Financial Analysis and the Predictability of Important Economic Events

By Ahmed Riahi-Belkaoui | Go to book overview

2

The Prediction of Stock Returns Using Popular Financial Ratios

INTRODUCTION1

Fundamental information analysis, or financial statement analysis, seeks the valuation of corporate securities by the evaluation of value-relevant accounting fundamentals. Various studies have identified value-relevant fundamentals in the context of a return-fundamentals relation. 24 While Ou and Penman 5 used a statistical search procedure in the determination of candidate fundamentals, Lev and Thiagarajan 6 relied on a guided search procedure based on analysts’ claim of usefulness in security valuation.

This chapter builds on previous research in the examination of value-relevant fundamentals by relying on a return-fundamentals relation. The search for fundamentals is however, different, focusing on a set of financial variables (fundamentals) popularized in the ‘‘textbook’’ literature as useful in security valuation.


SUPPORT FOR THE USE OF POPULAR RATIOS

This chapter relies instead on a search for fundamentals guided by the ‘‘popularity’’ of financial ratios in major financial analysis texts. Various reasons may support this choice.

First, the inclusion of these ‘‘popular’’ ratios in financial analysis texts is generally based on their theoretical explanations of fundamental relationships and signals experienced by the firms. For example, liquidity ratios refer to the ability of the firm to meet its short-term financial obligations when and as they fall due; capital structure ratios provide information about the extent to which nonequity capital is used to finance the assets of the firms; profitability ratios

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