Volume 1, Issue 1, 2007    
       
 

Informativeness of Accounting Information to Shareholders in Egypt: Perspectives from the Most Actively Trading Firms

   
       
 

Mohamed Hassan Abdel-Azim, UAE University, Mohamed.Hassan@uaeu.ac.ae
Tarek Ibrahim Eldomiaty, UAE University, T.Eldomiaty@uaeu.ac.ae

   
       
 

Abstract

This study examines the informativeness of accounting information to three classes of shareholder value; high, medium and low. The results indicate that shareholder value adjusts positively a target level according to the five categories of financial ratios. This shows a high degree of informativeness of accounting information to shareholders in Egypt. In general, the results show that shareholders in the three classes are quite affected by the firms’ assets efficiency and profitability. In addition, shareholders do not appreciate liquidity and cost elements. Shareholders in the low class in particular do not appreciate the benefits of costless financing and prefer short-term debt over long-term debt financing.

I. Introduction

The accounting information is considered the basic type of information to be released to firms’ stockholders. The literature utilized many forms of accounting information, the most common of which is the financial ratios that date back to over a century ago. Financial ratios provide the basic accounting information to various decision makers. Many studies assumed a close association between certain accounting information and stock market characteristics such as the effects of accounting information on stock returns and on stock risk. This association implies a degree of informativeness to some extent. That is, firms’ investors are influenced, with varying degrees, by the revealed information.

In this study, the informativeness of the accounting information is examined for three classes of firms which are high, medium and low market-to-book ratio as an indicator of shareholder value. Studies such as Peasnell,, 1982 and  Östermark & Aaltonen, 1995 examined certain accounting information (in the form of financial ratios) that are quite sophisticated to the typical investors to reach and to be influenced by. In this study, the true meaning of the informativeness is examined using the most usable forms of financial ratios.

Why accounting information in transition market?

The study of accounting information is significant to transitional markets for two reasons. First, transitional markets are generally less efficient than developed markets (Magnusson and Wydick 2002; Smith, et al., 2002; Jefferis and Smith, 2005; Marashdeh, 2005, 2006; Abuzarour, 2005; Simons and Laryea, 2006). This requires examining the extent to which accounting information is influential and informative in these markets. Second, transitional markets are characterized by a relatively high degree of information asymmetry (Cornelius, 1993; Economic and Social Council. 2004). This requires the examination of the extent to which the accounting information helps lessen the overall asymmetry. In this case, accounting information can play this role if this type of information is informative enough to the stockholders for which the shareholder value is considered as the dependent variable. Accordingly, the major objective of this study is to explore the extent to which the accounting information affects the shareholder value measured by the market-to-book ratio. It is worth to note that the MB ratio is of significant practical use in transitional stock markets. Since this ratio compares the market value of a stock to its book value, it offers, then, a practical criterion on the extent to which the transitional stock market is developing and progressing. Therefore, the MB ratio can be adequately be used in the case of Egypt stock market being considered in a transitional stage.

Research Questions

The methodology in this paper is designed to measure the quantitative effect of financial accounting information in the case of the actively trading firms in Egypt. The measurement is related to three shareholder value classes to show the extent to which accounting information affects each class. Therefore, this paper is to find answers to the following question: what is the speed of adjusting shareholder value to a target value in association with financial accounting information? It is worth noting that the speed of adjustment shows the extent to which the financial accounting information is related to shareholder value. This is quite useful for policy as well as corporate decisions makers when setting policies for financial disclosure and ultimately is to be considered as a basis for a future comparison with other transitional markets.

The contribution of the paper can be outlined as follows. First, this study is the first to address the issue of shareholder value in Egypt as a transition economy.[1] Second, contrary to other related studies that address the shareholder value as a single level, this study differentiates between three shareholder value classes to show the extent to which accounting information is informative. The three classes view is adopted since it was realized that considerable differences exist between the three classes. The descriptive statistics of the three MB classes show that the mean of each class is 5.93, 3.32 and 1.19 for the high, medium and low shareholder value classes respectively. The standard deviation for each class is also quite indicative; 6.94, 2.54, and 0.85 for the for the high, medium and low shareholder value classes respectively. This indicates that the differences between the three classes are significant and, therefore, the characteristics of each class are expected to provide meaningful and distinctive results. Third, differently from other related studies, this study examines the informativeness of accounting information in a dynamic manner utilizing the properties of the partial adjustment model.

