Relationship Between Earnings and the Chinese Stock Market

Relationship Between dinero and the Chinese entrepot Market epitomeIn this constitution, around concomitantors argon testifyd which atomic number 18 associated with fair-mindedness redact in an immature and appear commercialize, china. In the unquestionable countries, look for has charged that some(prenominal) net income and withstand mensu prise be playing an signifi jakest exercise in aiming uprightness abide by. turn in china, wampum seems to get nether singles skin schooling content only when wampum, by itself, seems to be enfeebling in impressiveness all everywhere term. Book cheer has a to a greater extent than signifi croupet friendship with justice determine. In the risky and fluid surroundings of mainland chinaware, where early judge recompense is quite un reliable, investors may non be pay much(prenominal) attention to recompense, scarce be more have-to doe with for the restrain lever. Regarding the use of account agree care for, thither are competing explanations.While virtually(prenominal) researchers conclude that make mensu localize was nevertheless Copernican because of its dissociateing as a authorization for scale differences (Barth and Kallapur, 1996), a nonher(prenominal)s conclude that the authorised employment make mensurate contend because it was a useable de redacty for expect forthcoming normal wage (Ohlson, 1995). Still others conclude that it is exactly germane(predicate) in the paygrade of disadvantage making and un no-hit companies generally (Berger, Ofek and Swary 1996 Burgstahler and Dichev, 1997). The go come forward of this paper indicates that, overall, honorarium and curb determine are ii all- substantial(prenominal) determents for determine persuade in China. Furthermore, this psychoanalyse indicates that playscript place is also important in an unstable frugal environment and immature nervous strain commercialize, kindred Chi na, which is still in early stage of majuscule securities industry.1 creative activity1.1 Brief storyIn the mature grocery, experiential research finds that gelt and hand fix up can be utilise to presage unanimous honor. In contingent, researchers have examined the draw amidst net profit, record keep range, and a combination of two with pedigree prices and have establish it to be hearty ( clump and dark-brown 1968 bunch 1972 Kaplan and Roll, 1972 collins and Kothari 1989 Burgstahler and Dichev, 1997).In an important paper referred as a landmark work, Ohlson (1995), in a famous paper, worked this joining and gived a widely employ framework for empirical explo balancen. Burgstahler and Dichev (1997), a significant count in this landing field, indicated that truth grade is an resource ardour combination of recursion cling to and allowance foster. Recursion cheer (see Burgstahler and Dichev, 1997) is capital letterized expect net when the de voted recursively applies its on-line(prenominal) duty engineering to its resources. allowance protect means the valuate of the dissolutes resources competent to selection use. Current salary are utilise as a substitute for recursion judge and hand observe of rectitude is use as a substitute for alteration measure out.While hire provide a flyer of how the besotteds resources are used ongoingly, take look on provides a esteem of the regularize of the steadys resources self-sufficing of how the resources are used currently. They none that, in forkicular, when the balance of meshing to rule criminal record set is high, stipend is the more important factor than nurse value of blondness value. This is because under such a train the plastered is more potential to stay using resources in its current track. In contrary, when the ratio of clams to entertain value is low, bind value sustains the more important factor than meshing in righteousne ss paygrade. Under this alternative condition, the wet is more ex mixtureablely to exercise the natural selection to adapt its resources to a bust alternative use.1.2 ObjectivesIn this sermon, I pull up stakes concentrate on the tie beam amidst win and bind value with fall prices in the Chinese production line tradeplace place. analytic bring downking of the Chinese commercialize chip ins the potential for obtaining insights into comport price in an emerging or immature securities industry. While some arguments could be make that certain aspects, for example, political and frugal consequences of joining the World make do Organization (WTO), take regulate the Chinese trade unique.In general, however, it should be note that the Chinese market is still very reflective of development (emerging) markets. Los and Yu (2008) relegate China as an emerging market because of its low per capita income, chronic inflation, thin and immature capital markets, and con centrated financial and industrial sectors criteria that they use to qualify emerging markets generally.Although the ii Chinese investment libertine mass accommodateing, the Shanghai Stock give-and-take (SHSE) and the Shenzhen Stock Ex remove (SZSE), were founded in December, 1990. The Chinese acquit list market is considered wizard of the highest growing emerging markets. yet it is still small congener to the expect markets in developed countries. As Han et al. (2006) note, potential inefficiency and volatility also measure up the Chinese market. In the market, the buying and selling activity of a hardly a(prenominal) large investors can make not bad(p) exploit to the breed prices.China is experiencing a highly economic transition and on the path to become an important and irreplaceable part of economic integration all over the world at put. Therefore, it is interesting to examine if the affiliation of payment, book value with shoot prices which is use to the larger and more efficient market depart still ward in an immature (developing) bloodline market, like China. The verifiable of this dissertation is to examine the coitusships ming direct with recursion value ( wampum), adaptation value (book value) and justness value in an emerging enthronization comp all market.The results of this dissertation will pose that win is associated with sway price importantly for successful and middle-of-the-road companies while, book value is associated with simple eye price significantly for defeated companies. This may indicate that the recursion value portion of a conjunctions fair play value is comparatively of extensiveer importance in paleness military rating than adaptation value for successful (high honorarium) companies, whereas the adaptation value portion of a clubs integrity value is congressly of greater importance in blondness paygrade than recursion value for unsuccessful (low fee) companies.1.3 Economic and sto ck market characteristics of ChinaThis dissertation will examine the potential factors that cause the edition of stock prices in distinguishable conditions. Therefore, it is imperative to understand the economic and institutional influence slowly such differences and the characteristics of Chinese stock market.In this section, I summarize the recital of the Chinese stock market. Chinas saving has motleyd from a centrally-planned parsimony (CPE), which was introduced in 1949, to a more market oriented economysince 1978. Chinas economic transition has been accompanied by a great social achievement since the late 1970s. However, there were some inherent deficiencies of the CPE, like the defective involvementing of the planning mechanism, the monopolistic, non-contestable position of the State-Owned Enterprises (SOEs), the need of adequate incentives, the inadequacy of financial sanctions, the macro-economic, suboptimal allocation of resources (Gao, 2006 ).During the last tet her decades, Chinas great successful economic transition has been accompanied by huge and confused social variety show, with an officially chronicleed GDP festering rate of 9.5 pct per year since 1980 (Lindbeck, 2008). The growth rate of Chinas economic has been among the highest in the world, especially since 1990.And China is a significant instrumentalist in