Investigation on the Under and Overvalued Stocks of PSU Banks Quoted on NSE

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1 Investigation on the Under and Overvalued Stocks of PSU Banks Quoted on NSE Rachna Agrawal Associate Professor, Department of Management Studies, YMCA University of Science & Technology, Faridabad, Haryana. Rajesh Kumar Research Scholar, Department of Management Studies, YMCA University of Science & Technology, Faridabad, Haryana. Abstract: The present paper uses Capital Asset Pricing Model (CAPM) to analyze the under and overvalued stock of PSU Banks listed on NSE. The return on the individual security (y) is regressed on the market return (x) under the security characteristic line to estimate the security market line (SML). This research paper studies under and overvalued stocks by comparing the holding period return to the reconsider under the complete market assumptions. Another objective of the paper is to provide information that aid financial decisions. Key Words: (1) CAPM; (2) Market return; (3) Overvalued stock; (4) Undervalued stock I. INTRODUCTION Since liberalization, Indian capital market has undergone tremendous transformations and has evolved as a vibrant system of investment flows. A dynamic capital market is a significant segment of the financial system of any country as it plays relevant role in mobilizing savings and channelizing them for productive purposes. The efficient fund allocation depends on the stock market efficiency in pricing the different securities traded in it. The modern capital theory focuses upon systematic factors as sources of risk and contemplated that the long run return on an individual asset must reflect the changes in such factors. An enquiry into such factors through different methodologies suggested in finance literature would help the investors to design their investment strategies meaningfully. There are various models for valuation of stocks such as discounted cash flow model (DCFM), the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Model (APM) based on the limitations of market equilibrium and the existence of a perfect market. Therefore, there is a need to give suitable approach in the hand of investors regarding the under and overvalued stock under the capital asset pricing model so that investment strategies may be formulated accordingly. II. THE MODEL CAPM, an extension of portfolio theory of Markowitz by William Sharp, John Linter and Jan Mossin, is empirically used for the valuation of assets which are traded in the secondary market. The model was developed in the early 1960's by Sharpe (1964), Linter (1965) and Mossin (1966). This model provides the expected return for risky assets. It explains that a linear relationship exists between a security's required rate of return and its beta. Here Beta is used to measure the systematic risk. In the simple sense, CAPM predicts that the expected return on an asset above the risk- free rate is linearly related to the nondiversifiable risk, which is measured by the asset's Beta. III. ASSUMPTIONS OF THE MODEL There are some of the assumptions of CAPM; those assumptions are being adopted for making base of research paper. Investors make decisions based solely upon risk-return assessments. These judgements take the form of expected values and standard deviation measures. The purchase or sale of a security can be undertaken in infinitely divisible units. Investors can short sell any amount of shares without any limit. Purchases and sales by single investor in total determine prices by their actions. This means that there is a perfect competition where investors in total determine prices by their actions. Otherwise, monopoly power could influence prices (retunes). There are no transaction costs. Where there are transaction costs, returns would be sensitive to whether the investor owned a security before the decision period. The purchase or sale of securities is done in the absence of personal income taxes. This means that people may indifferent to the form in which return is received (dividends or Capital gains). The investor can borrow or lend any amount of funds desired at an identical riskless rate (Example The Treasury bill rate). Investors share identical expectations with regard to the relevant decision period, the necessary decision inputs, their form and size. Thus, investors are presumed to have identical planning horizons and to have identical expectations regarding expected returns, variances of expected returns and co-variances of all pairs of securities. Otherwise, there would be a family of efficient frontiers because of differences in expectations. The Capital Asset Pricing Model has two lines Capital Market Line (CML) and Security Market Line (SML). The CML as the name represents the efficient frontier formed by combining risk free rate of return (T-bill) with return on index of common stock. In other words, CML explains about the market price of risk. The SML is used to calculate the expected return on the equity. 81