The paper is organized as follows. Section II discusses the links between and among the accounting information, stock market characteristics and shareholder value. Section III describes the research variables. Section IV discusses the data and methodology of the study. Section V describes the results and discusses the analysis respectively. Section VI concludes.

II.  Accounting Information, Stock Market Characteristics and Shareholders Value

The literature on corporate financial fundamental analysis is one of the well-established fields of study in the finance theory (Graham et al., 1962; Foulke, 1968; Bellemore and Ritchie, 1974; Strong, 2001; Corrado and Jordan, 2002; Li, 2003). The literature has been trying to examine the interdisciplinary of three fields of study: financial management, corporate finance and investments. These fields have always been related to each other through the two valuation systems: the public accounting reports and security market (Zellner, 1988; Östermark and Aaltonen, 1995). The common form of fundamental information is financial ratios that have been used based on the assumption that they reflect events that have affected the firm’s operations. These events include (a) those occurred within the factor input markets and (b) those occurred within the output markets of the firm. These events may be specific to a particular industry or maybe economy-wide events (Gonedes, 1973).

As financial ratios have been used extensively for corporate financial reporting, it is now a common understanding that if corporate financial reporting is to be adequately supportive of investment decision making, then clearly it must provide information useful to the formation of risk and return assessment (Farelly et al., 1985). On the use of fundamental information, Li (2003) used financial statement information to develop a model of firm’s long-term earnings growth which provides reliable financial indicator that distinguishes between high- and low-growth firms.

This study extends the relationship between the fundamental analysis and stock market characteristics to address one more dimension, which is shareholder value being commonly measured by the market-to-book ratio. The BM (or alternatively MB) ratio is one of the fundamentals that have been exposed to an extensive empirical examination. The BM ratio is the relationship between the book value of common equity to the market value of common equity. This relationship is typically expressed in the form of B/M ratio, rather than M/B ratio, for some practical reasons. As Beaver and Ryan (1993) indicate, the book-to-market form is used because the book value of common equity can take on small values or negative values. If book value is in the denominator of the ratio, problems of interpretation arise, while no particular problems arise if book values appear in the numerator. Therefore, the indications of B/M ratio, or M/B ratio, are the same when the book values are not discrete. It is established in the theory of finance that the BM ratio reflects the relationship between firm’s historical value of its assets and the economic value, or market assessment, of common equity. This ratio has long been recognized as an indicator to many financial characteristics such as:

(a)     An indicator to expected return on equity being taken as an association between price to book value (Preinreich, 1932; Edwards and Bell, 1961; Graham et al., 1962; Peasnell, 1982).

(b)     A growth indicator (Preinreich, 1932; Kay, 1976; Brief and Lawson, 1992).

(c)     Is determined by leverage (Graham, et al., 1962).

(d)     An indicator to the mispriced stocks (Rosenberg et al., 1985).

(e)     Explains mean stock returns (Chan et al., 1991; Fama and French, 1992).

(f)      A tool used in a contrarian investment strategy, e.g., a ‘value investment strategy or value stocks’ versus a ‘glamour investment strategy or glamour stock’ (Lakonishok et al., 1994).

(g)     A measure of the value created to the shareholder (Shapiro and Balbirer, 2000).

(h)     A ‘margin of safety’ (Bodie et al., 2003), which indicates that analysts sometimes consider the stock of a firm with a low MB ratio to be a “safer” investment, seeing the book value as a “floor” supporting the market price because the firm always has the option to liquidate its assets for their book values. However, this view is questionable because some firms do sometimes sell for less than book value.

 

III.  Research Variables and Proxies
 
Dependent Variable

The dependent variable is the firm’s market-to-book ratio. This ratio is recognized as a measure of shareholder value. In this study, the M/B (rather than B/M) ratio is used as the dependent variable for two reasons: (1) it is a common measure of the value created to shareholders, and (2) the data used in this study does not contain negative values that can cause any interpretation problems.

Independent Variables
 

Primarily, the independent variables include the financial ratios as a form of accounting information that

reflects firm’s fundamentals. The literature on the use of accounting information is extensive and does not

include a consensus of the number, type and measurement of the financial ratios to be used. Therefore,

through considerably surveying the relevant literature this study is examining a total of eighty-nine financial

ratios. The financial ratios examined in this study are chosen on the basis of what follows.
 

