“Dimitrie Cantemir” Christian University

Knowledge Horizons - Economics

Volume 5, No. 4, pp. 182–190
P-ISSN: 2069-0932, E-ISSN: 2066-1061
© 2013 Pro Universitaria
www.orizonturi.ucdc.ro

Does Fundamental Analysis Predict Stock Returns?

Evidence from Non-Financial Companies Listed on KSE

Nadeem IQBAL1, Sajid Rahman KHATTAK2, Muhammad Arif KHATTAK3

1Faculty of Business Administration, BZU Sub Campus, Dera Ghazi Khan, Pakistan, Email: drnadeemiqbal1@gmail.com
2Muhammad Ali Jinnah University Islamabad, E-mail: Sajidktk99@yahoo.com
3Faculty of Management Sciences, Muhammad Ali Jinnah University Islamabad, E-mail: Arif@jinnah.edu.pk

Abstract Present study aims at investigating whether historical accounting data (fundamental analysis) can Key words:
predict future stock returns. The paper goal is to show the predictive quality of fundamental analysis Karachi Stock Exchange,
and FSCORE in Pakistan. This paper use five signals from five different areas of; profitability ratios, Fundamental Analysis,
efficiency ratios, liquidity ratios, leverage ratios, and market based ratios for the study. Data were FSCORE, OLS
selected for ten year period from 2000 to 2009. The sample of the study consists of all non-financial
companies listed on Karachi Stock Exchange having ten years consecutive data are available. For
data analysis the study used ordinary least square (OLS). The study found that fundamental
analysis cannot predict stock returns in Pakistani listed companies. The study found that FSCORE JEL Codes:
has insignificant relation with stock returns of Pakistani listed companies. E20, D51

The model through which in investors make investment

1. Introduction
Financial research shows that number of firm
characteristics such as firm size, past stock price
performance, and value and growth attribute are useful
in predicting stock returns. The method through which
we analyze the company’s stock prices by historical
accounting and financial data is called fundamental
analysis. Fundamental analysis deals with the
company’s earnings and expenses, assets, liabilities,
management experience, profits, and industry
dynamics. Investors used historical financial information
to predict future stock returns. On behalf of these
predictions they make investments strategies to get
excess returns (Piotroski, 2000, 2004; Fama and
French, 2004; Elleuch 2009; Mahmoud and Sakr,
2012). Investors try to beat the stock market by
predicting the future events in stock exchange. For this
purpose they used fundamental and technical analysis
(Frankkel and Froot, 1986, 1990). Our study also used
fundamental analysis to shows their predicting power of
stock returns in Pakistan. Investors make investment
decisions through fundamental analysis and will depend
on these sources of company’s information: Balance
Sheet, Income Statement, Annual Report, Newspapers,
Company Announcements, and Industry News.
decisions by analyzing company’s stock prices by using
market data such as stock prices, changes in stock
prices, volume of stock traded, and market trends is
called technical analysis. In technical analysis we
cannot used the company overall data, but heavily
depend on market trends to determine the stock prices
movement in future (Neely, 1997). In technical analysis
we used market data, financial charts and tables, so the
individual who analyze the data will make their view
about stock prices and market trend and make their
decisions accordingly.
This paper examines investment strategies based on
fundamental analysis to find firms having strong
financial performance from the firms having weak
financial performance in Pakistan. The objective of this
paper is to find that where fundamental analyses are
helpful to forecast stock returns in Pakistani firms. The
paper used five readily- available fundamental signals
which are considered more efficient by financial experts
in predicting stock returns these are ; leverage, returns
on assets, cash flow, market to book ratio, and
accruals. To measure the strength and predictive
quality this paper use aggregate score based on these
fundamental signals (Piotroski 2000, 2004; Fama and
French, 2004; Mahmoud and Sakr, 2012). The
aggregate score or fundamental score (FSCORE)

