Working Paper Series: WP No 1620

Technical Stock Valuation of a Company:

The Bangladesh Perspective

Imam Abu Sayeed, PhD

Md. Waheduzzaman Sarder
Md. Shamim Mondal
Alok Roy

Monetary Policy Department

 Technical Stock Valuation of a Company:
The Bangladesh Perspective
Imam Abu Sayeed, PhD1
Md. Waheduzzaman Sarder
Md. Shamim Mondal
Alok Roy

Abstract

The paper describes the relationship between risk and expected return and determination of risk free
rate in valuation of a stock. The stock pricing says that the expected return of a security equals the rate on a risk-
free security plus a risk premium. If this expected return does not meet or beat the required return, then the
investment should be taken carefully considering the growth potential of the stock. Using the stock price of a
company, ACI, and all share price index of Dhaka Stock Exchange (DSE) we can compute the expected return.
If the average risk-free rate of 91-day government treasury bill is 7 percent, the beta (risk measure) of the stock
is 1.14 and the average expected market return over the period is 10 percent, the stock expected return is 10.42
percent (7 percent +1.14(10 percent -7 percent)). Here the risk premium is 3.42 percent. In evaluating the ACI
stock we have used the OLS method considering the unit root and other tests of significance. The time path of
risk free rate is impacted by market trends. BB prudently maintains the volatility of the risk free rate using its
instruments. The risk free rate has a role to maintain a tradeoff with the funds between banks and the capital
market. This paper analyzes the risk free rate, risk premium, and related variables to evaluate the stock in order
to maintain financial stability.

JEL Classification: C58, D53, E58 and F47

Keywords: Financial econometrics, financial market, central bank, policies, and model application

1. Introduction

Determination of risk free rate of 91-day government treasury bill is crucial, which is
basically impacted by inflation trend in the country. Inflation rate is also used as underlying factor in
determining interest rate and exchange rate in Bangladesh. The average inflation rate during 1994 to
2014 is 6.64 percent with a peak of 12.71 percent in December 1998 and a record low -0.02 percent in
December 1996. Inflation reached at 10.96 percent in February 2012 starting from as low as 2 percent
in 2001. Rise and fall in inflation rate does not immediately impact the banks deposit and lending
interest rate due to stickiness or inelasticity of interest rate comparing inflation rate. Usually banks are
followed average inflation rate (6.64 percent) rather using extreme high (12.71 percent) or low (-0.02
percent) in determining risk free rate, deposit and lending rate and exchange rate in Bangladesh. High
CRR and SLR in reserve money (RM) are also contributed to follow the historical average rate of
inflation calculation in determining risk free rate in Bangladesh. Prevailing fixed deposit (term
deposit) rate for six months tenor 12.50 percent is ample to attract local currency and foreign funds in
the banking system. Bangladesh observed stable money demand function with limited short term
fluctuation and long run convergence. Dhaka inter-bank offered rate (DIBOR) is calculated for near
term and far term settlement accepting rational expectation. Surge in inter-bank call money rate is
addressed using Open Market Operation (OMO) of BB. To reduce the currency growth and mobilize

1
The authors are Deputy General Manager (Research), Joint Director (Research), Deputy Director (Research)
and Assistant Director (Research) of Monetary Policy Department, Bangladesh Bank respectively. Views
expressed in this paper are authors' own and do not necessarily reflect those of Bangladesh Bank. The authors
are grateful to Biru Paksha Paul and Md. Akhtaruzzaman for their thoughtful contribution. Comments are most
welcome to [email protected], [email protected].

1
the marginal savings risk free instrument of Directorate of National Savings (DNS) has role in
Bangladesh. Exercise reveals that comparing India and Pakistan DNS rates is higher comparing
average inflation rate in the country. However considering average inflation rate and discussed
sectoral development average expected market is assumed at 10 percent level along with 7 percent of
risk free rate allowing short term market fluctuation. The regression result suggests that the beta (risk
measure) of the ACI stock is 1.4. The ACI is over performed comparing the market. All this helps to
evaluate the ACI stock expected return at 11.20 percent level, which is robust comparing the long
term investment perspective. Cochrane and Hansen (1992) have suggested that fluctuation in stock
prices can be explained by time-varying discount rates and future excess returns. Cochrane and
Hansen (1992) also pointed out by using an alternative methodology to decompose the variability of
stock prices also found the variability of excess return to be more important than the variability of
dividend growth.

