Evaluation of risk in the price to book value ratio of firms at the Nairobi stock exchange.

Abstract

This study examines the relationship between price to book value ratio and risk of stocks listed at the Nairobi Stock Exchange at single asset level. The price to book value (PBV)ratio belongs to a family of relative valuation ratios that is widely discussed in finance and investment literature. This research seeks an answer to the question, Do shares with high price to book ratio show high risk? The study sample is all the securities listed in the NSE from 1996 to 2003. Secondary data sources from the NSE and annual reports of listed companies will form the database. Annual share prices are used to calculate price to book ratio and security returns. Security returns are calculated after adjusting the security prices for dividends, seasonal equity offerings and stock splits. The resulting security returns are then used in estimating risk inherent in the sampled shares listed at the NSE. Two rankings are extracted, one based on price to book ratio and another on risk. Each extracted ranking is then classified by assigning values, 1 and 0 depending on whether it is above or below the market average ratio or risk. The correspondence in the two rankings is then measured using cross tabulations. The findings indicate that risk as derived from the variability in return on equity is related to price to book ratio. This suggest that earnings variability is a major factor in the changes in price to book ratio. However, the surprise result is the absence in the relationship between variability in return per share and price to book ratio given that return per share is derived from the market price per share. The conclusion is that investors interested in analyzing risk need not entirely rely on price to book ratio for that purpose and that largely, the differences in price to book ratio could be explained by other factors and not necessarily risk.