identify firms improvement in all signals during the last
fiscal year. Every year firms are rated and classified on
the basis of these financial signals. Firms having high
FSCORE are considered strong, while firms having low
FSCORE are considered weak firms in the respected
year. The words strong or weak does not means that
the firm is financially or size wise strong or weak, but
instead it shows that firms financial signals improve
from last year (strong), or when these signals perform
weak in the current year from the previous year are
considered weak. If the firms specific signal improve in
the current year then we give weight 1, if the current
year performance is bed then the previous year then
weight 0. Leverage and accrual are opposite to the
above weightage system, if they improve in the current
year from the previous year then we give weight 0,
otherwise 1. In this way we calculate aggregate score
or FSCORE. After applying the necessary tests we run
simple regression model (ordinary least square) both on
FSCORE and variables (ratios) to check their predictive
power. We found that FSCORE has the less predictive
power (20 %) compare to the traditional ratios which
has (23 %) predictive power. Cash flow has positive but
insignificant relations with stock returns in Pakistani
firms. Negative relations are found between leverage
and stock returns. Return on assets, and market to
book ratio have found positive and significant impact on
future stock returns prediction in Pakistani listed firms.
We also used sector wise and year wise dummies to
check sector wise and year wise impact on stock
returns prediction. We found that sectors have no or
less impact on future stock returns, while year wise
impact has existed.
1.1. Fundamental analysis and classical theory of
share prices
According to this theory profits is the key driver or
dimension of stock prices. Therefore investors must
estimate and analyzed all fundamental conditions
because they influence the future profits. The belief that
brokers and investors decrease or increase, both the
sales and profits, when buying and selling stocks,
before the actual change occur in fundamental
conditions. Actual change in profits happened too
slowly so it’s difficult to get maximum profits. The
founder of this theory claimed that share prices are the
current value of the entire expected dividend in the
future. Changes in profit will also bring changes in
dividends and affect the share prices (Karl Marx, 1919).
1.2. Fundamental analysis and confidence theory of
share prices
According to the confidence theory of share price
increase or decrease in stock prices will depend upon
the traders and investors confidence in the future trend
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Volume 5, No. 4, pp. 182–190, © 2013 Pro Universitaria
of share prices, profits and dividends. At first glance,
classical and confidence theory seems same because
both theories focus on stock prices depend on profits.
The main difference between these two is that
confidence theory depends on marketing psychology
while classical theory depends on statistical data (C.
Kindleberger, 1978).
1.3. Fundamental analysis and conventional theory
of share prices
According to the conventional theory of stock price
when fundamental conditions are good then share
prices moves upward and when bed stock prices
moves downward. All these theories support the use of
fundamental analysis for stock prices prediction. Now
we also see the theory related to technical analysis
(Teweles and Bredley: The Stock Market, 1998).
Investors want to predict stock returns in order to earn
excess returns based upon historical financial and
market information. However, predicting stock returns is
closely linked to market efficiency and is still a financial
puzzle in developing countries. According to market
efficiency theory it is difficult for investors to predict
stock prices in developed economies, while in inefficient
markets like Pakistan investors can get excess returns
through the use of historical information. Therefore, this
research study is supposed to fill the research gap to
investigate the predictive power of fundamental
analysis in stock market of Pakistan, and whether
investors can earn excess return or not based upon
fundamental strategy.
2. Literature Review
Literature in finance shows that investors make
investment decisions through the analysis of historical
data namely balance sheet, income statement, annual
report, newspaper, industry news and company
announcement (Dugalic, 2000). Fundamental analysis
considers the company’s assets and liabilities, earnings
and expenses, management experience, profit and
industry dynamics. The analysis deals with the
historical accounting data especially ratios related to
profitability, activity, efficiency, leverage, and market
based ratios which were useful to predict stock returns
(Wang 2007; Tian 2008; Li 2009; and Tamimia 2011).
How financial signals are important for a business to
perform well (improve stock returns) would depend
upon that how efficiently these indicators were
evaluated and interpreted by the business,
(Richardson, 2009). Adequate liquidity to operate day to
day operation, proper combination of debt and equity,
proper utilization of firm’s assets, managing inventory
period, receivable period, payable period, cash
conversion cycle; all these lead to produce better
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Volume 5, No. 4, pp. 182–190, © 2013 Pro Universitaria
market based ratios and help organization to perform
well and get excess stock returns (Sen, 2009).
According to Fama and French efficient market