2. Objective of the study

To understand and examine the underlying factors of an investment decision in a stock market
and related economic factors affecting the stock price valuation and direction toward financial
stability is the concern of this study.

3. Investigative Methodology

Judgmental and econometrics exercise have been pursued in analyzing theoretical and
practical issues related to stock price valuation from multidimensional perspective for maintaining
financial stability.

4. Discussion

The remainder of the paper is organized as follows: Section 5 reviews the literature survey in
details considering elements of stock price evaluation and financial stability. Section 6 analyzes the
evaluation of ACI stock price. Determinants of risk free rate and financial stability issues are
described in Section 7. Section 8 concludes with suggestions and policy interactions.

5. Literature Review

The major implication of the model is that the expected return of an asset will be related to a
measure of risk for that asset knows as beta according to Sharpe et.al (1999). Bhatti, M. H. (2010)
has been concluded that the CAPM is not supportive in high risk securities, it is only supportive in
low risk securities and CAPM is not valid in Pakistan Stock Market. Because CAPM in most of the
years give results of expected return totally different from the actual returns. In this test 60 samples of
the different companies were taken and out of 360 only 28 results were supportive and show the
accuracy of CAPM. While in the study of Bangladesh the Capital Asset Pricing Model (CAPM) is
strongly supportive in Bangladesh stock market in reference to Baten, M. M. (2006).

Market inefficiency is the major drawbacks for developing countries like Bangladesh where
the regulatory system and information transparency is not certainly proficient to get the confidence of
the investors and provide the sufficient basis for analyzing the data without anomalies. Evidences
found that the stock markets of Bangladesh are weak form inefficient pointed out by Moberek, A.,
Keasey, K. (2000 ). Sometimes it is assumed that to some extent stock markets of Bangladesh are
weak form efficient. In this paper it was tried to analyze what are the influence of some micro
economic factor such as net asset value per share, dividend percentage and earnings per share on the
equity return of bank leasing and insurance companies of Bangladesh? Stock prices have a significant
positive effect on long term money demand and its omission can lead to serious misspecification in
the money demand function in both short and long term elaborated by Baharumshah et.al (2009).

Rahman et.al (2006) it their article an attempt has been made to investigate and done an
empirical study where the CAPM is still alive in DSE with the consideration of two more variables.

2
This study also attempts to take into account whether the Fama-French`s CAPM model is applicable
in Bangladesh DSE with the consideration not only the beta factor but also the factors such as book to
market value and size (market capitalization and sales), involve to determine the stock return in an
emerging market like Bangladesh and minimize the gap between theoretical and empirical studies.
Girard and Rahman (2007) suggest use a multifactor CAPM model to investigate whether country
investable risk drives cross-sectional expected returns in investable emerging market stocks in
addition to established firm-specific risk components such as beta, size, and price-to-book-value
ratio. LeRoy and Porter,(1981) and Shiller(1981) found that under the assumption of constant
discount factor stock prices were too volatile with movement in future dividends. The decomposition
of stock price movement is very sensitive to what assumption is made about the presence of
permanent changes in either real dividend growth or excess stock return mentioned by Wohar and
Mark(2006).

Data used:

ACI monthly data ranging April, 2010- July, 2013 is captured in estimating beta value. DSE
all share price index is used to capture the market sentiment. Starting point April, 2010 is considered
to calculate the after share market slowed down effect of 2010. Later on July, 2013 new index was
launched. These factors insist us to chose this data range.

