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CHAPTER II
LITERATURE REVIEW
Review of Literature
A comprehensive evaluation of literature relevant to research field is given in this chapter.
It involves a review of pertinent literature that has been published in books, journals,
essays, theses, and other academic works on the topic of study.
Theoretical Review
Shares offer enticing prospects for earnings, making them increasingly favored among
investors as an investment avenue. However, understanding share price behavior is
inherently complex due to the inherently higher risk associated with shares compared to
fixed-return investments. Below, we delve into the principal theoretical literature
concerning share price dynamics.
Efficient Market Hypothesis (EMH)
Fama (1965) championed effective market hypothesis (EMH), suggesting that at any
given stage, stock prices precisely mirror all the information that is now accessible on
specific stocks and the stock market as a whole. This is credited to the prompt
dissemination of new information, which promptly integrates into security prices.
Consequently, as per the EMH, no market participant holds an edge in forecasting stock
price fluctuations, as all pertinent information is accessible to the entire market.
Despite this, some investors believe they can outperform the market by employing
fundamental analysis—examining financial data such as company earnings, dividend
payouts, and asset values—or methodological analysis, which comprises studying past
stock prices to forecast coming movements. These analyses allegedly empower investors
to attain returns surpassing those acquired by retaining a randomly chosen portfolio of
similarly risky individual stocks (Malkiel & Fama, 1970).
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However, under the EMH framework, investors essentially participate in a game of
chance rather than skill when trading securities. Therefore, consistently outperforming the
market becomes nearly impossible as prices quickly adjust to all pertinent market
information. EMH not only takes into account the mode and origin of data but also its
value and rush of dissemination among investors. This raises concerns regarding the
nature of available information and its integration into stock prices. According to Fama
(1965), EMH may exist at three levels:
Weak Form of EMH
Stock price fluctuations in the weak type of market productivity have a random pattern
and are not influenced by historical price movements. This suggests that current prices
already take into account all pertinent data, including historical trading volumes, stock
prices, and returns. As a result, past stock and market data are useless for predicting
future price movements. Attempting to identify mispriced stocks and achieve above-
average profits through the analysis of past prices is futile due to the random nature of
stock price movements.
Thus, using information that is already known to all market participants provides no
advantage. Investors and analysts cannot rely on technical analysis, such as charting past
stock prices and trading volumes, to forecast future price movements, as it does not
enable them to outperform the market.
Semi-Strong Form of EMH
According to semi-strong version of the efficient market hypothesis (EMH), current stock
prices represent all information that is available to the public as well as all previous price
fluctuations (Fama, 1965). Data disclosed in a company's financial statements, earnings
and dividend announcements, prospective merger agreements, competitor financial
performance, and macroeconomic factor estimates are examples of publicly available
information. This information is distributed at irregular intervals and promptly absorbed
by the market.
Consequently, investors who engage in fundamental analysis, scrutinizing relevant
reports and announcements in an attempt to consistently earn above-average returns, are
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likely to be disappointed. This is because stock prices already reflect such new public
information, leaving little room for investors to capitalize on it.
Strong-Form of EMH
The effective market hypothesis in its strong variant (EMH) represents the most
formidable version, asserting that present stock prices encompass all pertinent
information, encompassing both public and private, or insider, information (Fama, 1965).
Consequently, stock prices reflect the true or intrinsic value of shares, resulting in fair
pricing in the stock market. This effectively eliminates the opportunity for investors to
gain exclusive access to information that could impact stock prices.
In accordance with the strong form of EMH, even corporate insiders within a company
would find it challenging to systematically achieve abnormal returns using inside
information. This privileged information includes intricate insights into the financial
specification and major strategies of the firm, along with strategic decisions undisclosed
to shareholders. Within the framework of EMH, investors essentially engage in a game of
chance rather than skill when buying and selling securities. Consequently, stock volumes
and prices fluctuate over time as investors react to varying levels of information in the
market. Thus, if investors in the NSE receive information indicative of expected market
performance, they will respond accordingly, leading to a new market equilibrium. These
phenomena have the potential to cause a positive or negative association between market
trading volumes and stock volatility.