hypothesis, information available to everyone (publically
available information) cannot be used or helpful to
predict stock returns, on the other hand literature proof
that fundamental analysis was useful tools for investors
to predict stock returns. Fundamental signals were
positively and significantly correlated with stock returns,
(Elleuch, 2009). The pioneer work of (Ou and Penmen,
1989) found that through fundamental analysis
investors can get abnormal returns. They also argue
that fundamental signals have the power to forecast
future stock returns. By using various fundamental
signals from leverage, activity, profitability, and market
based indicators and found the forecasting power of
these signals. Greig and Stober (1992) restudied the
work of Ou and Penmen and reached to different
conclusion. They conclude that by using hedge portfolio
investors can get abnormal returns, because in hedge
portfolio firm size and CAPM beta were of equal size of
all firms. The work of Ou and Penmen was also
criticized by (Abarbanell and Bushee, 1998) arguing
that they used number of accounting ratios which had
no conceptual and theoretical background.
Starting from the same objectives Lev and Thiagarajan
(1993) used 12 fundamental factors which were
considered useful for securities evaluation by
researcher and found that financial signals had the
predictive power. Abarbanell and Bushee (1998) also
worked on the same phenomenon and found the same
results as (Lev and Thiagarajan, 1993). Piotroski (2000)
used nine fundamental signals and show their
predictive power through FSCORE. First FSCORE was
calculated individually for each signal, by adding 1 if the
signal improves in the current year from the previous
year. After that each signal FSCORE were combined
and regressed with stock returns and found significant
relation exists between FSCORE and stock returns.
Financial signals have mixed results in determining the
share prices.
Hatta (2012) studied the firm financial factors and
variation in stock returns. Financial signals earnings per
share, price earnings ratio, debt to equity ratio, current
ratio, net profit margin, dividend per share, and return
on assets were selected for the study. The study found
that earnings per share and price earnings ratio had
positive relation with stock return, while debt to equity
and net profit margin had negative relation with stock
returns. Kabajeh et al. (2012) examined the relationship
between return on assets, return on equity, and return
on investment on stock returns together and individually
in Jordan. They found that these ratios together had
strong positive impact on stock returns, and individually
return on assets and return on investment had positive
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impact on stock return, while return on equity had
positive but weak relation with stock returns individually.
Mahmoud and Sakr (2012) investigated the predictive
power of fundamental analysis in terms of firm
performance and stock returns in Egypt. Firm’s
performance and profitability were measured through
return on equity. By using ten financial indicators
(changes in asset turnover, changes in leverage, gross
profit margin, return on assets, changes in return on
assets, cash flow from operation, changes in cash flow
from operation, changes in current ratio, accrual, and
cash flow from stock holder) they found that aggregate
signals had positive correlation with stock return and
firm performance.
Besides the positive relationships, various studies
showed negative and some other showed insignificant
results. For example, Zarezadeh et al. (2011) examined
the relationship between financial variables and stock
prices in Malaysia. They used fuzzy regression for their
study and found positive relationship between financial
signals and stock returns. They also found that
earnings per share and dividend per share have
negative relation with stock return. Aono and Iwaisako
(2010) examined the relationship of financial ratios and
stock returns in Japan. They found that price earnings
ratio had weak forecasting power in Japan
comparatively in US studies. They also found that
lagged stock returns and interest rate had strong
predictive power by using Japanese data. Sharma and
Preeti (2009) examined stock return prediction through
fundamental analysis in India. Fundamental signals
were selected from profitability, cash performance,
operating efficiency and liquidity. They used Piotroski
methodology by calculating Fscore, and found
insignificant relation exists between stock returns and
fundamental signals. Yaoguang (2009) introduced book
to market ratio and size of the firm and its impact on
stock returns in China. Their finding were similar to
previous studies as market based ratios had significant
relations with stock returns, while size of the firm had
negative impact on stock returns. Martani et al. (2009)
also worked on financial ratios and their predictive
power of stock returns. They used financial ratios, firm
size, cash flow, leverage, liquidity, profitability, and
market based ratios for their study. They found that
market based ratios, profitability, and turnover ratios
had positive and significant relations with stock returns,
while leverage and liquidity ratios had negative relations
with stock returns. Elleeuch (2009) examined the
relationship between fundamental analysis strategy and
stock return predictability. Using nine variables namely
inventory, account receivable, investment, gross
margin, labour force, return on assets, cash flow, and
accrual and found positive significant relation between
aggregate fundamental signal and future stock prices.