6. Evaluation of ACI stock price

Recent developments in financial econometrics suggest the use of nonlinear time series
structures to model the attitude of investors toward risk and expected return. For example, Cochrane
and Hansen, (1992 ) have remarked that “a major contribution of the auto regressive conditional
heteroskedasticity (ARCH) literature is the finding that apparent changes in the volatility of
economic time series may be predictable and result from a specific type of nonlinear dependence
rather than exogenous structural changes in variables.”

Bera, A. K., and Higgins, M. L. (1993) have argued that “it is both logically inconsistent and
statistically inefficient to use volatility measures that are based on the assumption of constant
volatility over some period when the resulting series moves through time.” In the case of financial
data, for example, large and small errors tend to occur in clusters, i.e., large returns are followed by
more large returns, and small returns by more small returns. This suggests that returns are serially
correlated.

When dealing with nonlinearities, Campbell and MacKinlay (1997) make the distinction
between: A. linear Time Series: shocks are assumed to be uncorrelated but not necessarily identically
independent distributed (iid). B. nonlinear Time Series: shocks are assumed to be iid, but there is a
nonlinear function relating the observed time series {Xt}∞t=0 and the underlying shocks, {εt}∞t=0.

However, considering the essence of ARCH model we have deployed OLS model to
determine the fair price of an investment. We have tested the properties of OLS and found that our
model is iid, which addressed the clustered errors and nonlinearities mentioned in ARCH model.
Calculating the risky asset's rate of return using capital asset price pricing model (CAPM) can then be
used to discount the investment's future cash flows to their present value and thus arrive at the
investment's fair value. One can then compare the fair price with its market price. If the price estimate
is higher than the market's, one can consider the stock may move lower. If the price estimate is lower,
it could consider the stock to be overvalued. Using the ACI stock price and DSE all share price index
we can compute the expected return. If the average risk-free rate of 91-day government treasury bill
is 7 percent, the beta (risk measure) of the stock is 1.14 and the average expected market return over
the period is 10 percent, the stock expected return is 10.42 percent (7 percent +1.14(10 percent -7
percent)). Here the risk premium is 3.42 percent. Literature survey shows the average ROE is around
6.00 percent in Bangladesh comprising good performing and shocking performing stock.

3
 The paper describes the relationship between risk and expected return and determination of
risk free rate in valuation of a stock. The stock pricing says that the expected return of a security
equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or
beat the required return, then the investment should be taken carefully considering the growth
potentiality of the stock.

The beta of ACI indicates that it is over performed compare to market (DSE) in terms of beta
coefficient of ACI, which 1.14 percent. It may be noted that the ACI stock has been randomly
choosing in this exercise. So ACI choice is free from biasness. ACI and DSE regression is significant
at less than 1 percent level. Standard error is the root of variance. Dividing DSE coefficient with the
standard error we get the t-Statistic. The value of t-Statistic is 5.18 shown in Table-2. Here, in the
model the F-statistic is high (26.83). The adjusted R2 value (0.40) is less than R2 value (0.41). These
tests suggest that there is no autocorrelation problem in the ACI (dependent) and DSE (independent)
model. However, theoretically increase in risk free rate and CPI has negative relation with ACI stock
price. The rise in interest rate will increase the bank deposit rather investing money in individual
stock. The movement of ACI and DSE can be seen in Figure 1. The variance of ACI is higher
comparing DSE resulting higher risk-return relationship.

Figure 1: Movement of ACI Stock Price and DSE Index

Source: Dhaka Stock Exchange, 2015

Additional incorporation of variables such as risk free rate, CPI, gold price and petroleum
price increased the ACI beta at 1.24 percent (Table-3) with higher volatility. But the P-value in the
multiple regression model is higher than 10 percent level. In this regard I have tested pair-wise
multicoliarity. It may be noted that multicolliniarity is a sample phenomenon. Presence of
mulicolliarity may be increased the P-value more than 10 percent level. But the multicollinarity test
model suggests (Table-1) the correlation coefficient of the DSE, T Bill, CPI, gold and petroleum is
less than 50 percent level. So there is no multicolliniarity issue in increasing p-value. Higher pair-wise
correlation impact the variance inflated function (VIF) resulting lower t-Statistic. But the t-Statistic is
higher only in case of DSE and ACI relationship. In other cases the t-Statistic is less than 2. The p-
value for each term tests the null hypothesis that the coefficient is equal to zero (no effect).