1-     Popularity: the ratios that are commonly examined in previous studies in the literature. This also includes the ratios discussed in the ‘Corporate Finance,’ ‘Financial Management’ and ‘Investment’ textbooks that include financial ratio analysis as one of the main topics (Foulke, 1968; Myer, 1969; Johnson, 1971; Soldofsky and Olive, 1974; Bellemore and Ritchie, 1974; Lev, 1974;Van Horne and Wachowicz, 1995; Radcliffe, 1997; Emery and Finnerty, 1997; Besley and Brigham, 2000; Shapiro and Balbirer, 2000; Strong, 2001; Corrado and Jordan, 2002; Bodie et al., 2003; Fraser and Ormiston, 2004). This is not an exclusive list of the financial ratios rather than a list of the most common and recent texts in the literature. The relevant references are extensive. For example, Beaver (1966), when choosing the ratios, examined nineteen financial statement analysis texts. Beaver (1968) examined up to thirty-six sources including ten financial statement analysis texts, six general finance texts, five security analysis texts, eight journal articles dealing with ratio analysis, four accounting texts, and three government studies of the use of the ratios. Courtis (1978) examined ten textbooks in accounting and finance. In this study, the authors have added eight textbooks in corporate finance and financial management.

2-     Convenience: the ratios that are commonly mentioned in (or easily calculated using) corporate reports and/or financial analysts reports. The financial ratios commonly discussed in Financial Management textbooks are also considered a good basis. This criterion allows examining the extent to which the on-reach financial ratios reflect corporate fundamentals and, therefore, affect investors behavior

3-     Scope: the financial ratios are basically corporate rather than industry ratios.

4-     Availability: the financial ratios are available for all firms included in the study for seven years. It is worth noting that number of the asset utilization ratios and dividends-based ratios are not included in the examined ratios due to (a) the unavailability of relevant asset utilization data, and (b) the firms included in the sample suffer from disruptions in dividends payments.

 

IV.   Data and Methodology

Data

The data used in this study are obtained from Kompass Egypt Financial Year Book (Fiani & Partners) and the stock market publications in Egypt. The data cover the six years 1998-2003. The total number of firms included in the study is 99 non-financial firms. Firms were selected based on two criteria. First, the non-financial firms amongst the 100 actively trading firms in Egypt stock market. Second, the non-financial firms amongst the 100 firms with the highest market value.

The firms included in the study were then divided into three groups: firms with high, medium, and low MB ratio respectively. For each firm, the average MB for seven years was calculated. Firms’ average MBs (scaled by the growth rate of MB for seven years) were arranged in a descending order, then, the sum of all was divided by three (this is to produce three classes). Starting from the first firm with the highest MB, the first group of firms was chosen whose sum of MB equal to the sum of MB divided by three. So were the second and the third groups chosen. As a result, the first group with the highest MB includes twenty-one firms, the second group with the medium MB includes twenty-two firms, and the third group includes fifty-six firms. The descriptive statistics of the ratios included in this study are shown in table (A) in the appendix.

Methodology
 

(a) Estimation: The methodology examines the effects of the accounting information (financial ratios) on the firm’s MB ratios that are classified into three levels: High, medium and low MB. The properties of the partial adjustment models capture the effects under consideration. The estimating equation of the partial adjustment autoregressive model takes the form that follows. A more detailed discussion about the structures of partial adjustment models is further explained in Kennedy (1998, pp.143-156) and Greene (2000, pp.720-724).


[1] This is to the best knowledge of the authors according to a survey of other related studies.

The usefulness of studying the effects of accounting information is met by the properties of the partial adjustment model. That is, in general, sometimes the economic theory specifies that the desired rather than the actual value of the dependent variable is determined by the independent variables(s). But, this relationship cannot be estimated directly because the desired level of the dependent variable is unknown. This dilemma is usually resolved by specifying that the actual value of the dependent variable adjusts or is adjusted to the desired level according to some simple rule. In the partial adjustment models, the actual value adjusts by some constant fraction of the difference between the actual and desired values (Kennedy, 1998). The partial adjustment formulation offers a number of significant practical advantages (Greene, 2000) that (1) It is intrinsically linear in the parameters (unrestricted), and (2) its disturbance is non-autocorrelated if the error term was to begin with. As such, the parameters of this model can be estimated consistently and efficiently by ordinary least squares in regression equations.