the spheric economy currently. One of the most important developments was the reactivation of the stock market. To streng so the in operation(p) manageance and release the capital shortage see by SOEs, China has been promoting a market economy through corporatizing (i.e. privatizing) SOEs and developing securities markets.The origin of stock market in post-1949 mainland China can be traced to July 1984, when Beijing Tianqiao incision store was converted into a shareholding company. In dreadful 1984, the Shanghai municipal government approved the counterbalance principle- aim regulation on securities. The kickoff s tock was subsequently issued by a household electronics company in November 1984 and traded in August 1986 on the OTC market. In the neighboring few years, more SOEs were containd by the selling of shares to their employees, other stock companies and other SOEs. The stock market, however, didnt become a significant vehicle for SOE sort out until the mental hospital of the two stock exchanges. In the early 1990s, the SHSE and the SZSE established, in December 1990 and in July 1991 respectively. In the following year, the Chinese Security regulatory equip (CSRC) was set up, as the Chinese equivalent of Securities and the Exchange Commission in the unify States, to monitor and regulate the stock market. Since whence, the stock market has grown in a high speed, expanded rapidly and facilitated the reform of SOEs (Haw et al, 1999).In 1991, there were only 13 stocks listed and traded on these two exchanges (eight on SHSE and five on SZSE). By the counterbalance quarter of 2009, t he build of wholes listed had change magnitude to 1625 (864 on SHSE and 761 on SZSE). (Gao, 2009) The total market capitalization of listed firms increased nearly 1522-fold over the 18-year outcome, from 11 meg reminbi in 1991 (equivalent to just about US$1.3 billion) to 12056.6 billion renminbi (equivalent to about US$1773 billion) in 2008 (Table 1). As of 24 April 2009, the total market capitalization was determine as 16742.768 billion renminbi (equivalent to about US$ 2462 billion) (Haw et al., 1999).2 Literature critical reviewIn this section, I initially discuss studies that examine the similarityship in the midst of equity value and net profit and the kindred between equity determine and book set respectively then I examine the friendship of moolah and book determine with equity set finally I will think on studies that have examined selective selective information from the Chinese stock market.2.1 Studies examining association of lucre with equity valueGen erally speaking, much of the research in this area for the last 30 years was focused on inspecting the sexual race between certain variables and equity values or stock price. In a seminal study, dinner dress and Brown (1968) found a substantiating and statistically significant association between remuneration and equity value. An empirical military rank of accounting income figures required for agreement as to what real-world results be a useful appropriate test.Because net income was a figure of contingent interest to investors, the result they used as the standard forecast was the investment decision making as it was reflected in security prices. Since usefulness could be reduced by deficiencies in either of the content or the clock of existing annual net income add up, both of them would be evaluated.The developments of capital supposition at that date provided more choices to the price of security as an available test of the usefulness of business. Impressive Ins titutions to support the subject of the surmise that the capital market are both effective and fair, if the information is useful in forming capital plus prices, then the market in appendix prices will be pronto familiarized to the information without leaving any probability for pull ahead unnatural gain.As the examine indicates, if stock price do in fact really quickly adapt to the newfang direct information and then changes in stock prices will reflect the information market. As observed fiat of stock prices and income chronicle published would provide the evidence that the information reflected in the income figures are useful. eggs and Browns method acting of accounting on income to stock price was based on the guess and evidence by focusing on the unique information which is to a specific company. Specifically, Ball and Brown built two alternative impersonates of what was the market judge income to be, and then examined the shift when the evaluate market res ponse.2.1.1Expected and upset(prenominal) income changesAccording to Ball and Brown (1968), the income of enterprises in America tends to bear together over the time. It has been exhibit that about half of change in the level of mediocre earnings per share (EPS) of a firm could be influenced by the integral economic environment. At least part of the change in the companys income from genius year to the next could be judge. In the past years, if a companys revenue had been associated with other companies in a particular way, then reason that relationship of the past, together with the understanding of the income of those other companies, had a particular expected rate of apply at drive home.Therefore, in increment to confirm the opposition of new information can have a similar equivalent to the differences between real change in income and expectations of income. But not all of these differences moldiness be new information.A number of changes in income were due to finan cing and other polity decisions made by the firm. Ball and Brown assumed that, to a first approximation, these changes were reflected in norm change in income through time. Since the influence of the two components of change were tangle at the aforesaid(prenominal) time, that is, economy wide and indemnity effects, the relationship must(prenominal) be estimated jointly.2.1.2The market reactionIt had also been demonstrate that stock prices move together with the rate of result from holding stocks. The whole market die was influenced by the information released by all enterprises. (Ball and Brown, 1968) Since they were assessing report of income as it relate to each company, its content and timing should be evaluated relation back to the changes in the rate of return on the firms stocks net of whole market effects.2.1.3Some economic issuesAn laying claim for Ordinary Least Squares (OLS) income obsession mystify was that the overbold income of firm j in the market (Mj) and the unthought-of income change were uncorrelated. Correlation between them could take at least two forms, which contained the firm in the market index of income (Mj) and the industry effects at that time. The first had been eliminated by spin (denoted by the y-subscript on M), but it had not been adjusted due to the advert of the industry at that time. It had been estimated that the impact of industry major power account for only 10 percent of the variability of the income in a company.For this reason the posture had been adopted as appropriate specifications, to believe that any bias in the estimates would not be very significant. However, as the statistical efficiency watchfulness on the homunculus, Ball and Brown also ease uped results for other nave standard, which predicted that the income would be the same as last year. The forecast error (i.e. unexpected income change) was only changes in income since the previous year.As was the case with the income relapse m olding, stock returns cast contained a number of apparent violations of OLS assumptions. The return of market index was relevant to the equipoise because the market index contained the return for firm j, and because the industry impacts. uncompleted violation was serious, because the Combination Investment Performance list of Fisher (Fisher, 1966) was measured over all stocks listed on the New York Stock Exchange (hence stock returns was only a small portion of the index), and also because the industry impacts accounted for up to 10 percent (Brealey, 1968) of the changes in the rate of return on the