55 1175.675 837.5944 701564.47 .240 .752 -1.503 1.481
0 0 6 7
actual 8 2452.0 163.90 2615.95 1149.937 878.8941 772454.85 .897 .752 -.512 1.481
5 5 1 3
Valid N 8
(listwise)

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 APPENDIX V

Descriptive Statistics for Pharmaceuticals sector for the year 2008

Minimu Maximu Std.
N Range m m Mean Deviation Variance Skewness Kurtosis
Statisti Statisti Statisti Std. Statisti Std.
c c Statistic Statistic Statistic Statistic Statistic c Error c Error
expected 8 669.16 41.47 710.63 334.620 228.6604 52285.57 .373 .752 -.865 1.481
0 0 8
actual 8 650.25 34.30 684.55 291.150 209.3045 43808.40 .956 .752 .581 1.481
0 7 1
Valid N 8
(listwise)

Descriptive Statistics for IT sector for the year 2008

Minimu Maximu Std.
N Range m m Mean Deviation Variance Skewness Kurtosis
Statisti Statisti Statisti Std. Statisti Std.
c c Statistic Statistic Statistic Statistic Statistic c Error c Error
expected 8 1217.1 93.89 1311.07 495.808 424.0906 179852.89 1.273 .752 .735 1.481
8 8 6 0
actual 8 1278.8 45.05 1323.90 456.200 412.7566 170368.06 1.531 .752 2.337 1.481
5 0 6 3
Valid N 8
(listwise)

54
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 APPENDIX VI

CALCULATION OF ROE FOR 16 SELECTED REGULAR DIVIDEND PAYING

COMPANIES FOR THE PERIOD 2002-2010

Aurobindo Pharma Cadilla Healthcare

year net income Equity ROE net income equity ROE

after tax Capital after tax capital

2002 77.5125 238.5 32.5 101.393656 287.56 35.26

2003 23.366068 230.89 10.12 51.530204 221.54 23.26
2004 16.28951 60.22 27.05 40.40152 165.58 24.4
2005 14.85715 59.5 24.97 34.361523 135.87 25.29
2006 12.529881 152.99 8.19 27.177018 111.29 24.42
2007 6.063624 133.56 4.54 21.510819 94.47 22.77
2008 26.73684 135.72 19.7 24.435801 85.41 28.61
2009 49.167955 213.31 23.05 12.791034 76.41 16.74
2010 32.89211 172.21 19.1 11.219184 91.66 12.24

Dr. reddy FDC

year net income Equity ROE net income equity ROE

after tax Capital after tax capital

2002 205.682956 1358.54 15.14 8.86836 28.1 31.56

2003 138.755384 1245.56 11.14 4.689432 22.32 21.01
2004 27.670725 267.35 10.35 3.22272 17.28 18.65
2005 84.436335 238.05 35.47 3.448236 16.61 20.76
2006 23.116718 269.74 8.57 3.352464 15.02 22.32
2007 7.029152 253.76 2.77 2.546872 12.28 20.74
2008 37.25274 253.42 14.7 7.638864 20.64 37.01
2009 54.323632 226.16 24.02 3.802299 16.27 23.37
2010 84.312095 184.45 45.71 4.205954 14.66 28.69