Twaijry (2006) studied the relationship between the
stock prices and financial signals. The studied found
that dividend ratio had strong relation with stock return.
Tuna (2006) also found that book to market ratio had
positive relation and leverage had negative relation with
stock returns. Piotroski (2004) studied the investment
decision based on financial statement analysis. The
objective of the study was to found that either these
investment decisions were profitable for investors who
using historical accounting data. By using nine
fundamental factors (net income, cash flow from
operation, changes in net income, accrual, changes in
leverage, changes in liquidity, changes in margin, and
changes in turnover) he found that fundamental signals
had the predictive power, so it helpful for investors to
make investment decision based on accounting data.
Nguyen (2003) examined the relationship of stock
returns with fundamental analysis in Japan. The studied
used the same methodology as (Piotroski, 2000) and
found a strong relationship between stock returns and
financial indicators. The study also argues that in those
years in which financial score were high can bring
variation in stock prices.
Finally, Zahid et al. (2012) studied the relationship of
macroeconomic variables and its impact on stock
returns variation in Karachi Stock Exchange. They
found that economic growth had positive but weak
impact on stock returns variation, money supply had
positive but insignificant relations with stock prices,
while inflation and exchange rate had negative but
significant relation with stock prices movement.
Reviews of different literature led us to hypothesize the
relationship between the five variables as follows;
Hypothesis 1: There is positive impact of Fundamental
Signals and stock returns.
Hypothesis 2: There is positive impact of FSCORE and
stock returns.
3. Methodology of research
This study explores the relationship between
fundamental analysis and their predictive power of
stock returns of non-financial companies listed on
Karachi Stock Exchange. The study used yearly data
from 2000 to 2009. In this study we select those
companies having consistent 10 years (from 2000 to
2009) relevant data are available are selected for study.
On the basis of this restriction only 211 non-financial
companies listed on Karachi Stock Exchange were
selected for the study. Data were taken from different
sources, especially from balance sheet analysis of non-
financial companies a report issued by State Bank of
Pakistan, also from Karachi Stock Exchange website,
and from KHI stocks. Data are reliable and accurate
because it’s issued by a regulatory body namely State
Bank of Pakistan.
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Volume 5, No. 4, pp. 182–190, © 2013 Pro Universitaria
Five fundamental signals have been chosen for this
study. These signals are design to measure four
different dimensions of the firm’s financial conditions:
profitability, liquidity, leverage, and market based ratio.
Fundamental signals include leverage, cash flow, return
on assets, market to book ratio, and accruals. On the
basis of these signals we calculate FSCORE, a method
used by (Fama and French, 2004; Elleuch, 2009; and
Mahmoud and Sakr, 2012).
FSCORE: each signal performs good or bad in the
respective years. If these signals perform well the
resultant FSCORE will be high, and if they perform bad
the resultant FSCORE will be low. If a signal performs
will from the previous year then 1, if signal perform bad
from the previous then 0. FSCORE is the sums of all
these signals. FSCORE will range from higher 5 to a
lower 0.
FSCORE = F_Lvg + F_CF + F_ROA + F_MBR +
F_ACC (1)
Leverage ratio
Leverage measure the extent to which the firm depends
on long term debt financing. Leverage ratio is equal to
total debt of the firm divided by total assets of the
current year plus total assets of the previous year
divided by 2. Leverage is either good or bad for
companies; depends upon the situation, if the firm earn
more from the interest they pay on debt is good for a
firm, and if the interest charges is more from the funds
they generate from leverage then it’s bad for a firm. In
both cases it also increase firm financial risk and may
stop financial flexibility (Brigham and Ehrhardt, 2003).
There found negative relationship between leverage
and stock returns (Bradshow, Ridshardson and Sloan,
2004). In this paper we assume that increase in debt is
consider bad signal for a firm, so if leverage increase
from the previous year is weighted 0, other wise 1.
Cash flow ratio
Cash flow ratio is equal to cash flow divided by total
assets. Greater the ratio is good for a firm. If cash flow
ratio increase from the previous year in the current
year, then F_CF equal to 1, other wise 0.
Return on assets
Return on assets is equal to net income divided by total
assets. Increase in this ratio shows improvement in firm
cash flow and good for a firm. Overall firm profitability is
measure through this ratio. Firm having positive ROA is
better than the firm having negative ROA. Improvement
in ROA from the previous is equal to 1, 0 otherwise.
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Volume 5, No. 4, pp. 182–190, © 2013 Pro Universitaria