(b) Sensitivity Analysis (Robustness of the Estimates):

In the literature of fundamental analysis, selective reporting is highly likely given the very large number of potential regressors. For this, Extreme Bound Analysis (EBA) avoids the pitfalls of selective reporting by directly incorporating prior information and following a systematic approach to testing the fragility of coefficient estimates. As indicated by Leamer (1983, 1985), Leamer and Leonard (1983) and Levine and Renelt (1992), the EBA uses equation that takes the form



II. Results and Discussion

Table (1) shows the results of regressing the fundamental financial ratios against MB ratios (as a proxy fro the shareholder value). The results are divided into two parts. Part (a) discusses the estimates of the regression coefficients and part (b) discusses the robustness (the sensitivity analysis) of the estimates.

(a) Estimates of the Stepwise Regression Coefficients:

Table 1 shows the significant accounting information contained in the financial ratios and their association with the three shareholder value classes. The financial ratios are classified into the common five categories. This aims at showing the type of accounting information that contributes the most to shareholder value classes.




Regarding the speed of adjustment , the results show that the financial ratios help adjust shareholder value to a target level. This is true since all coefficients of  are positive and statistically significant. This is considered one of the fundamental results of this study since it is obvious that shareholder value is positively associated with accounting information. The values of the coefficients of the speed of adjustments are quite important. In the high shareholder value class, the financial ratios help adjust high shareholder value to the target value at a speed of 0.5263, the next is the low shareholder value which adjusts at a speed of 0.2813, and then the medium shareholder value which adjusts at a speed of 0.2255. This indicates that the accounting information contained in the financial ratios contribute the most to the high, the low, and the medium shareholder value respectively. It is worth noting that the speed of adjustments in the medium and low classes are very close to each other (0.2255 and 0.2813 respectively). This could be explained that shareholders in these two classes utilize the financial ratios, hence, accounting information, by the same manner relatively.  

The results also show that shareholder value classes are associated with certain categories of financial ratios. The high shareholder value class is positively associated with two categories: assets efficiency and profitability. The medium shareholder value is associated with three categories: solvency, asset efficiency and profitability. The low shareholder value is associated with the five financial categories. The signs of the estimates in the medium and low classes are quite informative as well. In the medium class, the negative coefficient of cash and receivables/expenditures (CRTE) indicates that high liquidity is not appreciated by the shareholders. The same is true for the negative coefficient of accounts payable turnover (APT). Since the latter ratio is calculated as cost of goods sold/accounts payables, the negative sign indicates that the shareholders do not appreciate the high cost elements especially the cost of goods sold. The positive signs of assets annual growth and profitability ratios indicate that these two items contribute to shareholder value positively. In this case, a quite similarity exists between the high and medium shareholder value classes. The results also show that the Gas, Oil & Mining Industries is associated with a decreasing shareholder value in the medium class.

In the low shareholder value class, the negative estimates of the fixed assets turnover (FAT) and working capital/cash flow (WCCF) indicate that shareholder in this class do not appreciate the operational roles of sales, fixed assets and working capital. This is why these firms are associated with low shareholder value. On the other hand, the negative coefficient of inventory/current assets (InvCA) has a similar implication as in the medium class that shareholders do not appreciate firms’ liquidity. The negative coefficient of cost of sales/sales (COGSS) also has a similar implication as in the medium class that shareholders do not appreciate cost elements. Regarding the leverage ratios, the negative coefficient of current liabilities/working capital (CLWC) indicates that shareholders in this class do not appreciate the benefits of costless financing such as current liabilities. Nevertheless, the positive coefficient of short-term debt financing (STDR) indicates that shareholder favor short-term debt financing rather than long-term debt. This also shows that the viable financing source is the short-term debt. The estimates of profitability ratios show the operational and investment trends in the low shareholder value class. That is, the positive coefficient of market value added (MVA) and growth of EBIT per share (GEBIT) indicate that shareholders are interested in the value of their investments and in the firms’ operational prospect such as the growth of earnings before interest and tax. On the other hand, the negative coefficients of retained earnings ratio (REA) and stock return (SR) provide evidence on that claim. That is, shareholders in the low class do not prefer retained earnings and, at the same time, a decreasing stock return is associated with low shareholder value.