2 Under the SML, the market rewards for the systematic risk only which is measured by the Beta co-efficient. The SML states that there is a linear relationship between the expected return on individual stock and beta. This relationship is known as SML. Re = Rf +β (Rm- Rf) Where, Re = Expected return on the security; Rf = Risk free return; Rm = Expected return on market portfolio; β = Systematic rate of asset. This key relationship between return and systematic risk is known as SML that describes the expected return for all assets and portfolio of asset efficient or not. The difference between the expected return on any two assets can be related simply to their difference in beta. The higher beta is for any security, the higher must be its expected return. The relation between beta and expected return is linear. IV. REVIEW OF EXISTING LITERATURE Since its introduction in early 1960s, CAPM has been one of the most interesting topics in the financial economics. Almost every financial manager or investor, who is willing to invest in securities, must justify his decision partly based on CAPM. The reason is that the model provides the means for a firm to calculate the return that its investors demand. One of the classic empirical studies becomes supportive evidence is that of Black, Jensen and Scholes (1972). Using monthly return data and portfolios rather than individual stocks, Black et al tested whether the cross-section of expected returns is linear in beta. By combining securities into portfolio, one can diversify most of the firm specific component of the returns, thereby enhancing the precision of the beta estimates and the expected rate of return of the portfolio securities. The authors found that the data are consistent with the predictions of the CAPM i.e. the relation between the average return and beta is close to linear and those portfolios with high (low) betas having high (low) average returns. Another classic empirical study found supportive in this context i.e. Fama and McBeth (1973); they examined whether there is a positive linear relation between average returns and beta. Moreover, the authors investigated whether squared value of beta and volatility of asset returns can explain the residual variation in average returns across assets that are not explained by the beta alone. In the early 1980s, several studies suggested that there were deviations from the linear CAPM risk return trade-off due to other variables that affect this trade-off. The purpose of these studies was to find the components that CAPM was unable in explaining the risk return trade-off and identify the variables that create those deviations. In particular, the earnings yield (Basu 1977), leverage, the ratio of a firm's book value of equity to its market value. The general reaction to Banz's (1981) findings, that the CAPM may be missing some aspects of reality, was to support the view that although the data may suggest deviations from CAPM, these deviations are not so important as to reject the theory. Banz (1981) tested the CAPM by checking whether the size of firms can explain the residual variation in average returns across assets that remain unexplained by the CAPM's beta. Benz challenged the CAPM by demonstrating that firm size does explain the cross sectional-variation in average reruns on a particular collection of assets better then Beta (β). The author concluded that the average returns on stocks of small firms (those with low market value of equity) were higher than the average returns on stocks of large firms (those with high market values of equity). This research has been expanded by examining different sets of variables that might affect the riskreturn trade-off. However, this idea has been challenged by Fama and French (1992). They showed that Banz's findings might be economically important as it raises the question of validity of the model. V. THE ACADEMIC DEBATE CONTINUES Other empirical evidence on stock returns is based on the argument that the volatility of stock returns in constantly changing. When one considers a time varying return distribution, one must refer to the conditional mean, variance and covariance that change depending on currently available information. In contrast, the usual estimates of return, variance, an average squared deviations over a sample period, provide an unconditional estimate because they treat variance as constant over time. The Fama and French [1992] study has itself been criticized. In general the studies responding to the Fama and French challenge by and large take a closer look at the data used in the study. Kothari, Shaken and Sloan [1995] argue that Fama and French's [1992] findings depend essentially on how the statistical findings are interpreted. Amihudm, Christensen and Mendelson [1992] and Black [1993] support the view that the data are too noisy to invalidate the CAPM. In fact, they show that when a more efficient statistical method is used, the estimated relation between average return and beta