Market to book ratio
This ratio shows the market value of the stock relative
to its book or accounting value. Market value of the
company is its current value of stocks determined by
financial marketplace. Greater the ratio is good for a
company. F_MBR is equal to 1 if positive, 0 otherwise.
Accrual ratio
Accrual ratio is equal to accrual divided by total assets
of the firm. Accrual measure the earning perseverance
of the firm. Firm total earning is decreasing in the
relative magnitude of accrual components of earnings
Sloan (1999), Collin and Hribar (2000). This paper
assumes that if F_ACCR increase from the previous
year is equal to 0, other wise 1.
Lag values of variables
This is the first lag value of all variables for the purpose
to check it that previous data or values can predict
future values of these variables or not. Previous values
of these signals also affect future values (Aono and
Iwaisako, 2010). We also used this as an independent
variable in our study.
Dummy variables
To analyze the impact of fundamental analysis on stock
returns across different sectors and across different
time periods, we used the dummy variables. Sector
wise dummy was created using a particular sector as
reference point. The reference sector is assigned the
value of 1 while rest of the sectors are assigned the
value of 0. This practice is repeated for each sector as
reference point. Year wise dummy is created using a
particular year as reference point. The reference year is
giving the value of 1 and remaining years are given 0
as value. This exercise is repeated for every year as
reference year.