A low p-value (< 0.05) indicates that I can reject the null hypothesis. In other words, a
predictor that has a low p-value is likely to be a meaningful addition to my model because changes in

4
the predictor's value are related to changes in the response variable. Conversely, a larger
(insignificant) p-value suggests that changes in the predictor are not associated with changes in the
response. Apart from developed country’s capital market the TBILL, CPI, gold and petroleum price
has no impact on ACI stock pricing according to the conducted study and econometric analysis of the
stipulated sample data set.

Drawing OLS regression model stating dependent and independent variables:

Y = β1+ Ui ………………… (1)

Y = β1+ β2X1 + β3X2 + β4X3 + β5X4 +β6X5+Ui ………………… (2)

Here, dependent variable is ACI stock price denoted by Y and the independent variables are:
X1 = DSE all share price index; X2 = Risk free rate of return; X3 = Consumer Price index (CPI); X4 =
Gold Price and X5 = Petroleum Price.

Table-1 Correlation coefficient

DSE TBILL CPI Gold Petroleum
DSE 1
TBILL 0.128 1
CPI 0.234 0.148 1
Gold 0.286 0.277 0.348 1
Petroleum 0.149 0.301 0.136 -0.064 1
Source: Authors' Calculation

Table-2: Empirical Results (ACI and DSE)

Variable Coefficient t-Statistic Probability F-statistic
DSE 1.1377 5.1794 0.0000 26.8259
Source: Authors' Calculation

Table-3: Empirical Results (ACI and all variables under consideration)

Variable Coefficient t-Statistic Probability
DSE 1.2447 5.5122 0.0000
T-Bill -0.2318 -1.0074 0.3209
CPI -3.3427 -1.7364 0.0915
Gold Price -0.1081 -0.0025 0.9980
Petroleum Price 18.6000 0.6609 0.5131
F-statistic=6.5115
Source: Authors' Calculation

The bar diagram of ACI exhibits normal distribution pattern, which support to run OLS. ACI
data exhibits normal distribution with Jarque-Bera 7.94 and provability 0.019. Chart of DSE data also
demonstrated normal distribution.

5
Capital market line (CML) diagram.

The vertical axis (0 to Q) is theoretical illustration of expected market return (Figure 2). The
horizontal line 0 to P is the measure of riskiness. The 0 to Rf is the return on 91-day government
treasury bill return. The distance between A and Rf is the risk premium. The distance of 0 to A is the
expected return. CML is the Capital Market Line.

Figure 2: CML Diagram

CML

Rf

0 M P

7. Determinants of risk free rate and financial stability issues

Trends of call money rate, overall liquidity of the market and government finance need are
the underlying factors of determination of risk free rate in Bangladesh. Theoretically rise in call
money appreciate the Taka comparing foreign currency. Export, import and remittances are impacted
by exchange rate. BB prudently maintains this rate bearing in mind the consequences of inflation and
output. As a lender of last resort BB supply and mop-up the liquidity allowing market first in
balancing liquidity. Considering interest rate, exchange rate, inflation and GDP growth BB use its
instrument to attain the financial stability. Due to lack of secondary market banks are using yield
curve rates for valuation of government securities in their book according to Sayed (2014).
Development of secondary market using government securities will enhance the liquidity in the
market in case of need. The outcome of BB’s policy action can be shown in yield curve (Figure 3)
shown next.