is positive and significant. Black [1993] suggests that the size effect noted by Banz [1981] could simply be a sample period effect i.e. the size effect is observed in some period and not in others. Despite the above criticism, the general reaction to the Fama and French [1992] findings has been to focus on alternative asset pricing models. Deepak Chawla [2009] in India has examined 10 portfolios, covering 50 stocks, over a 5-year period from 1 January 2003 to 1 February 2008 to verify the efficiency and efficacy of the model and finds that CAPM fails completely in the Indian context. According to his study the intercept term, which is expected to be zero, is found to be significant for all 10 portfolios. Kapil choudhary and Sakshi chodhary (2010) has examined the Capital Asset Pricing Model (CAPM) for the Indian stock market using monthly stock returns from 278 companies of BSE 500 Index listed on the Bombay stock exchange for the period of January 1996 to December The findings of this study are not substantiating the theory's basic result that higher risk (beta) is associated with higher levels of return. The model does explain, however, excess returns and thus lends support to the linear structure of the CAPM equation. 82

3 The theory's prediction for the intercept is that it should equal zero and the slope should equal the excess returns on the market portfolio. The results of the study lead to negate the above hypotheses and offer evidence against the CAPM. The tests conducted to examine the nonlinearity of the relationship between return and betas bolster the hypothesis that the expected return-beta relationship is linear. Additionally, this study investigates whether the CAPM adequately captures allimportant determinants of returns including the residual variance of stocks. The results exhibit that residual risk has no effect on the expected returns of portfolios. In 2008, Khan & Jain (Financial Management) has identified that the CAPM has several implications for, such as Risk-Returns relationship for an individual security as well as for efficient portfolio; Identification of under and overvalued assets traded in the market; Pricing of assets not yet traded in the market; Effect of leverage on cost of equity (rate of return required by equity shareholders); Capital Budgeting decisions and cost of capital; Risk of the firm through diversification of project portfolio. To summarize, all the models above aim to improve the empirical testing of CAPM. There have also been numerous modifications to the models and whether the earliest or the subsequent alternative models validate or not the CAPM is yet to be determined. VI. OBJECTIVES OF THE RESEARCH PAPER Security market generally provides a facility in which investors and enterprises can come together with confidence to create prosperity through sharing of risk and rewards. This paper has been motivated by under and overvalued of PSU banks stock. The main objectives of the paper are: 1. To investigate the under and overvalued stocks of PSU Banks; 2. To provide information that may aid to financial decisions. On the basis of above mentioned objectives, this study will contribute to advice investors to buy or sell the assets as per CAPM application. VII. RESEARCH DESIGN & METHODOLOGY The study investigates under and over-valued stocks of six PSU banks traded on NSE. The six banks are as: State Bank of India; Bank of India; Allahabad Bank; Indian Overseas Bank; Oriental Bank of Commerce. The period of this study has been for twenty-four months period starting from October 2009 to September 2011 for investigating purpose about stock returns. Total (24 months * 6 PSU Banks) 144 monthly returns on stocks have been calculated to observe the value of the PSU bank stocks. The date closing price of stocks, CNX PSU bank index have been taken from the NSE equity trading records from October 2009 to September Similarly total 144 monthly holding period returns have been calculated on these six banks for the same period. The return on an individual stock (Re) calculated under the SML, has been compared with monthly holding period return for each stock to investigate whether it is under or over-valued. Here it is assumed that any dividend or dividend yield will be incorporated by the monthly holding period return of the particular companies. The market return (Rm), risk free return (Rf) and beta (β) are the main elements of CAPM. The market return (Rm) is calculated from CNX PSU bank index by (EP-BP)*100/BP. 3-months fixed deposit rate of interest 8% and 8.5% per annum for the year 2009 and 2011 has been taken respectively as the proxy for risk-free rate. Beta (β) is used to measure the sensitively of individual return of stock in response to the market return. VIII. DATA ANALYSIS AND INTERPRETATION The under and over-valued stocks of six PSU banks listed on the NSE have been analysed for the period of twenty four months as stated from October 2009 to September 2011 under the SML. *For the purpose of well