Table 1. Measurement of fundamental signals

No: Fundamental Definition Fscore

1 Leverage Total debt t/( Total assets t+ Total assets t-1) 1 if negative change, 0 otherwise
2 Cash Flow R Cash Flow t/ Total Assets t-1 1 if positive change, 0 otherwise
3 ROA Net Income t/ Total Assets t-1 1 if positive change, 0 otherwise
4 MBR Share prices / Book Value per Share 1 if positive change, 0 otherwise
5 ACC R Accrual t/ Total Assets t-1 where Accrual = ( CA- Cash) – CL - Dep 1 if negative change, 0 otherwise

If changes in these ratios increase in the current year β0 = Intercept

from the previous year (positive change) then we β1 = Slope
assign a weight 1, if negative then we assign a weight FSCORE= Fundamental Score of all signals
0. This calculation is same for all signals except accrual = Error Term
ratio, and leverage in which the above situation will SR (-1) = First lag of stock returns
reverse. It means that, when accrual ratio or leverage Fscore (-1) = Lag value of Fscore
ratio increase in the current year from the previous Lvg (-1) = Lag value of leverage
year, then we assign a weight 0, otherwise 1. CF (-1) = Lag value of cash flow
General equations for this study are: ROA (-1) = Lag value of return on assets
SR = β0 + β1 sr (-1) + β2 Lvg (-1) + β3 CF (-1) + β4 ROA (- MBR (-1) = Lag value of market to book ratio
1) + β5 MBR (-1) + β6 ACC (-1) + β7 (Dum Sec) + β8 (Dum Year) + Acc (-1) = Lag value of accruals
…………………………………………….. (1) Lag values of all these variables are used to check
SR = β0 + β1 sr (-1) + β2 FSCORE (-1) + β3 (Dum Sec) + β4 (Dum either the previous year value predict the current or
Year) + ………................................. (2) future values or not.
Where,
SR = Stock Return

4. Empirical Results
Table 2. Descriptive Statistics

SR C LVG CF ROA MBR ACC_R

Mean 0.18 1 0.18 0.05 0.053 0.79 -0.21
Median 0 1 0.17 0.06 0.042 0.49 -0.14
Maxim 9 1 1.04 1.89 1.857 25.74 0.99
Minim -0.97 1 0.007 -3.85 -1.747 -25.07 -3.91
S. Dev. 0.78 0 0.11 0.17 0.169 1.90 0.39

