An analysis of financial ratios for the Oslo Stock Exchange.

• Author: Hillestad, Ole-Christian

Share prices are driven by companies' operations, funding and the risk premium required by investors. This article examines financial ratios that may reflect these three variables for the Oslo Stock Exchange in the period 1997 to 2007. The operating profits of listed companies are high at present. However, there are indications that earnings are levelling off. Listed companies have increased their equity ratios and appear to be very robust. However, much of the increase in equity consists of intangible assets. Still, even with increased book value, profitability has remained at a historically high level. Valuation multiples provide a somewhat mixed picture of the pricing of equities on the Oslo Stock Exchange. We argue that it may be useful to use multiples that adjust for cyclically high earnings, and perhaps also for changes in the composition of equity.

1. Introduction

   Norges Bank monitors the Norwegian equity market for three reasons. First, developments in share prices, share issues and the financial reports of listed companies may provide us with information about cyclical developments. Second, this information provides indications of general developments in the Norwegian corporate sector. This is important for banks' earnings and therefore for financial stability. Third, developments on the Oslo Stock Exchange may also have a direct bearing on financial stability. Financial institutions derive income from the sale and issue of shares, and price changes affect the value of the shares on the institutions' balance sheets. The Stock Exchange is also a source of funding for both financial institutions and other enterprises.

   This provides motivating factors for analysing the forces driving share prices. According to financial theory, share prices reflect the present value of the expected cash flow from companies to shareholders. Five factors are crucial for determining present value:

   --Value added

   --Labour costs

   --Funding

   --Taxation

   --Required rate of return / cost of capital

   The most important is value added in companies. Value added can be defined as operating income less operating costs excluding labour costs. Non-labour operating costs represent value added outside the company. Much of the value added in companies accrues to employees in the form of wages (and to the state in the form of income tax). Operating profit is operating income less all operating costs, including wages. Operating profit is the share of the value added that accrues to the investors (and the state in the form of corporate and capital taxes). Employees often have a clearly defined contractual claim. It is therefore the investors that run the greatest risk and have the greatest potential gain from variations in value added.

   Financing determines how operating profits are distributed among investors. More debt financing increases potential value added for equity holders. At the same time, changes in the interest rate level will have greater consequences for return on equity (ROE).

   The purpose of this article is to discuss key figures that can shed light on developments in operating profit, financial conditions and risk premiums (the market's valuation of the shares). Current developments in financial ratios are discussed on the basis of an internally developed data set.

   The article is structured as follows: Section 2 provides the theoretical basis for studying the accounts and financial ratios that are discussed later. The data set is described in Section 3. This is followed by a discussion of how fundamentals can be aggregated across companies. Developments in corporate operating profits and financing are discussed in Sections 4 and 5, and their collective effect on ROE is considered in Section 6. Section 7 considers assessments of equity valuation relative to fundamentals. A key question is whether valuation multiples reflect the risk premium on shares. Section 8 provides a summary of the article.

2. Share prices, earnings and risk premium

   The relationship between share prices, earnings and risk premium can be illustrated by means of simple share pricing models. Both Gordon's formula and the EVA model are based on the assumption that the value of shares is equal to the present value of shareholder cash flow.

   Gordon's formula

   In Gordon's formula, the price of a share is assumed to be equal to the present value of all future dividends. At time t the share price is [P.sub.t] and the dividend [D.sub.t] Shares are expected to generate annual dividends that grow at a constant annual rate of g. If the cost of capital (the required rate of return) is equal to k, the relationship between share price, dividend, dividend growth rate and cost of capital can be expressed as follows:

   [P.sub.t] = [D.sub.t](1 + g) / (k - g) (1)

   It is reasonable to assume that the cost of capital for shares is higher than for risk-free investment alternatives. It is therefore usual to split the cost of capital into long-term risk-free interest rate (r) and a risk premium (rp). The risk premium is an extra compensation investors get when they carry systematic market risk.

   k = r + rp (2)