interpretation, the period of each table has been divided into two parts: Period from October 2009 to September 2010 taken as Table-1(a) and other part (from Oct.2010 to Sept.2011) taken as simply Table-1. This parameter has been applied in each table of this paper. Beta (β), compared with equity risk premium shows the amount of compensation equity investors need for taking an additional risk. It has been observed from the Table-1 that the stock of Canara Bank in the month of October, February, April and June has been irregularly underpriced on the parameters of SML. This indicates a further increase in the price or in the Holding Period Return (HPR). For the search of stock's bottom line which can be seen from the table (1) that there is an irregular decline in the HPR in the month of November, March and May. For the months of October, November, December, January, April, May, June, July, August and September there is no Market's Excess Return because of the negative return from the market as whole (see table 1). Here, the Market's Excess Return is simply the difference between market return (Rm) and risk free rate of return (Rf). Consequently, there are no chances of the Stock's Excess Return. However in the month of March, Stock's Excess Return is 3.89%. The Stock's Excess Return is calculated by multiplying the Market's Excess Return (Rm Rf) by β. Similarly table 1 (a) also states about the irregularity among the HPRs as these are under -valued in the months of June, July and September. The return on equity is negative on several occasions irrespective of the higher Beta. For example Beta in the months of 11-November, 11-January, 11-July, 11-August, 9-Decemner 83

4 and 10-January are very high but the stocks of Canara Bank has generated negative return on equity in the same months (see table 1 and 1a) and similarly negative HPR can be seen in the few months. It has been observed from the Table 2 that the stock of SBI has been irregularly underpriced in the month of October, February and March on the parameters of SML. In the other months, the HPR is negative because of the negative performance of the market (Rm) in the respective months. Because of the negative market returns, the SBI has performed no stock's excess return in these ten months. Similarly, the HPR and Re are negatively performed in the months of 10 November, 11-January, 11-May, 11-July, 11-August, 11- September (Table 2 a) and 09-Cotober, 10-February, 10-May (see table 2) irrespective of having higher Beta in these respective months. The Table (3) states that the stock of Bank of India has been undervalued in the months of October, November and February. Its HPR is negative in the months of October, November, December, January, April, June, July, August and September. Consequently this stock has generated no stock's excess return. The market's excess return 4.05% is generated only in the month 84

5 of March and the same month has generated 3.76% stock's excess return (Market's Excess Return multiply by beta). Similarly Table -3(a), developed on the CAPM, shows irregularity regarding the HPR, Re, Market excess return and stock's excess returns on the various parameters used under the CAPM in the Indian market. The investors of IOB have faced negative return on investment in the month of October, November, December, January, April, May, July and August (see Table 4). The stock of the concern company is undervalued in the months of June and September on the parameters of SML. Accordingly the HPR for several months are performed negative because of the negative market return. Consequently, there are no chances for the market's excess return and stock's excess return for these months. The market's excess return and stock's excess return are performed 4.05% and 1.99% respectively in a single month of March (see Table 4). similarly Table -4(a) states that the higher Beta of the IOB's stock in the months of 09-October and 09-December (1.04) have not been properly compensate with the either higher HPR or Re in the respective months. Hence, irrespective of the higher Beta,, negative HPR and Re have been generated in these months which shows no proper risk-return trade off under the CAPM. From the Table-5, it can be observed that the stock of ALB has been undervalued in the months of October, June and September on the parameters of SML. The markets excess return and stock's excess return are performed 4.05% and 2.55% respectively in the month of March. The negative market return cause 85