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The above table shows the descriptive statistics for all stock return is being explained by fundamental signals
variables. The mean, median, maximum value, (Leverage, Cash Flow, ROA, MBR, and Accrual).
minimum value, and standard deviation of all variables Column 2, 3 and 4 in the Exhibits 1 show the values of
are presented in the above table. After the descriptive coefficients, t-statistics and p-value respectively, for
statistics we apply diagnostic tests which is presented regression analysis. As can be seen from the table that
in the below table. value of intercept is significant at p<.05 which shows
that some other very relevant signals have been
Table 3. Diagnostic Tests excluded from the model. However, our objective was
only to study the effect of fundamental analysis thus the
exclusion of those relevant signals does not hamper the
objectives of this study. Regression coefficient for ROA
is 0.64; this value is insignificant at p< .05 at 95%
confidence level. Logically this relation can be
explained in term of investors’ expectations about
companies’ performance. Positive expectations about
Different tests are applied to diagnose serial correlation, companies’ performance (ROA as measure of
functional form, multicolinarity, and heteroscedasticity profitability) generate demand for their stock and thus
of data. The above table shows the results of these push the stock prices up but here insignificant relation
diagnostic tests. Colum 4 contains the probabilities for shows that roa cannot predict stock movement in
these tests, as the values of all these tests are Pakistani firms. Coefficient of regression for market to
insignificant; there are no issues of serial correlation, book value is .10 which is insignificant at p<.05. Logic
Functional Form and Heteroscedasticity. of such relationship can be found in fact that expected
increase in stock prices in a greater proportion to book
Table 4. Correlation Matrix value causes increase in expected return because of
increase in capital gains.
LVG CF ROA MBR SR ACC R
Coefficients for accruals, cash flows and leverage
LVG 1.00
CF -0.17 1.00 showed insignificant values as well. Accruals and
ROA -0.27 0.70 1.00 leverage both add to financial risk of a company and
MBR -0.09 0.05 0.10 1.00 thus are expected to influence the stock prices as the
SR -0.01 0.11 0.12 0.10 1.00 investors add risk premium to their required rates of
ACC R -0.79 0.13 0.26 0.07 0.00 1.00 return. But, according to Modigliani and Millar (1958)
the value of firm is dependent upon the expected cash
The correlation matrix indicates that leverage have flows produced by the firm regardless of the fact that
negative association with the stock returns, while all operations are financed through debt or equity.
other ratios (CF, Accrual, ROA, and MBR) have positive Moreover, according to static trade off theory the
association with the stock returns. financial distress is not felt by the investors up to a
In order to study the effect of fundamental analysis certain limit and if companies limit their leverage below
(measured through different financial ratios) on stock this point they may not experience the negative impact
return, we used two regression models. In first model of leverage on stock prices. Historically cash flows and
we took all fundamental ratios as independent variable earnings per share show a positive relation to stock
and stock returns as dependent variable. In second returns when the value of stock is considered as
model we used the F-SCORE (as sum of all present value of expected cash flows. One plausible
fundamental signals) as independent variable and the explanation of insignificant relation of stock returns to
stock returns as dependent variable. The data was cash flows can be the market imperfection and
analyzed using simple regression technique in E-views investors’ irrationality (a concept advocated by
7. Results of these regression analyses are discussed behavioral finance). Lag values of stock return and
in the following section. market to book ratios are significant which shows that
previous stock returns and market to book ratios values
5. Findings of the study impact on future values of these two variables, while
Exhibits 1 show the regression statistics. The most cash flow, accruals and leverage ratios shows
important value with respect to significance of insignificant relation with their previous values.
regression model is F statistics. F stat value of 17.25 is We move further in our analysis to examine the impact
significant at p<.05, thus our model is significant. R of fundamental analysis on stock returns by taking F-
square value is 0.20 which shows the explanatory SCORE as independent variable. Results of the
power of independent variables. Thus 20% variation in analysis are shown in Exhibits 2. Exhibits 2 show the
model summary of our second regression model (F-
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Volume 5, No. 4, pp. 182–190, © 2013 Pro Universitaria
SCORE and lag value of stock returns as independent
variables). The model is significant with F-statistic value
of 17.46, significant at p<0.05. R square value of .2030
expresses the explanatory power of the model. F-
SCORE explains 20.30% of the variation in stock
returns.
Column 2 of Exhibits 2 shows the values of intercept
and regression coefficient for F-SCORE. Similar to our
first model, the value of intercept is significant showing
the exclusion of some relevant signals from the model.
However, our objective was only to study the effect of
fundamental analysis thus the exclusion of those
relevant signals does not hamper the objectives of this
study.
Regression coefficient for F-SCORE is 0.5544; the
value is insignificant at p<.05. Thus our study match
with the study of (Preeti and Sharma, 2009) which also
found insignificant relation found between Fscore and
stock returns. The results thus reject our hypothesis
that FSCORE is helpful in predicting the future stock
returns. FSCORE lag values have insignificant relation
which shows that previous FSCORE values cannot
affect future FSCORE values or prediction.
6. Conclusions
This study examines the impact of fundamental
analysis, FSCORE, and their predictive power of stock
returns for the period of 2000 to 2009 by using simple
regression (ordinary least square). The study used five
variables from four different areas of, profitability,
liquidity, efficiency, and market based ratios. These
variables are cash flow, return on assets, leverage,
market to book ratio, and accrual ratio. The study
calculates FSCORE to check the validity and predictive
power in Pakistani non- financial firms. In this study two
model are used, in first model we simply use these
ratios as independent variables and regressed with
dependent variable stock returns. In the second model
we calculate FSCORE of these ratios which is
independent variable and regressed with dependent
variable stock returns.
This study is aimed at investigating the impact of
fundamental analysis on stock returns. The aim is also
to check the validity and forecasting quality of FSCORE
in non-financial sectors listed on Karachi Stock
Exchange. The purpose of the study is to help investors
to make efficient and accurate investment decisions
regarding future stock prices. The practical implication
of this study is to help investors, stock exchange
dealers, and brokers etc to forecast stock prices
through FSCORE (fundamental analysis) and get
excess returns.
In our study we found a positive but insignificant impact
of FSCORE and stock returns prediction. These results
are consistent with the previous studies such as (Preeti
188
and Sharma, 2009), but is inconsistent with the study
(J.D Piotroski, 2004; Fama and French, 2004; J.
Elleuch, 2009; D. Seng and J.R Hancock, 2012). These
studies also found positive and significant relations
between FSCORE and stock returns predictability. We
use FSCORE for the first time in Pakistan. We found
that FSCORE shows insignificant relation with stock
returns in Pakistan, so our result is consistent with the
study of (Preeti and Sharma, 2009) in India. Coefficient
of return on assets and market to book ratio shows
positive but insignificant relation with stock returns.
Investors see company’s profitability (return on assets
and return on equity) while making investment
decisions. If these ratios (ROE, ROA) are greater or
equal to the average of industry they make investment
decisions, which affect the company and can bring
variation in stock prices and thus stock returns.
All variables of the study have insignificance coefficient
value, such as leverage, accrual ratio, roa, mbr, and
cash flow. Liquidity ratios measure the companies’
ability to meet its current obligations as and when they
become due. So there is no direct relation of liquidity
ratio and stock returns. Thus cash flow ratio is not
expected to significantly impact the stock prices and
thus stock returns. Accruals and leverage both add to
financial risk of a company and thus are expected to
influence negatively the stock prices. However,
according to static trade off theory the financial distress
is not felt by the investors up to a certain limit and if
companies limit their leverage below this point they may
not experience the negative impact of leverage on stock
prices. When the value of stock is considered as
present value of expected cash flows, so there should
be positive relationship founded between cash flows
earnings per share and stock returns. One plausible
explanation of insignificant relation of cash flows with
stock return can be the market imperfection and
investors’ irrationality. This study has also some
limitations as will which are describe below.
Besides the significance of this study, there are also
some limitations of the study as will. First, this study
use only fundamental analysis for the study, and ignore
technical analysis. It’s not our study limitation but it’s
give more insight to our study to use technical analysis
as well. Investor use both fundamental and technical
analysis for future stock prediction, first they use
fundamental analysis to find out undervalued
companies, and then use technical analysis to know
about the right time to inter into the market. Second,
this study use shorter time periods, ten years from 2000
to 2009, so it will be better for the study to use data for
longer time period. Third, this study only use data from
Pakistani listed companies; it will better to capture the
entire Asian market for the study.