Empirical Review
This portion of literature evaluation thoroughly explores significant previous studies on
stock prices. While there exists a vast body of research both in foreign and Nepalese
contexts, only a select few are briefly reviewed below.
A study on share price drivers was conducted by Tabot and Pbrijlal (2016), concentrating
on 14 firms that were listed between 2009 and 2013 on the Johannesburg Stock
Exchange. They found, employing multiple regression analysis, that the P/E ratio, EPS,
and DPS together explained 57.8 percent of changes in share prices. Notably, dividend
per share did not significantly correlate positively with share prices, although EPS and the
P/E ratio did.
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Sharif, Purohit, and Pillai (2015) used panel data from 41 listed businesses between 2006
and 2010 to investigate factors influencing share prices in the Bahrain Stock Exchange.
Their analysis, which used a variety of regression models, revealed that the P/E Ratio,
firm size, DYR, BVPS, return on equity, and dividend yield all had a major effect on
share prices in the Bahraini market.
Between 2005 and 2011, Almumani (2014) found quantitative elements that affected the
share prices of registered banks on the Amman Stock Exchange. They discovered positive
correlations between market share prices and factors such DPS, EPS, size, price-earnings
ratio, and BVPS through ratio analysis and regression models.
Haque, Datta, and Rahman (2013) investigated financial variables impacting share prices
in the capital market, focusing on Reneta Pharmaceuticals Limited (RPL) in Bangladesh
from 2004 to 2011. Their analysis showed that return on assets, P/E ratio, and cash flow
per share all had a big effect on share prices.
Khan (2012) examined factors that influence share prices at Pakistan's Karachi Stock
Exchange, examining 34 different firms from different industries over a ten-year period
(2000-2009). They discovered, through the use of regression models, that the P/E ratio,
DPS, and gross domestic product all had favorable correlations with share prices.
From 2006 to 2011, Srinivasan (2012) examined the underlying factors influencing share
prices in India's six main industries. Through the use of regression models, they
discovered that, in industries such as manufacturing, pharmaceuticals, energy, and
infrastructure, share prices were positively impacted by BVPS, EPS, and P/E ratio,
whereas DPS had a negative effect.
In the Indian stock market, Nirmala and Sanju (2011) found factors that influence share
prices, with a particular emphasis on the automobile, healthcare, and public sector
undertakings sectors between 2000 and 2009. Their research showed P/E ratio and DPS
had a beneficial effect on share price in all industries.
From 1993–1994 to 2008–2009, Sharma (2011) investigated realistic relationship
between equity share prices and a number of variables, including BVPS, DPS and EPS.
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They discovered that the market share prices were significantly impacted by BVPS, DPS,
and EPS.
Al-Shubiri (2010) investigated the causes influencing Jordanian commercial banks'
market stock price changes between 2005 and 2008. The study employed regression
analysis to identify significant correlations between market stock price and variables such
as GDP, dividend %, and net asset value per share.
Vossen and Ness (2010) emphasized the importance of managing liquidity risk for
ensuring the solvency of insurance companies. They noted that well-developed financial
systems contribute to faster and more stable long-run growth, with insurance companies
playing a significant role.
Akintoye and Oseni (2009) studied the effects of macroeconomic conditions on share
prices by surveying businesses listed between 2001 and 2007 on the Nigerian Stock
Exchange. Positive correlations were seen between the values of stocks and many
parameters, including the gross domestic product, oil price, DPS, EPS, and foreign
exchange rate.
While Bagchi (2013) found a negative association between liquidity management
practices and business profitability, Mathuva (2009) found a favorable connection among
the profitability and liquidity of insurance companies in Kenya.
Between 1989–1990 and 1998–1999, Malhotra and Prakash (2001) looked at the factors
that affected market prices for shares in the 'A' and 'B' groups on the Indian stock market.