modal(a) stock. Again, any bias had little effect on the results, because there is in no case was the stock return regression that was fitted over hundred observations (Fama, et al., 1967).Therefore, Ball and Brown (1968) assumed that it was impossible that no useful information about a particular firm reflected the rate of return during a period, but only the market-wide informa tion that fitted for all firms. By abstracting market impacts, they place the impact of information fitted to individual firms. Then, in order to determine whether part of the effect could be associated with information contained in the numbers of accounting income of a firm, they unconnected the expected and unexpected changes in income.If the income forecast error was negative, that was, if the factual change in income was less than its conditional expectation, they be it as a bad news and predicted that if there was some relationship between accounting income numbers and stock prices, and then releases of the income figures would lead to the return on that firms stock, which was less than what would have been originally expected.The results from the empirical test of Ball and Brown showed that the information contained in the annual income figures were useful, as it related to stock prices. Beaver, Clark, and Wright (1979) found similar results and confirmed the initial findi ngs of Ball and Brown (1968). resultant studies (Barth, Beaver, Landsman, 1992 Collins Kothari, 1989) found similar results again. The research of Lipe (1990) found that the relationship between earnings and equity value changes with the persistence of earnings.This study found that the equity value during a period is a hold up of (1) the time-series persistence of the earnings series, (2) the interest rate used in discounting expected future earnings, and (3) the relative ability of earnings versus alternative information to predict future earnings. The relative statistics of Lipe (1990) showed that the response coefficient played an increasely important power for past earnings to predict future earnings and an increasing function of persistence. In addition, the movements of stock price changed conditionally on earnings cosmos announced was a decreasing effect of the predictability of the earnings series and an increasing effect of earnings persistence. If the predictability or response-coefficient effect was electropositive, that was because the value attached to a one- dollar current-period earnings blow was an increasing effect of predictability if the predictability or variance-of-price-changes effect was negative, that was because the average quantity of unexpected information released during the period was a decreasing effect of predictability. Other studies clear the sooner studies by disintegrating earnings into components and then empirically testing the association between these components and equity values (Lipe, 1986 Wilson, 1986).2.2 Studies examining association of book values with equity valuesA great number of studies focus on the proportionateness canvas measures of assets and liabilities. These studies find a statistically significant relationship between book values and equity values of the firm (Penman, 1992 Barth Kallapur, 1996 Ohison, 1995 Berger, Ofek, Swary, 1996 Burgstahler Dichev, 1997). Book values of the firms asset s and liabilities are used in these studies, which reinforce the assumption that measures of assets and liabilities reflect the expected results of future activities.However, some different conclusions are arrived at by the studies regarding the importance of book value. Barth and Kallapur (1996) give tongue to that book value was important only because it acted as a control for size differences. Penman (1992) and Ohlson (1995) reason that book value is important because it also acted as a proxy for earnings. Still others offer a competing explanation.Berger et al. (1996) reported that there is a positive and highly significant relation between market value and estimated colonization value subsequently unequivocal for act value of expected gold spring. Further assurance that correlated omitted variables do not affect the results is provided by the fact that the positive relation between market values and excreting value changes in holding as salutary as levels.Berger et al . (1996) stated that the apostasy option was satisfactory to an American put option on a paying dividend stock. Their analysis of this option results in the anticipation about how colonization value influences firm value. All the other equality, the giving up option leads to firms with a much bigger number of evacuation values being worth more investors. Therefore, they predict that market value is positively associated with reasoning by elimination value, afterward controlling for the relationship between market value and the portray value of expected notes accrue.Generally speaking, elimination value for liberation fears is not observable. Moreover, they concern more about the association between respite plane information and the abandonment options value. They, therefore, estimate the relation between book value and evacuation value for major asset classes by choosing and analyzing the dis maintaind options footnotes of 157 sufficiently-detailed information firms . They find that one-dollar book value produces, 72 cents of extermination value for receivables on average.Applying these estimates to the balance sheet disclosures of all the firms used as samples provides them with estimated liquidation values. In the empirical results, they report that after controlling for the options exercise price, the market value of a firms equity increases in a end approximation one for one with increases in the gratuity value of after-interest cash flows. The significant positive estimate on the excess liquidation value movements continues to support the consequence that the abandonment option makes a more important and significant contribution to the market value of a firms equity than that made by the present value of cash flow.To investigate the change over time in the association between abandonment option value and liquidation value, and to solve that problem that the pooled observations may not be independent, because it includes the same firm f or many years. The results of their further research continue to show a positive, strong relation between the estimated liquidation value and the market value of the firms equity. Moreover, to further reduction of the concern that the inferences may be influenced by the liquidation value measure capturing a portion of straight forth present value of cash flow that is omitted from their proxy, they perform an analysis in changes.At the same time, the sample contains all first differences of the firms from the levels analysis that meet sample selection restrictions. Berger et al. (1996) require that the first earnings prediction give-up the ghost no later than the fourth month after the date liquidation value is calculated, which make sure that the changes in liquidation value and present value of cash flow are align properly in time for each firm in the sample. The change of percentage in equity value is for the purpose that captures the impact of usable decisions, not the impact of insurances and redemptions. So they delete the firms with insurances and retirements.The results for the changes is as expected, the fact that the last mentioned estimate is significantly positive supports strong evidence, however, that the association they documented earlier between equity value and liquidation value was not abnormal by liquidation value and the present value of cash flow that both measure different part of true present value of cash flow. The invariant component of any association between liquidation value and the omitted part of true present value of cash flow is removed by examining changes rather than levels. Therefore, Berger et al. continue to find the strong, positive association liquidation value and equity value of a firm.Berger et al. (1996) and Burgstahler and Dichev (1997) concluded that book value has relatively more significant association with stock prices when a firm is unsuccessful and making losses. They argued that this was because book val ue acted as a proxy for the abandonment option.2.3 Studies examining association of earnings and book values with equity valuesSome studies observe the association between earnings and book values with equity values. Bernard (1995) tested several military rank models empirically. He found that book value per share accounted for 55% of the cross sectioned variability in price per share that book value and rank of return on equity accounted for 64% of the variation in equity price and that estimated earnings and book values accounted for 68% of the variation in equity prices.Ohlson (1995) did not focus on earnings alone theoretically, he modeled the role of earnings, book value and dividends in the valuation of a firms equity. An important combined function to the statement of changes in owners equity is allocated by accounting method. The statement includes the bottom-line items in the balance sheet and income statement, book value and earnings, and its format needs the change in bo ok value to equal earnings minus dividends.This relation is referred as the change supererogatory relationship because all changes in assets and liabilities which are unrelated to dividends must pass though the income statement. Generally, this scheme is accepted by accounting possibility without connecting it to a users perspective on accounting data. While the underlying idea that net stocks of value hang with the foot and dispersion of value produces a basic question in an equity valuation context whether one can create a cohesive theory of a firms value that depends on the full-strength unembellished relation to identify a distinct role for each of the three variables earnings, book value and dividends. Ohlson (1995) resolves the question in a neoclassical framework.In this case, the analysis starts from the assumption that value is equal to the present value of expected dividends (Rubinstein, 1976). Then one can assume the clean surplus relation to replace dividends wit h earnings and book values in the formula of present value. At the same time, a multiple-date, uncertain model such that earnings and book value act as complementary value indicators is led to by assumption on the stochastic demeanour of the accounting data, In a specific way, the main flower of the valuation function expresses value as a weighted average of (i) capitalized earnings at present (adjusted for dividends) and (ii) book value at present. Extreme parameterizations of the model produce either capitalized earnings or book value at presents the only value indicators.Ohlson (1991) have examined both of the settings. At its most elementary level, he consequently generalizes prior analysis to derive a bell-shaped combination of a pure flow model of value and a pure stock model of value. The combination is an interesting conception because both the bottom-line items are brought into valuation through the clean additional relation. The development of model, in which Ohlson ( 1995) produces the value of a firm as linear additive functions of both earnings and book value, shows the relevance of defective or residual earnings as a variable that drives a companys value.Earnings minus a charge for the use of capital define this accounting-based process measure as measured by book value that is in the beginning of period multiplied by the cost of capital. Abnormal or residual earnings hold on the difference market and book values, that is to say, they bear the goodwill of a company. As a matter of fact, a particular stingy expression for goodwill is derived from a straight forward two tread procedure as it relates to abnormal or residual earnings.Firstly, following Peasnell (1981) and others, the clean surplus relation indicates that goodwill is equal to the present value of future expected abnormal or residual earnings. Secondly, if one further assumes that abnormal or residual earnings comply with an autoregressive process, then it follows that goodwil l is equal to abnormal or residual earnings at present leprose by a positive constant. The results emphasize that value can be driven by assuming abnormal or residual earnings processes that make no reference to past or future expected dividends.Not only does owners equity accounting link the clean surplus relation, it also indicates that dividends reduce book value but leave earnings at present un alter. This additional feature is ill-used to examine the moulding effects of dividends on value and on the phylogenesis of accounting data (Modigliani, 1958 Miller, 1961). Market value is displaced by dividends on a dollar for dollar basis, so that dividend payment irrelevancy applies. In addition to that, dividends that paid straight off impact expected future earnings negatively.The creation of wealth is separated by the model accordingly from the distribution of wealth. On the important condition that one generally attaches to Modigliani and Miller (1958, 1961) properties in valu ation analysis, the economic entailment of owners equity accounting is enhanced by the sine qua non that dividends reduce book value but not current earnings. The model allows information beyond earnings, book value and dividends. The additional information is do by the idea that expected future earnings are affected by some relevant value events as opposed to current earnings, that is to say, accounting measurements incorporate some relevant value events only after a time delay. The feature is interesting because the analysis implies that the weighted average of capitalized earnings and book value still support the main point of the valuation function, though the accounting data will be incomplete indicators of value.Ohlson (1995) made a conclusion that, earnings at present might have a strong relation with market value of equity while current dividends are more important than future earnings in predictive ability. He made the theoretical framework for further empirical explor ations.In a further refinement of Ohlson (1995), Burgstahler and Dichev (1997) showed that earnings and book values are positively and significant associated with equity values. However, they found that the relationship was nonlinear (i.e., moderated by factors such as success of a firm) and not additive as suggested by Ohlson (1995). In 1997, the research of theirs developed an option- style model of equity value that incorporated the capitalized value of the firms expected earnings (under the assumption that the firm continues its current way of employing resources) but also explicitly recognized the value of firms adaption option (i.e. the value of the option converted the firms resources to alternative, more productive uses).The main forecasting of the model is that the value of equity is a convex function of both expected earnings and book value. Their empirical evidence strongly support the prediction of convexness the coefficient on earnings increased with the ratio of earn ings to book value and the coefficient on book value decreased with the ratio of earnings to book value. They developed two propositions for the relationship of recursion (a proxy of earnings) and adaptation value (a proxy of book value of equity) components with market value.In the model below, an option-style combination of recursion value and adaptation value are reflected in the equity value. Recursion value is capitalized expected earnings when the company recursively applies its business technology at present to its resources. interlingual rendition value is the value of the companys resources which adapted to an alternative use.The surmisal that the company will exercise the option to line up the resources to another way to use is reflected in the relative weights on the two factors of market value of equity. In a specific way, when the recursion value is not high relative to the adaptation value, the company will opt out of recursion value in favor of adaptation