6
 Figure 3: Yield curve on BB-bill, T-Bill and BGTB (as of Mar 31, 2015)

12.4 20-Year BGTB

12.2 (11.9700%)
12.0
11.8 15-Year BGTB
11.6 (11.4000%)
11.4
11.2 10-Year BGTB
Weighted average yield (WAY) for BB-bill, T-Bill and BGTB(%)

11.0 (10.8152%)
10.8
10.6
10.4
10.2
10.0
9.8 5-Year BGTB
9.6 (9.4403%)
9.4
9.2
9.0 2-Year BGTB
8.8 (8.4707%)
8.6
8.4
8.2 364-Day T.Bill (8.2381%)
8.0 182-Day T.Bill
7.8 (7.9041%)
7.6
7.4 91-Day T. Bill
7.2 (7.4861%)
7.0
6.8
6.6
6.4
6.2
6.0
5.8
5.6
5.4 30-Day BB. Bill
(5.2506%)
5.2
5.0
0 1 2 3 4 5 6 7 8
9 10 11 12 13 14 15 16 17 18 19 20 21
Years-to-maturity
Source: Monetary Policy Department, Bangladesh Bank, 2015.

8. Conclusion with suggestions and policy interactions

The deposit rate and lending rate of banks are determined using the risk free rate as an
underlying factor. The average inflation rate and call money rate are contributed in arriving risk free
rate and average market rate. Government savings instrument rates are also crucial in this regard. The
ACI beta is calculated econometrically bearing in mind the elasticity of ACI stock price comparing
Market (DSE). Expected return and growth potentiality of the company stimulate the stock valuation.
Central bank role is crucial in determining risk free rate and stimulating informed investment
decision in banks and capital market by the individuals.

7
References

Baharumshah, A. Z., Mohd, S. H., Yol, M. A.. (2009). Stock price and demand for money in China:
New evidence. Int. Fin. Markets, Inst. and Money, 19, 171-187.

Baten, M. M. (2006). An Empirical Testing of Capital Asset Pricing Model in Bangladesh. Research
(Science). Bahauddin Zakariya University, Multan, Pakistan, pp. 225-234.

Bera, A. K., and Higgins, M. L. (1993), “ARCH Models: Properties, Estimation and Testing,” Journal
of Economic Surveys, Vol. 7, No. 4, 307-366.

Bhatti, M. H. (2010). Validity of Capital Assets Pricing Model: Evidence from KSE-Pakistan.
European Journal of Economics, Finance and Administrative Sciences, 20, pp. 140-153.

Campbell, J. Y., Lo, A. W., and MacKinlay, A. C. (1997), The Econometrics of Financial Markets,
Princeton, New Jersey: Princeton University Press.
Cochrane, John H. and Hansen, Lars Peter, (1992), Asset Pricing Explorations for Macroeconomics.
NBER Macroeconomics Annual, Vol. 7. pp. 115-165.

Girard Eric C. and Rahman, Hamid (2007), Capital Control Premium and Investable Risk in
Emerging Capital Markets. The Journal of Investing, Vol. 16, No. 4: pp. 117-128.

LeRoy, S.F., and Porter, R.D.,(1981), The present- value relation: tests based on implied variance
bound. Econometrica, 50, 1345-1371.

Moberek, A., Keasey, K.. (2000). Weak-form market efficiency of an emerging market: Evidence
from Dhaka Stock market of Bangladesh, ENBS Conference paper, Oslo, Norway.

Rahman, Mostafizur; Baten, Azizul; Uddin, Belal; Zubayer, Mahmud (2006), Fama-French`s CAPM:
An Empirical Investigation on DSE. Journal of Applied Science, vol. 6, Issue 10, p.2297-
2301.

Sayed, Imam Abu (2014), Yield Curve of Bangladesh and Burning Economic Issues, Indian Journal
of Economics and Development, Vol. 2(4).

Sharpe, William F., Alexender, Gordon J., and Bailey, Jeffery V. (1999) Investments. Prentice Hall,
Inc.

Shiller, R.J.,(1981), Do stock price move too much to be justified by subsequent changes in
dividends? American Economic Review, 71, 421-436.

Wohar and Mark, E. (2006). What drives stock prices? Identifying the Determinants of Stock Price
Movements. Southern Economic Journal.