Regarding the firm-specific variable, the positive coefficient of the size dummy in the low shareholder value class shows that large size firms are associated with low shareholder value. This result meets the general trend observed in Egypt stock market which has been suffering from decreasing market value and market capitalization during the period of this study. As for the industry type, three industries (Agriculture & Fisheries, Food & Beverages, Mills & Storages Industries) are associated with the low shareholder value and another three industries (Chemicals & Fertilizers, Engineering & Electrical, Utilities & Services Industries) are associated with a decreasing shareholder value.

(b) Robustness of the Estimates (Sensitivity Analysis)

The sensitivity analysis focuses on the variables that refer to the speed of adjusting shareholder value
 [
] to a target level [] in the partial adjustment model. These variables show the extent to which shareholder value adjusts to a target level according to the content of accounting information contained in the financial ratios. Table (2) includes the results of the sensitivity analysis.




The results of sensitivity analysis show a considerable degree of consistency. The estimates of the speed of adjusting  shareholder value are robust at the three shareholder value classes. This means that the estimates of speed of adjustment will not vary (stable) according to the variations in firms’ five categories of financial performance. That is, the accounting information is quite informative to all shareholder value classes.

A sensitivity analysis is also carried out to the firm-specific variables. This is to add more robustness to the results. Two reasons for doing this further analysis are outlined. First, from a methodology point of view, the firm-specific variables are used to show the extent to which firms characteristics can influence the results. That is, whether the results are affected by factors other than the variables under consideration. Second, according to the methodology of this paper, it is quite informative to see whether firm-specific variables are associated with shareholder value classes robustly.





 

The results in table (3) also show that the firm-specific variables (which appear in the medium and low shareholder value classes only) are robust. This means that those firms’ characteristics are quite stable and will not affect the speed of adjusting shareholder value in the medium and low classes.

II.  Conclusion

This study attempts to quantify the informativeness of financial accounting information (contained in the financial ratios) in association with three shareholder value classes. In general, the results show that the financial accounting information plays a significant role to the high and medium shareholder value classes since shareholders in these classes appear to be interested in the growth of total assets and profitability, which is an indicator of long-term prosperity. Nevertheless, the accounting financial information plays a limited role to the low shareholder value class. That is, shareholders in latter class appear to be interested in firm’s liquidity and leverage levels rather than long-term growth and profitability. In addition, it is worth to note that the responses of the shareholders in the high and medium classes are converging relatively to the extent that the results of these two classes can be regarded jointly as if they belong to one class. This does not mean that the classification of shareholder value into three classes beforehand was not justified. Unless the three classes’ classification was not attempted, we would no have reached this conclusion regarding the responses of shareholders in the low class in comparison with those in the high and medium classes.

Regarding the use of the ‘Partial Adjustment Model,’ it is worth noting that this technique (along with the three classes’ classification) turned out useful in finding out the diversion in shareholders interests and responses. Therefore, this technique is quite relevant to the nature and purpose of this study. Taking into account that the first order of the dependent variable (Yi,t-1 and Yi,t) is examined, the period of six years, although not optimal (from a theoretical point of view), but can be considered quite adequate to produce meaningful results.

In this regard, the diversion is shareholders interest and responses leads to the realized considerable instability in the Egyptian stock market and, eventually, contributes to the market inefficiency. This is evidenced by other previously mentioned studies of stock market inefficiency in Egypt. In addition, the results show that firm-specific variables (size and industry type) do matter to the low shareholder value class relatively. This adds to the informativeness of the accounting information since it is observed and well known that most of the industries in transitional market in general, and in Egypt, in particular, are associated with low shareholder value due to elements of market inefficiency. This conclusion is supported by the results of the sensitivity analysis of the firm-specific variables where all estimates are found robust.

Policy Implications

On the policy level, the issue of financial accounting informativeness is to be related to the issue of financial disclosure. That is, the findings of this study suggest that financial disclosure is to focus of the firms’ growth prospects and profitability. These two factors are found highly significant to the high and medium shareholder value classes. In addition, policy-wise, financial reporting is to play an effective role by narrowing the low shareholder value class and expanding the high and medium classes. The release and analysis of firms’ growth and profitability related financial information can help reach and improve this objective substantially. In addition, since financial ratios, and generally, financial information are known to affect shareholders decision, the findings of this study show that the release of firms’ growth and profitability information is highly supported by shareholders.

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