Case III: Empirical Assignment
Abstract
In this case study, an investment strategy will be given for the period between April 2017 and the end of
2018 based on accounting information and stock returns of the S&P 500 for the year 2016.
Leverage
The leverage is for many investors essential to look at when determining an investment strategy.
The most common measure for the leverage is said to be the financial-debt-to-assets (FD/AT) ratio.
However, the appropriateness of using the FD/AT as an indicator for leverage is to be doubted. The
problem lies with the fact that non-financial liabilities are taken into account. Therefore, we used the
financial-debt-to-capital (FD/CP) ratio and the total-liabilities-to-assets (LT/AT) ratio as proxies for the
leverage (both in terms of market and book values). Then a regression is produced using the following
variables: equity (levered) beta, return on assets (ROA), market-to-book (M/B) ratio, profitability of the
firm (sales growth), the tangibility of the assets, net investments, Research & Developments expenses and
a dividend dummy, to find out what the effect of these variables are on the leverage.
As seen in table 4, the coefficients differ from each other when looking at the market and the
book value. The most interesting part is the M/B ratio, which changes from being positive when using the
book value to being negative when using the market value. The M/B ratio is often used as an indicator of
whether a firm is a value firm or a growth firm. A value firm has stocks that are undervalued by the
market prices, whereas a growth firm is using every resource to innovate and expand their products or
services. Because the value firms are undervalued, it has a lower book debt, but a higher market debt.
This explains the difference in values between the market values and book values.
In contrast to the M/B ratio, the equity beta is negative when using book values and positive
when using market values. Equity beta is an indicator for systematic risk of a stock, which explains the
positive correlation when using market values, because more systematic risk is present in the market.
Return on assets has as expected a significant negative correlation with the leverage ratios. More
debt leads to a lower return on assets.
The tangibility of the assets stays being negative correlated regardless of the leverage measure
used. More tangible assets does not necessarily come with more leverage, as many papers suggested to be
the case.
The regression shows that net investments increase when more debt is attracted. A significant
positive correlation can be seen with every leverage measure. Thus, a great proportion of the firm’s
, investments are done with debt.
Almost all the independent variables in Table 4 are highly significant. There are some exceptions,
for example the equity betas in regression (1) seems to be insignificant. Also, the tangibility in estimating
the market value leverages seem to be insignificant. Overall, the independent variables are significant
within the regression. Therefore, it can be concluded that the independent variables are very powerful in
estimating the leverages.
Validation
In order to make sure that the obtained results from the regressions in Table 4 are valid, it is
necessary to test for the different industries in the dataset. This is done by reproducing the regressions
from Table 4 using industry fixed effects, which can be found in Table 5. The coefficients differ from
each other, some more than others, but the regressions are overall comparable. However, there are a few
striking differences to be found. First of all, the tangibility doesn’t seem to be consistent in its valence for
the regression (3) and (4). Also, the sales growth seems to switch its valence in regression (3). And lastly,
R&D expenditures has doubled its coefficient using industry effects. Therefore, it can be concluded that
the differences in industries does not have a striking effect for the overall regression. However, the
previously mentioned variables should be investigated as it might be affected by the differences in
industries.
Investment Strategy
Two forms of investment strategies are the most interesting to consider given the information that
is provided and that can be calculated: value investing and growth investing.
In case of pursuing a value investing strategy you will be looking for underpriced firms, which are firms
with stock prices that are worth more than what they are currently trading for in the market. Value stocks
are characterized by a high dividend yield, a low price-to-book ratio and/or a low price-to-earnings ratio.
The dividend yield indicates the percentage of the annual dividend over the stock price and is a measure
of the investment’s productivity. Value firms usually are mature firms and maintain a stable dividend
issuance. The price-to-earnings ratio measures a firm’s current share price relative to its earnings per
share. A low P/E ratio indicates a low share price in proportion to the per-share earnings, which means
that the share price could be valued higher. A low price-to-book ratio denotes a share price that is not in
line with the book value of the firm’s assets.
On the contrary, growth firms tend to be overpriced due to the fact that investors anticipate
significant growth in the near future. Growth firms are constantly innovating and developing to grow. The
need of capital leads to a near zero dividend payout rate. Whether the expected growth will eventually be
Abstract
In this case study, an investment strategy will be given for the period between April 2017 and the end of
2018 based on accounting information and stock returns of the S&P 500 for the year 2016.