6 drastically fall in the HPR in the months of November, December, January, February, April, May, June, August and September. Consequently there is no stock's excess return in these months. The higher Beta of ALB's stock (Table 5a) in the months of 09-December (1.45) and 09-February (1.12) have received negative HPR and Re. The concern company stocks are undervalued in the months of 09-October, 09-November, 10- January10-April, 10-May, 10-July, 10-August and 10- September on the parameters of SML, see Table -5(a). On the parameters of SML, the stock of Oriental Bank is undervalued in the month of October, February and June (see Table 6). The market's excess return and stock's excess return are performed 4.05% and 2.99% respectively in the single month of March. The HPR of the Oriental Bank is negative in all months except the month of October, March, May and July because of the negative market return (see Table 6). The irregularity among the higher returns can also be seen in the Table 6(a). The higher Beta in the months of 09-December (1.25) and 10-May (1.03) have not been compensate with negative returns instead of compensating it with high HPR and Re. The stocks of Oriental Bank have been undervalued in the months of 09-October, 09- November, 10-January, 10-March, 10-April, 10-July, 10-August and 10-September showing a further increase in the HPR. The HPR and Re are performed negatively because of the negative performance of the market as whole. 86

7 IX. CONCLUSION The Capital Asset Pricing Model is no means a perfect theory. This study found a negative relationship between beta and excess returns indicating an inefficient capital market. On several occasions it has been found that underpriced stocks of PSU banks are continuously underpriced in the subsequent months which are not in line with the CAPM. Canara Bank stock has higher Beta in the months of 11-Jan. (1.09), 11-July (1.39), and 11-Aug. (1.09), 10-Jan. (1.09) but has generated negative HPR in the respective months and higher beta in the months of 11-Jan (1.09), 11-July (1.39) and 11-Aug. (1.09) has also generated negative Rate of Return on stock. Thus, it can be concluded that CAPM is not a suitable descriptor of asset prices in India over the chosen sample period. Moreover, residual variance, representing unsystematic risk, is also found significant in certain cases. Moreover, the regressions show poor explanatory power. It provides a usable measure of risk that helps investors to determine what return they deserve for putting their hard-earned money in stocks of PSU Banks in India. REFERENCES [1] Ball, Ray.. Anomalies in Relationships Between Securities' Yields and Yield-Surrogates. Journal of Financial Economics. 6:2, pp , [2] Banz, Rolf W.. The Relationship Between Return and Market Value of Common Stocks. Journal of Financial Economics. 9:1, pp. 3-18, [3] Basu, Sanjay.. Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: A Test of the Efficient Market Hypothesis. Journal of Finance. 12:3, pp , [4] Bhandari, Laxmi Chand.. Debt/Equity Ratio and Expected Common Stock Returns: Empirical Evidence. Journal of Finance. 43:2, pp , [5] Blume, Marshall and Irwin Friend. A New Look at the Capital Asset Pricing Model. Journal of Finance. 28:1, pp , [6] Campbell, John Y. and Robert J. Shiller. The Dividend-Price Ratio and Expectations offuture Dividends and Discount Factors. Review of Financial Studies. 1:3, pp , [7] Capaul, Carlo, Ian Rowley, and William F. Sharpe, International Value and Growth StockReturns. Financial Analysts Journal. January/February, pp , [8] Carhart, Mark M. On Persistence in Mutual Fund Performance. Journal of Finance. 52:1, pp , [9] DeBondt, Werner F. M. and Richard H. Thaler. Further Evidence on Investor Overreaction and Stock Market Seasonality. Journal of Finance. 42:3, pp , [10] Dechow, Patricia M., Amy P. Hutton and Richard G. Sloan. An Empirical Assessment of the Residual Income Valuation Model. Journal of Accounting and Economics. 26:1, [11] Rosenberg B., Reid K., Lanstein R. Persuasive evidence of market inefficiency. Journal of Portfolio Management 11:9-17, [12] Markowitz, Harry. Portfolio Selection: Efficient Diversification of Investments. Cowles Foundation Monograph No. 16. New York: John Wiley & Sons, Inc, [13] Merton, Robert C. An Intertemporal Capital Asset Pricing Model. Econometrica. 41:5, pp [14] Miller, Merton, and Myron Scholes. Rate of Return in Relation to Risk: A Reexamination of Some Recent Findings, in Studies in the Theory of Capital Markets. Michael C. Jensen, ed. New York: Praeger, pp , [15] Mitchell, Mark L. and Erik Stafford. Managerial Decisions and Long-Term Stock Price Performance. Journal of Business. 73:3, pp , [16] Pastor, Lubos, and Robert F. Stambaugh. Costs of Equity Capital and Model Mispricing. Journal of Finance. 54:1, pp , [17] Piotroski, Joseph D. Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers. Journal of Accounting Research. 38:Supplement, pp.1-51, [18] Reinganum, Marc R. A New Empirical Perspective on the CAPM. Journal of Financial and Quantitative Analysis. 16:4, pp , [19] Roll, Richard. A Critique of the Asset Pricing Theory's Tests' Part I: On Past and Potential Testability of the Theory. Journal of Financial Economics. 4:2, pp , [20] Rosenberg, Barr, Kenneth Reid, and Ronald Lanstein. Persuasive Evidence of Market Inefficiency. Journal of Portfolio Management. 11, pp. 9-17, [21] Sharpe, William F Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk. Journal of Finance. 19:3, pp [22] Internet Data base Information. 87