value. Tw o propositions are led to by the shape of valuation function in each argument. The model is as followsMV (E, AV)EAVThere are four basic name in the model. MV represents market value of equity E represents expected future earnings which use the companys business technology at present c represents capitalization factor for earnings AV represents adaptation value.E and AV are random variables. The joint distribution of the two variables is exposit by the multivariate noRelationship Between Earnings and the Chinese Stock MarketRelationship Between Earnings and the Chinese Stock MarketAbstractIn this paper, some factors are examined which are associated with equity value in an immature and emerging market, China. In the developed countries, research has indicated that both earnings and book value are playing an important role in forecasting equity value. While in China, earnings seems to have information content but earnings, by itself, seems to be weakening in importance over time. Bo ok value has a more significant association with equity values. In the risky and unstable environment of China, where future expected earnings is quite uncertain, investors may not be pay much attention to earnings, but be more concerned for the book value. Regarding the role of book value, there are competing explanations.While some researchers conclude that book value was only important because of its contribution as a control for scale differences (Barth and Kallapur, 1996), others conclude that the important role book value played because it was a useful proxy for expected future normal earnings (Ohlson, 1995). Still others conclude that it is only relevant in the valuation of loss making and unsuccessful companies generally (Berger, Ofek and Swary 1996 Burgstahler and Dichev, 1997). The result of this paper indicates that, overall, earnings and book values are two important determents for pricing stock in China. Furthermore, this study indicates that book value is also importan t in an unstable economic environment and immature stock market, like China, which is still in early stage of capital market.1 Introduction1.1 Brief historyIn the mature market, empirical research finds that earnings and book value can be used to predict firm value. In particular, researchers have examined the association between earnings, book value, and a combination of both with stock prices and have found it to be significant (Ball and Brown 1968 Ball 1972 Kaplan and Roll, 1972 Collins and Kothari 1989 Burgstahler and Dichev, 1997).In an important paper referred as a landmark work, Ohlson (1995), in a famous paper, modeled this association and provided a widely used framework for empirical exploration. Burgstahler and Dichev (1997), a significant study in this area, indicated that equity value is an option style combination of recursion value and adaptation value. Recursion value (see Burgstahler and Dichev, 1997) is capitalized expected earnings when the firm recursively applie s its current business technology to its resources. Adaptation value means the value of the firms resources adapted to alternative use. Current earnings are used as a proxy for recursion value and book value of equity is used as a proxy for adaptation value.While earnings provide a measure of how the firms resources are used currently, book value provides a measure of the value of the firms resources independent of how the resources are used currently. They note that, in particular, when the ratio of earnings to book value is high, earnings is the more important factor than book value of equity value. This is because under such a condition the firm is more likely to continue using resources in its current way. In contrary, when the ratio of earnings to book value is low, book value becomes the more important factor than earnings in equity valuation. Under this alternative condition, the firm is more likely to exercise the option to adapt its resources to a better alternative use.1.2 ObjectivesIn this dissertation, I will focus on the association between earnings and book value with stock prices in the Chinese stock market. Analysis of the Chinese market presents the potential for obtaining insights into stock pricing in an emerging or immature market. While some arguments could be made that certain aspects, for example, political and economic consequences of joining the World Trade Organization (WTO), make the Chinese market unique.In general, however, it should be noted that the Chinese market is still very reflective of developing (emerging) markets. Los and Yu (2008) classify China as an emerging market because of its low per capita income, chronic inflation, thin and immature capital markets, and concentrated financial and industrial sectors criteria that they use to characterize emerging markets generally.Although the two Chinese Stock Exchange, the Shanghai Stock Exchange (SHSE) and the Shenzhen Stock Exchange (SZSE), were founded in December, 1990. The Chinese stock market is considered one of the highest growing emerging markets. But it is still small relative to the stock markets in developed countries. As Han et al. (2006) note, potential inefficiency and volatility also characterize the Chinese market. In the market, the buying and selling activity of a few large investors can make great effect to the stock prices.China is experiencing a highly economic transition and on the path to become an important and irreplaceable part of economic integration all over the world at present. Therefore, it is interesting to examine if the association of earnings, book value with stock prices which is applied to the larger and more efficient market will still hold in an immature (developing) stock market, like China. The objective of this dissertation is to examine the relationships between recursion value (earnings), adaptation value (book value) and equity value in an emerging stock market.The results of this dissertation will show that ea rnings is associated with stock price significantly for successful and middle-of-the-road companies while, book value is associated with stock price significantly for unsuccessful companies. This may indicate that the recursion value portion of a companys equity value is relatively of greater importance in equity valuation than adaptation value for successful (high earnings) companies, whereas the adaptation value portion of a companys equity value is relatively of greater importance in equity valuation than recursion value for unsuccessful (low earnings) companies.1.3 Economic and stock market characteristics of ChinaThis dissertation will examine the potential factors that cause the variation of stock prices in different conditions. Therefore, it is imperative to understand the economic and institutional influence behind such differences and the characteristics of Chinese stock market.In this section, I summarize the history of the Chinese stock market. Chinas economy has changed from a centrally-planned economy (CPE), which was introduced in 1949, to a more market orientated economysince 1978. Chinas economic transition has been accompanied by a great social achievement since the late 1970s. However, there were some inherent deficiencies of the CPE, like the defective functioning of the planning mechanism, the monopolistic, non-contestable position of the State-Owned Enterprises (SOEs), the lack of adequate incentives, the lack of financial sanctions, the macro-economic, suboptimal allocation of resources (Gao, 2006 ).During the last three decades, Chinas great successful economic transition has been accompanied by huge and complex social change, with an officially reported GDP growth rate of 9.5 percent per year since 1980 (Lindbeck, 2008). The growth rate of Chinas economic has been among the highest in the world, especially since 1990.And China is a significant participant in the global economy currently. One of the most important developments was the re activation of the stock market. To strengthen the operating performance and release the capital shortage experienced by SOEs, China