Leverage
The leverage is for many investors essential to look at when determining an investment strategy.
The most common measure for the leverage is said to be the financial-debt-to-assets (FD/AT) ratio.
However, the appropriateness of using the FD/AT as an indicator for leverage is to be doubted. The
problem lies with the fact that non-financial liabilities are taken into account. Therefore, we used the
financial-debt-to-capital (FD/CP) ratio and the total-liabilities-to-assets (LT/AT) ratio as proxies for the
leverage (both in terms of market and book values). Then a regression is produced using the following
variables: equity (levered) beta, return on assets (ROA), market-to-book (M/B) ratio, profitability of the
firm (sales growth), the tangibility of the assets, net investments, Research & Developments expenses and
a dividend dummy, to find out what the effect of these variables are on the leverage.
As seen in table 4, the coefficients differ from each other when looking at the market and the
book value. The most interesting part is the M/B ratio, which changes from being positive when using the
book value to being negative when using the market value. The M/B ratio is often used as an indicator of
whether a firm is a value firm or a growth firm. A value firm has stocks that are undervalued by the
market prices, whereas a growth firm is using every resource to innovate and expand their products or
services. Because the value firms are undervalued, it has a lower book debt, but a higher market debt.
This explains the difference in values between the market values and book values.
In contrast to the M/B ratio, the equity beta is negative when using book values and positive
when using market values. Equity beta is an indicator for systematic risk of a stock, which explains the
positive correlation when using market values, because more systematic risk is present in the market.
Return on assets has as expected a significant negative correlation with the leverage ratios. More
debt leads to a lower return on assets.
The tangibility of the assets stays being negative correlated regardless of the leverage measure
used. More tangible assets does not necessarily come with more leverage, as many papers suggested to be
the case.
The regression shows that net investments increase when more debt is attracted. A significant
positive correlation can be seen with every leverage measure. Thus, a great proportion of the firm’s
, investments are done with debt.
Almost all the independent variables in Table 4 are highly significant. There are some exceptions,
for example the equity betas in regression (1) seems to be insignificant. Also, the tangibility in estimating
the market value leverages seem to be insignificant. Overall, the independent variables are significant
within the regression. Therefore, it can be concluded that the independent variables are very powerful in
estimating the leverages.
Validation
In order to make sure that the obtained results from the regressions in Table 4 are valid, it is
necessary to test for the different industries in the dataset. This is done by reproducing the regressions
from Table 4 using industry fixed effects, which can be found in Table 5. The coefficients differ from
each other, some more than others, but the regressions are overall comparable. However, there are a few
striking differences to be found. First of all, the tangibility doesn’t seem to be consistent in its valence for
the regression (3) and (4). Also, the sales growth seems to switch its valence in regression (3). And lastly,
R&D expenditures has doubled its coefficient using industry effects. Therefore, it can be concluded that
the differences in industries does not have a striking effect for the overall regression. However, the
previously mentioned variables should be investigated as it might be affected by the differences in
industries.
Investment Strategy
Two forms of investment strategies are the most interesting to consider given the information that
is provided and that can be calculated: value investing and growth investing.
In case of pursuing a value investing strategy you will be looking for underpriced firms, which are firms
with stock prices that are worth more than what they are currently trading for in the market. Value stocks
are characterized by a high dividend yield, a low price-to-book ratio and/or a low price-to-earnings ratio.
The dividend yield indicates the percentage of the annual dividend over the stock price and is a measure
of the investment’s productivity. Value firms usually are mature firms and maintain a stable dividend
issuance. The price-to-earnings ratio measures a firm’s current share price relative to its earnings per
share. A low P/E ratio indicates a low share price in proportion to the per-share earnings, which means
that the share price could be valued higher. A low price-to-book ratio denotes a share price that is not in
line with the book value of the firm’s assets.
On the contrary, growth firms tend to be overpriced due to the fact that investors anticipate
significant growth in the near future. Growth firms are constantly innovating and developing to grow. The
need of capital leads to a near zero dividend payout rate. Whether the expected growth will eventually be