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 IPCA Lupin

year net income Equity ROE net income equity ROE

after tax Capital after tax capital

200

2 22.067776 79.84 27.64 138.083942 415.54 33.23

200

3 18.280968 124.87 14.64 92.464032 298.56 30.97

200

4 60.58614 234.83 25.8 43.17897 134.85 32.02

200

5 53.1358 189.5 28.04 30.282962 108.58 27.89

200

6 26.21658 148.2 17.69 49.504272 155.04 31.93

200

7 34.323912 130.41 26.32 21.646872 121.68 17.79

200

8 65.661132 201.91 32.52 38.698712 107.08 36.14

200

9 53.17767 158.55 33.54 18.98659 93.53 20.3

201

0 24.59939 124.87 19.7 17.823732 80.76 22.07

Piramal Healthcae Torrent Pharma

year net income Equity ROE net income equity ROE

after tax Capital after tax capital

200

2 147.1664 446.5 32.96 45.0264 175.2 25.7

200

3 90.646094 363.02 24.97 50.139128 176.92 28.34

200

4 15.427828 52.28 29.51 17.843186 60.22 29.63

200

5 9.641922 50.14 19.23 12.934464 48.48 26.68

200

6 10.938642 45.98 23.79 7.48202 41.11 18.2

200 5.790831 26.31 22.01 24.352929 149.13 16.33

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 7
200

8 58.468828 106.52 54.89 30.47408 135.2 22.54

200

9 60.363684 117.99 51.16 25.033267 118.81 21.07

201

0 22.67552 106.96 21.2

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 Cmc Infosys

year net income Equity ROE net income equity ROE

after tax Capital after tax capital

200 30.1 29.1

2 29.32524 97.2 7 746.74755 2563.5 3

200 30.7 37.1

3 23.559012 76.54 8 1481.823772 3985.54 8

200 32.9 36.2

4 22.576808 68.56 3 87.448242 241.17 6

200 28.9

5 18.483978 63.87 4 82.44663 196.77 41.9

200 13.1 39.8

6 18.397314 140.01 4 100.678371 252.39 9

200 13.7 44.8

7 15.609244 113.77 2 86.735664 193.52 2

200 33.9 40.6

8 34.873044 102.84 1 198.367884 487.63 8

200 34.4 38.7

9 27.548556 79.99 4 167.289164 431.38 8

201 40.1

0 24.501764 60.98 8

oracle financial services Polaris

year net income Equity ROE net income equity ROE

after tax Capital after tax capital

200 17.1 17.7

2 53.550288 311.52 9 15.621952 88.16 2

200 22.0 17.1

3 53.387456 242.56 1 12.455118 72.54 7

200 15.7

4 52.298051 331.63 7 5.990037 66.63 8.99

200 18.8 14.4

5 53.48696 283.6 6 8.823492 61.02 6

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 200 19.3

6 35.016432 180.87 6 1.382006 55.06 2.51

200 10.4

7 28.90755 152.95 18.9 5.656392 54.18 4

200 19.7 14.8

8 25.11342 127.35 2 7.473291 50.19 9

200 26.7 16.4

9 57.357402 214.26 7 13.105968 79.72 4

201 31.5 28.2

0 43.803375 138.75 7 13.1871 46.68 5

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 TCS Tech Mahindra

year net income Equity ROE net income equity ROE

after tax Capital after tax capital

200 2865.8 31.2

2 1132.01075 5 39.5 73.8444 236 9

200 2159.8 63.4

3 835.213995 5 38.67 101.320236 159.66 6

200 66.6

4 59.280585 124.67 47.55 69.02274 103.56 5

200 72.0

5 49.723912 90.44 54.98 54.59949 75.78 5

200 40.7

6 74.6021 122.6 60.85 24.109932 59.18 4

200 108.7 24.9

7 78.767625 72.43 5 11.92111 47.78 5

200

8 0.886312 12.92 6.86

200

9
201

Unichem Wipro

year net income Equity ROE net income equity ROE

Capita

after tax l after tax capital

200 23.6 4568.5 32.4

2 131.74009 556.1 9 1481.571036 2 3

200 26.3 3548.6 24.7

3 127.7178 485.25 2 876.871415 5 1

200 35.07948 180.45 19.4 368.885475 1256.8 29.3

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 4 4 5 5
200 26.8 36.1

5 28.343532 105.72 1 204.328435 565.85 1

200 29.4 35.7

6 26.667403 90.49 7 55.869652 156.41 2

200 26.8 35.5

7 16.707992 62.32 1 26.717413 75.07 9

200 32.5 26.7

8 13.6836 42 8 43.171908 161.33 6

200 27.7

9 32.16831 129.19 24.9 41.479622 149.53 4

201 33.3 39.2

0 38.523015 115.65 1 43.820137 111.53 9

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APPENDIX VII

Chi-Square Tests for all values

Asymp. Sig.

Value Df (2-sided)
a
Pearson Chi-Square 992.000 961 .237

Likelihood Ratio 221.807 961 1.000

Linear-by-Linear 26.655 1 .000

Association
N of Valid Cases 32

a. 1024 cells (100.0%) have expected count less than 5. The minimum

expected count is .03.

Descriptive Statistics for the year 2009

Minimu Maximu Percentiles

N Mean Std. Deviation m m 25th 50th (Median) 75th

Actual 16 950.6094 728.70571 80.55 2615.95 428.2125 804.6250 1323.9625
Expected 16 935.9519 700.82836 61.92 2453.55 390.7425 752.1250 1428.2525

Symmetric Measures for the year 2009

Asymp. Std.

Value Errora Approx. Tb Approx. Sig.

Interval by Interval Pearson's R .898 .043 7.633 .000c
Ordinal by Ordinal Spearman Correlation .947 .035 11.037 .000c
N of Valid Cases 16

a. Not assuming the null hypothesis.

b. Using the asymptotic standard error assuming the null hypothesis.
c. Based on normal approximation.

62
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 Descriptive Statistics for the year 2008
Minimu Maximu Percentiles

N Mean Std. Deviation m m 25th 50th (Median) 75th

actual 16 373.6750 327.43460 34.30 1323.90 173.6000 268.3750 526.4625
expected 16 415.2144 339.49929 41.47 1311.07 165.9450 343.6800 511.4525

Symmetric Measures for the year 2008

Asymp. Std.

Value Errora Approx. Tb Approx. Sig.

Interval by Interval Pearson's R .963 .021 13.308 .000c
Ordinal by Ordinal Spearman Correlation .924 .055 9.010 .000c
N of Valid Cases 16

a. Not assuming the null hypothesis.

b. Using the asymptotic standard error assuming the null hypothesis.
c. Based on normal approximation.

63
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 APPENDIX VIII

Comparison of expected and actual values for Pharmaceuticals Sector for

the year 2009

1800
1600
1400
1200
1000
800
600
expected
400 actual
200
0

Comparison of expected and actual values for Information Technology

Sector for the year 2009

3000

2500

2000

1500 expected
actual
1000

500

0
cmc infosys oracle polaris tcs techmahindra unichem wipro

64
Rajat Gupta 9555487746
 Comparison of expected and actual values for Information Technology

Sector for the year 2008

800
700
600
500
400
300
200 expected
100 actual
0

Comparison of expected and actual values for Information Technology

Sector for the year 2009

1400

1200

1000

800
expected
600 actual

400

200

0
cmc infosys oracle polaris tcs techmahindra unichem wipro

65
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