This study provides a greater insight into the research
on fundamental analysis and their predictive quality in
Pakistan. But simply fundamental analysis is not
enough for successful forecasting decisions, so it is for
future implication to use both fundamental and technical
analysis for the better prediction of future stock returns.
Also, the time horizons will be increased as well as to
select the entire Asian market for the study.
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Table 5. Regression Test with Individual Variables (Exhibits 1)

Variable Coefficient Std. Error t-Statistic Prob.

C 0.065343 0.065838 0.992488 0.3211
CEM 0.001506 0.087665 0.017174 0.9863
CHE 0.066628 0.069139 0.963676 0.3354
ENG 0.381668 0.067018 5.695014 0
FE 0.082386 0.075109 1.096881 0.2729
JUT 0.22921 0.137591 1.665882 0.0959
MIS 0.046049 0.099622 0.462241 0.644
PB 0.246673 0.105198 2.344837 0.0192
SUG 0.129977 0.051367 2.530356 0.0115
TOB 0.216603 0.193331 1.120372 0.2627
Y01 -0.23336 0.073627 -3.16953 0.0016
Y02 0.491361 0.073725 6.664801 0
Y03 0.370957 0.077239 4.802737 0
Y04 0.587569 0.078058 7.527332 0
Y05 -0.0317 0.079257 -0.40001 0.6892
Y06 -0.34746 0.07487 -4.64082 0
Y07 -0.00628 0.077606 -0.08095 0.9355
Y08 -0.38703 0.075911 -5.09855 0
Y09 -0.28536 0.075726 -3.76829 0.0002
SR(-1) -0.09524 0.024239 -3.92917 0.0001
ACC_R(-1) -0.03289 0.051771 -0.63538 0.5253
ROA(-1) -0.07142 0.154295 -0.46289 0.6435
CF(-1) 0.069773 0.143028 0.487828 0.6257
MBR(-1) -0.01572 0.009698 -1.62051 0.1053
LVG(-1) 0.287548 0.175811 1.635549 0.1021
R-squared 0.206358 Mean dependent var 0.186645
Adjusted R-squared 0.194527 S.D. dependent var 0.779796
S.E. of regression 0.699852 Akaike info criterion 2.139277
Sum squared resid 788.5671 Schwarz criterion 2.221837
Log likelihood -1723.86 Hannan-Quinn criter. 2.169901
F-statistic 17.4426 Durbin-Watson stat 2.022982
Prob(F-statistic) 0

Table 6. FSCORE Test (Exhibits 2)

Variable Coefficient Std. Error t-Statistic Prob.

C 0.149764 0.07137 2.098416 0.036
CEM -0.00697 0.083686 -0.0833 0.9336
CHE 0.027101 0.067177 0.403421 0.6867
ENG 0.357164 0.065307 5.46896 0
FE 0.052707 0.074152 0.710795 0.4773
FSCORE 0.0069 0.011663 0.59131 0.5544
JUT 0.221685 0.137249 1.615212 0.1065
MIS 0.053393 0.099463 0.536812 0.5915
PB 0.211908 0.103514 2.047146 0.0408
SUG 0.139118 0.051333 2.710115 0.0068
TOB 0.138172 0.189135 0.730547 0.4652
Y01 -0.23392 0.073506 -3.18236 0.0015
Y02 0.496936 0.073576 6.75404 0
Y03 0.377331 0.077124 4.892528 0
Y04 0.585199 0.078098 7.493105 0
Y05 -0.03504 0.07951 -0.44073 0.6595
Y06 -0.34974 0.074923 -4.66805 0
Y07 -0.00517 0.077647 -0.06658 0.9469
Y08 -0.38869 0.075945 -5.11809 0
Y09 -0.2806 0.075771 -3.70329 0.0002
SR(-1) -0.09845 0.023952 -4.11034 0
FSCORE(-1) -0.00446 0.011693 -0.38155 0.7028

R-squared 0.20309 Mean dependent var 0.186645

Adjusted R-squared 0.192715 S.D. dependent var 0.779796
S.E. of regression 0.700639 Akaike info criterion 2.139717
Sum squared resid 791.8143 Schwarz criterion 2.21237
Log likelihood -1727.22 Hannan-Quinn criter. 2.166666
F-statistic 19.57466 Durbin-Watson stat 2.023127
Prob(F-statistic) 0

190