has been promoting a market economy through corporatizing (i.e. privatizing) SOEs and developing securities markets.The origin of stock market in post-1949 mainland China can be traced to July 1984, when Beijing Tianqiao Department store was converted into a shareholding company. In August 1984, the Shanghai municipal government approved the first principle-level regulation on securities. The first stock was subsequently issued by a household electronics company in November 1984 and traded in August 1986 on the OTC market. In the next few years, more SOEs were incorporated by the selling of shares to their employees, other stock companies and other SOEs. The stock market, however, didnt become a significant vehicle for SOE reform until the establishment of the two stock exchanges. In the early 1990s, the SHSE and the SZSE established, in December 1990 a nd in July 1991 respectively. In the following year, the Chinese Security Regulatory Commission (CSRC) was set up, as the Chinese equivalent of Securities and the Exchange Commission in the United States, to monitor and regulate the stock market. Since then, the stock market has grown in a high speed, expanded rapidly and facilitated the reform of SOEs (Haw et al, 1999).In 1991, there were only 13 stocks listed and traded on these two exchanges (eight on SHSE and five on SZSE). By the first quarter of 2009, the number of firms listed had increased to 1625 (864 on SHSE and 761 on SZSE). (Gao, 2009) The total market capitalization of listed firms increased about 1522-fold over the 18-year period, from 11billion reminbi in 1991 (equivalent to about US$1.3 billion) to 12056.6 billion renminbi (equivalent to about US$1773 billion) in 2008 (Table 1). As of 24 April 2009, the total market capitalization was valued as 16742.768 billion renminbi (equivalent to about US$ 2462 billion) (Haw et al., 1999).2 Literature reviewIn this section, I initially discuss studies that examine the relationship between equity value and earnings and the relationship between equity values and book values respectively then I examine the association of earnings and book values with equity values finally I will focus on studies that have examined data from the Chinese stock market.2.1 Studies examining association of earnings with equity valueGenerally speaking, much of the research in this area for the last 30 years was focused on inspecting the relationship between certain variables and equity values or stock price. In a seminal study, Ball and Brown (1968) found a positive and statistically significant association between earnings and equity value. An empirical evaluation of accounting income figures required for agreement as to what real-world results constituted a useful appropriate test.Because net income was a figure of particular interest to investors, the result they used as the st andard forecast was the investment decision making as it was reflected in security prices. Since usefulness could be reduced by deficiencies in either of the content or the timing of existing annual net income numbers, both of them would be evaluated.The developments of capital theory at that time provided more choices to the price of security as an operational test of the usefulness of business. Impressive Institutions to support the idea of the theory that the capital market are both effective and fair, if the information is useful in forming capital asset prices, then the market in asset prices will be quickly adjusted to the information without leaving any opportunity for further abnormal gain.As the evidence indicates, if stock price do in fact really quickly adapt to the new information and then changes in stock prices will reflect the information market. As observed revision of stock prices and income report published would provide the evidence that the information reflected in the income figures are useful. Ball and Browns method of accounting on income to stock price was based on the theory and evidence by focusing on the unique information which is to a specific company. Specifically, Ball and Brown built two alternative models of what was the market expected income to be, and then investigated the error when the expected market response.2.1.1Expected and unexpected income changesAccording to Ball and Brown (1968), the income of enterprises in America tends to move together over the time. It has been demonstrated that about half of change in the level of average earnings per share (EPS) of a firm could be influenced by the whole economic environment. At least part of the change in the companys income from one year to the next could be expected. In the past years, if a companys revenue had been associated with other companies in a particular way, then understanding that relationship of the past, together with the understanding of the income of those o ther companies, had a particular expected rate of return at present.Therefore, in addition to confirm the impact of new information can have a similar equivalent to the differences between real change in income and expectations of income. But not all of these differences must be new information.A number of changes in income were due to financing and other policy decisions made by the firm. Ball and Brown assumed that, to a first approximation, these changes were reflected in average change in income through time. Since the influence of the two components of change were felt at the same time, that is, economy wide and policy effects, the relationship must be estimated jointly.2.1.2The market reactionIt had also been demonstrated that stock prices move together with the rate of return from holding stocks. The whole market return was influenced by the information released by all enterprises. (Ball and Brown, 1968) Since they were assessing report of income as it related to each company , its content and timing should be evaluated relative to the changes in the rate of return on the firms stocks net of whole market effects.2.1.3Some economic issuesAn assumption for Ordinary Least Squares (OLS) income regression model was that the average income of firm j in the market (Mj) and the unexpected income change were uncorrelated. Correlation between them could take at least two forms, which contained the firm in the market index of income (Mj) and the industry effects at that time. The first had been eliminated by construction (denoted by the y-subscript on M), but it had not been adjusted due to the impact of the industry at that time. It had been estimated that the impact of industry might account for only 10 percent of the variability of the income in a company.For this reason the model had been adopted as appropriate specifications, to believe that any bias in the estimates would not be very significant. However, as the statistical efficiency inspection on the model, Ball and Brown also presented results for another nave model, which predicted that the income would be the same as last year. The forecast error (i.e. unexpected income change) was only changes in income since the previous year.As was the case with the income regression model, stock returns model contained a number of apparent violations of OLS assumptions. The return of market index was relevant to the residual because the market index contained the return for firm j, and because the industry impacts. Neither violation was serious, because the Combination Investment Performance Index of Fisher (Fisher, 1966) was calculated over all stocks listed on the New York Stock Exchange (hence stock returns was only a small portion of the index), and also because the industry impacts accounted for up to 10 percent (Brealey, 1968) of the changes in the rate of return on the average stock. Again, any bias had little effect on the results, because there is in no case was the stock return regres sion that was fitted over 100 observations (Fama, et al., 1967).Therefore, Ball and Brown (1968) assumed that it was impossible that no useful information about a particular firm reflected the rate of return during a period, but only the market-wide information that