Book-to-market ratio as a predictor of performance: a case study of companies listed at the Nairobi stock exchange (NSE)

Abstract

This research provides a test on the extent of predictive ability of book-to-market ratio in the Kenyan stock market. The use of book-to-market ratio as forecasting variable is examined using Nairobi Stock Exchange (NSE) data from 1996 to 2002.This study mirrors studies done earlier by Fama and French (1992), Chan, Hamao and Lakonishok (1996),Kothari, Shanken and Sloan (1997) among other researchers. These studies yielded varying results; others are in agreement that these ratios do well in forecasting stock returns while others conclude otherwise. The data used in this research was collected from NSE's daily stock prices for the period 1999 to 2002 from which the weekly returns for the listed firms were compiled for the same period. Book-to-market values for the firms included in the sample were also obtained from the NSE. This study focused on two portfolios of firms: those which consistently have the highest book-to-market ratios over the period 1996 to 1998, and for those which consistently have the lowest book-to-market ratios over the same period. The returns for the subsequent five years (1999 to 2002) are used to evaluate the predictive power of the book to market. A qualitative analysis was conducted in which various statistical tests were carried out. Chi square tests of independence were conducted to test whether the book-to-market ratio has significant explanatory power on the companies' future returns. Paired sample T-tests were used to confirm whether there is a significant difference between the average returns for the two portfolios while F-tests were conducted to test whether there is significant difference between variance for the two samples. The conclusions drawn from the research were that the portfolio for firms with low book to market ratio made significantly higher returns than the portfolio for firms with high book to market ratio. The portfolio with low book-to-market firms had an average return of 2% between 1999 to 2002 while the portfolio with high book to market ratio had average return of -10% during the study period. The book to market ratio is found to have predictive ability, though returns of the two portfolios did not differ significantly.