   The fact that the dividend in equation (1) grows at a constant rate (g), means that in this model there is no uncertainty associated with future dividends. This is an assumption that simplifies the expression. In reality, there is uncertainty associated with the dividend, which is the reason that investors require a risk premium (rp) as in equation (2). If a constant percentage (b) of earnings (E) is retained, while the remainder is paid as dividends, we have the following relationship between earnings and dividends:

   [D.sub.t] = [E.sub.t](1 - b) (3)

   Equation (1) can then be expressed as:

   [P.sub.t] = [E.sub.t] (1 - b)(1 + g) / (r + rp - g) (4)

   This means that share prices and earnings must covary. Or that the share price must be given by companies' earnings multiplied by a constant factor--the P/E multiple (2) (the fraction in equation (4)). This variable will be discussed in Section 6 in connection with valuation.

   However, it is useful to note the significance of uncertainty for equity valuation. It is reasonable to assume that the factors in the denominator in equation (4) will be most important for the P/E level. If short-term variations are disregarded, it appears that both the interest rate level (r) and earnings growth for the equity market as a whole (g) will depend to some extent on nominal growth in the economy. If the effect on P/E of changes in the interest rate level and growth offset one another to some extent, variations in the risk premium (rp) will affect the P/E level more strongly. A high (low) P/E may then reflect a low (high) risk premium.

   The Economic Value Added (EVA) model and abnormal return

   The EVA model is an alternative means of calculating the present value of equity. The basis of this model is that the present value of the cash flow to shareholders is equal to the book value when the return on equity is equal to the cost of capital. The equity value can then be calculated as book value (B) plus the present value of the difference between the return on equity and the cost of capital.

   [P.sub.t] = [B.sub.t] + [B.sub.t]([r.sup.EQ.sub.t+1]- k) / (1 + k) + [B.sub.t+1]([r.sup.EQ.sub.t+2] - k) / [(1 + k).sup.2] + [B.sub.t+2]([r.sup.EQ.sub.t+3] - k) / [(1 + k).sup.3] + ... (5)

   [r.sup.EQ.sub.t] is return on equity in year t, or the result as a percentage of book capital (r.sup.EQ.sub.t] = [E.sub.t] / [B.sub.t-1]). The difference between return on equity and cost of capital is the Economic Value Added or abnormal return. The advantage of the EVA model over Gordon's model, which requires a perception of (the constant) dividend growth in perpetuity, is the basis in known accounting variables ([B.sub.1]) and the need to be forward-looking for only the next few years. The model is also more flexible, as it can capture short-term variations in earnings which may have a substantial positive or negative value. Abnormal return is assumed not to be sustainable over time, partly because over time investors will move capital from poor to good projects.

   Assume that earnings and book value grow at a constant rate (g), and that the difference between return on equity and required rate of return is constant for n periods. With these simplifications, the relationship between share price, book value, required rate of return and return on equity can be found by means of the formula for a finite series. (3)

   [P.sub.t] = [B.sub.t] + [B.sub.t]([r.sup.EQ.sub.t+1] - k) 1 - [(1 + g / 1 + k).sup.n] / k - g (6)

   A price level higher (lower) than the book value is due to the fact that the return on equity in a period is assumed to be higher (lower) than the required rate of return. This may be a result of variation in earnings and/ or cost of capital. It will be seen later that the return on equity varies considerably--much more than it is reasonable to assume that the cost of capital varies. However, a given variation in the cost of capital will have a stronger effect than a corresponding variation in return on equity, because the cost of capital also affects the fraction in equation (6).

   The valuation ratio P/B (share price/book value) is discussed in Section 6, and a slight rewrite of equation 6 shows that use of the ratio P/B may be consistent with the EVa model:

   [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII.] (7)

   Whereas application of the Gordon model showed that a high (low) P/E could be related to a low (high) risk premium, equation (7) shows that the EVA model indicates that a high (low) P/B can also be related to a low (high) risk premium. It is true that both numerator and denominator in the fraction in equation (7) will rise with an increase in the risk premium, but the effect on the denominator will be stronger than the effect on the numerator.

   Insights from the models and Oslo Stock Exchange data

   Both models show that there should be a positive longterm...