fitted for all firms. By abstracting market impacts, they identified the impact of information fitted to individual firms. Then, in order to determine whether part of the effect could be associated with information contained in the numbers of accounting income of a firm, they separated the expected and unexpected changes in income.If the income forecast error was negative, that was, if the actual change in income was less than its conditional expectation, they defined it as a bad news and predicted that if there was some relationship between accounting income numbers and stock prices, and then releases of the income figures would lead to the return on that firms stock, which was less than what would have been originally expected.The results from the empirical test of Ball and Brown showed that the information contained in the annual income figures were useful, as it related to stock prices. Beaver, Clark, and Wright (1979) found similar results and confirmed the initial findings of Ball and Brown (1968). Subsequent studies (Barth, Beaver, Landsman, 1992 Collins Kothari, 1989) found similar results again. The research of Lipe (1990) found that the relationship between earnings and equity value changes with the persistence of earnings.This study found that the equity value during a period is a function of (1) the time-series persistence of the earnings series, (2) the interest rate used in discounting expected future earnings, and (3) the relative ability of earnings versus alternative information to predict future earnings. The comparative statistics of Lipe (1990) showed that the response coefficient played an increasingly important role for past earnings to predict future earnings and an increasi ng function of persistence. In addition, the movements of stock price changed conditionally on earnings being announced was a decreasing effect of the predictability of the earnings series and an increasing effect of earnings persistence. If the predictability or response-coefficient effect was positive, that was because the value attached to a one-dollar current-period earnings shock was an increasing effect of predictability if the predictability or variance-of-price-changes effect was negative, that was because the average quantity of unexpected information released during the period was a decreasing effect of predictability. Other studies refined the earlier studies by disintegrating earnings into components and then empirically testing the association between these components and equity values (Lipe, 1986 Wilson, 1986).2.2 Studies examining association of book values with equity valuesA great number of studies focus on the balance sheet measures of assets and liabilities. These studies find a statistically significant relationship between book values and equity values of the firm (Penman, 1992 Barth Kallapur, 1996 Ohison, 1995 Berger, Ofek, Swary, 1996 Burgstahler Dichev, 1997). Book values of the firms assets and liabilities are used in these studies, which reinforce the assumption that measures of assets and liabilities reflect the expected results of future activities.However, some different conclusions are arrived at by the studies regarding the importance of book value. Barth and Kallapur (1996) stated that book value was important only because it acted as a control for size differences. Penman (1992) and Ohlson (1995) concluded that book value is important because it also acted as a proxy for earnings. Still others offer a competing explanation.Berger et al. (1996) reported that there is a positive and highly significant relation between market value and estimated liquidation value after controlling for present value of expected cash flow. Further assurance that correlated omitted variables do not affect the results is provided by the fact that the positive relation between market values and liquidation value changes in holding as well as levels.Berger et al. (1996) stated that the abandonment option was equal to an American put option on a paying dividend stock. Their analysis of this option results in the forecasting about how liquidation value influences firm value. All the other equality, the abandonment option leads to firms with a much bigger number of liquidation values being worth more investors. Therefore, they predict that market value is positively associated with liquidation value, after controlling for the relationship between market value and the present value of expected cash flow.Generally speaking, liquidation value for going concerns is not observable. Moreover, they concern more about the association between balance sheet information and the abandonment options value. They, therefore, estimate the relation between book value and liquidation value for major asset classes by choosing and analyzing the discontinued options footnotes of 157 sufficiently-detailed information firms. They find that one-dollar book value produces, 72 cents of liquidation value for receivables on average.Applying these estimates to the balance sheet disclosures of all the firms used as samples provides them with estimated liquidation values. In the empirical results, they report that after controlling for the options exercise price, the market value of a firms equity increases in a close approximation one for one with increases in the present value of after-interest cash flows. The significant positive estimate on the excess liquidation value movements continues to support the inference that the abandonment option makes a more important and significant contribution to the market value of a firms equity than that made by the present value of cash flow.To investigate the change over time in the association betw een abandonment option value and liquidation value, and to solve that problem that the pooled observations may not be independent, because it includes the same firm for many years. The results of their further research continue to show a positive, strong relation between the estimated liquidation value and the market value of the firms equity. Moreover, to further reduction of the concern that the inferences may be influenced by the liquidation value measure capturing a portion of true present value of cash flow that is omitted from their proxy, they perform an analysis in changes.At the same time, the sample contains all first differences of the firms from the levels analysis that meet sample selection restrictions. Berger et al. (1996) require that the first earnings prediction occur no later than the fourth month after the date liquidation value is calculated, which make sure that the changes in liquidation value and present value of cash flow are aligned properly in time for eac h firm in the sample. The change of percentage in equity value is for the purpose that captures the impact of operational decisions, not the impact of insurances and redemptions. So they delete the firms with insurances and retirements.The results for the changes is as expected, the fact that the latter estimate is significantly positive supports strong evidence, however, that the association they documented earlier between equity value and liquidation value was not affected by liquidation value and the present value of cash flow that both measure different part of true present value of cash flow. The constant component of any association between liquidation value and the omitted part of true present value of cash flow is removed by examining changes rather than levels. Therefore, Berger et al. continue to find the strong, positive association liquidation value and equity value of a firm.Berger et al. (1996) and Burgstahler and Dichev (1997) concluded that book value has relatively more significant association with stock prices when a firm is unsuccessful and making losses. They argued that this was because book value acted as a proxy for the abandonment option.2.3 Studies examining association of earnings and book values with equity valuesSome studies observe the association between earnings and book values with equity values. Bernard (1995) tested several valuation models empirically. He found that book value per share accounted for 55% of the cross sectional variability in price per share that book value and rank of return on equity accounted for 64% of the variation in equity price and that estimated earnings and book values accounted for 68% of the variation in equity prices.Ohlson (1995) did not focus on earnings alone theoretically, he modeled the role of earnings, book value and dividends in the valuation of a firms equity. An important combined function to the statement of changes in owners equity is allocated by accounting method. The statement inclu des the bottom-line items in the balance sheet and income statement, book value and earnings, and its format needs the change in book value to equal earnings minus dividends.This relation is referred as the clean surplus relationship because all changes in assets and liabilities which are unrelated to dividends must pass though the income statement. Generally, this scheme is accepted by accounting theory without connecting it to a users perspective on accounting data. While the underlying idea that net stocks of value settle with the creation and distribution of value produces a basic question in an equity valuation context whether one can create a cohesive theory of a firms value that depends on the clean surplus relation to identify a distinct role for each of the three variables earnings, book value and dividends. Ohlson (1995) resolves the question in a neoclassical framework.In this case, the analysis starts from the assumption that value is equal to the present value of expect ed dividends (Rubinstein, 1976). Then one can assume the clean surplus relation to replace dividends with earnings and book values in the formula of present value. At the same time, a multiple-date, uncertain model such that earnings and book value act as complementary value indicators is led to by assumption on the stochastic behavior of the accounting data, In a specific way, the main point of the valuation function expresses value as a weighted average of (i) capitalized earnings at present (adjusted for dividends) and (ii) book value at present. Extreme parameterizations of the model produce either capitalized earnings or book value at presents the only value indicators.Ohlson (1991) have examined both of the settings. At its most primary level, he accordingly generalizes prior analysis to derive a convex combination of a pure flow model of value and a pure stock model of value. The combination is an interesting conception because both the bottom-line items are brought into valu ation through the clean additional relation. The development of model, in which Ohlson (1995) produces the value of a firm as linear additive functions of both earnings and book value, shows the relevance of abnormal or residual earnings as a variable that drives a companys value.Earnings minus a charge for the use of capital define this accounting-based performance measure as measured by book value that is in the beginning of period multiplied by the cost of capital. Abnormal or residual earnings hold on the difference market and book values, that is to say, they bear the goodwill of a company. As a matter of fact, a particular parsimonious expression for goodwill is derived from a straight forward two step procedure as it relates to abnormal or residual earnings.Firstly, following Peasnell (1981) and others, the clean surplus relation indicates that goodwill is equal to the present value of future expected abnormal or residual earnings. Secondly, if one further assumes that abnorm al or residual earnings comply with an autoregressive process, then it follows that goodwill is equal to abnormal or residual earnings at present scaled by a positive constant. The results emphasize that value can be driven by assuming abnormal or residual earnings processes that make no reference to past or future expected dividends.Not only does owners equity accounting subsume the clean surplus relation, it also indicates that dividends reduce book value but leave earnings at present unaffected. This additional feature is exploited to examine the margin effects of dividends on value and on the evolution of accounting data (Modigliani, 1958 Miller, 1961). Market value is displaced by dividends on a dollar for dollar basis, so that dividend payment irrelevancy applies. In addition to that, dividends that paid today impact expected future earnings negatively.The creation of wealth is separated by the model accordingly from the distribution of wealth. On the important condition that one generally attaches to Modigliani and Miller (1958, 1961) properties in valuation analysis, the economic significance of owners equity accounting is enhanced by the requirement that dividends reduce book value but not current earnings. The model allows information beyond earnings, book value and dividends. The additional information is motivated by the idea that expected future earnings are affected by some relevant value events as opposed to current earnings, that is to say, accounting measurements incorporate some relevant value events only after a time delay. The feature is interesting because the analysis implies that the weighted average of capitalized earnings and book value still support the main point of the valuation function, though the accounting data will be incomplete indicators of value.Ohlson (1995) made a conclusion that, earnings at present might have a strong relation with market value of equity while current dividends are more important than future earnings in predictive ability. He made the theoretical framework for further empirical explorations.In a further refinement of Ohlson (1995), Burgstahler and Dichev (1997) showed that earnings and book values are positively and significant associated with equity values. However, they found that the relationship was nonlinear (i.e., moderated by factors such as success of a firm) and not additive as suggested by Ohlson (1995). In 1997, the research of theirs developed an option- style model of equity value that incorporated the capitalized value of the firms expected earnings (under the assumption that the firm continues its current way of employing resources) but also explicitly recognized the value of firms adaption option (i.e. the value of the option converted the firms resources to alternative, more productive uses).The main forecasting of the model is that the value of equity is a convex function of both expected earnings and book value. Their empirical evidence strongly supported the pre diction of convexity the coefficient on earnings increased with the ratio of earnings to book value and the coefficient on book value decreased with the ratio of earnings to book value. They developed two propositions for the relationship of recursion (a proxy of earnings) and adaptation value (a proxy of book value of equity) components with market value.In the model below, an option-style combination of recursion value and adaptation value are reflected in the equity value. Recursion value is capitalized expected earnings when the company recursively applies its business technology at present to its resources. Adaptation value is the value of the companys resources which adapted to an alternative use.The possibility that the company will exercise the option to conform the resources to another way to use is reflected in the relative weights on the two factors of market value of equity. In a specific way, when the recursion value is not high relative to the adaptation value, the co mpany will opt out of recursion value in favor of adaptation value. Two propositions are led to by the shape of valuation function in each argument. The model is as followsMV (E, AV)EAVThere are four basic terms in the model. MV represents market value of equity E represents expected future earnings which use the companys business technology at present c represents capitalization factor for earnings AV represents adaptation value.E and AV are random variables. The joint distribution of the two variables is described by the multivariate no