They came to the conclusion that the price behavior of 'B' group shares was primarily
driven by variables such as BVPS, EPS, DPS, P/E ratio, and market price to book value
ratio.
Irfan and Nishat (2002) made an effort to describe how fundamental variables in Pakistan
from 1981 to 2000 affected pricing changes. Their empirical results showed that
throughout the given period, share price variation in Pakistan was not significantly
influenced by fundamental characteristics such as DYR, DPR, firm size, leverage,
earnings volatility, and asset expansion.
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In their 2009 study, Somoye, Akintoye, and Oseni examined the variables that affected
stock prices in Nigerian stock market between 2005 and 2007. They discovered that
although certain variables, such as EPS, DPS, and the gross domestic product, reflect
positive correlations with stock prices, they did not significantly influence share prices
during that time.
The relationship between explanatory factors in the common engineering and cotton
textile industries, such as DPS, EPS, BVPS, yield, cover, and MPS, was examined by
Balkrishna (1984). The analysis found that in both industries, the most important factors
influencing market price were BVPS and DPS.
DPS and yield were found to be major predictors of share price in Zahir and Khanna's
(1982) investigation of stock price determinants across 101 industries in India for the
1976–1977 and 1977–1978 fiscal years. Furthermore, the book value per share's positive
coefficient demonstrated its impact on share prices.
Joshi (2004) and Maharjan (2007) found positive associations between liquidity, capital
adequacy, and insurance profitability. Similarly, Poudel (2012) and Jha (2012)
demonstrated inverse impacts of liquidity on financial performance.
Tripathy (2010) emphasized the importance of volatility and trading volume in
influencing stock prices, emphasizing their function in reflecting market activity and
offering investors insights.
Ghimire and Mishra (2018) looked into what factors affected stock prices in the Nepalese
market between 2012 and 2017. They found that factors like price-earnings ratios and
market-to-book values had a major impact on share price, while dividends and BVPS also
had a optimistic effect.
While DPS, BVPS, and EPS did not consistently correlate with market share prices,
Neupane's (2004) investigation into the causes influencing share price on the Nepal Stock
Exchange revealed that their combined influence was significant in shaping the formation
of market price per share among listed companies.
Joshi (2010) highlighted the significant position of the share market in Nepal's economic
development, with factors such as organizational information, profitability, market
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operation framework, and government investment policies identified as key determinants
influencing the performance of the Nepalese share market.
Recent changes in the Nepalese share market indicate that greater investor engagement
may be possible if thorough information about effective financial markets is made
available. If their stocks are reasonably priced, small and medium-sized investors might
be more expected to invest in stock market, which could increase their savings and
investments. Nonetheless, a lot of investors lose money for a variety of reasons, which
emphasizes how crucial it is to evaluate the correlation among trading amount, stock
return, and return volatility on the NEPSE.
Dhaugoda et al. (2016) discovered that while the book - to - market ratio had a negative
impact on stock returns, earning yield, dividend yield, and price-earnings ratio all had a
favorable impact. In a similar vein, Bhattrai (2014) identified a strong negative
association between dividend yield and share price, as well as significant positive
relationships among EPS, P/E ratio and share price. The P/E ratio, dividend yield, and
EPS all have a substantial impact on the share price of Nepalese commercial banks.
After researching Nepalese stock market, Pradhan (1993) determined that larger stocks
often had greater market value to book value and P/E ratio. Several research on trading
amount and its association to stock return and return instability have yielded contradictory
results.
The principle of this study is to look into connection between trading volumes, stock
returns, and return volatility in Nepalese insurance companies. It analyzes effects of
market capitalization, book-to-market ratio, company size, turnover rate, book value per
share, and trading volume on return volatility and stock returns in Nepal's insurance
industry.
Acharya (2008) looked at the aspects that affect stock prices in Nepalese commercial
banks and concluded that NEPSE's share prices are heavily influenced by factors
including growth rate, political stability, information disclosure, EPS and DPS.
Alternatively, it was discovered that factors such as interest rates, retention ratios, equity
costs, market liquidity, and management changes had no effect on share prices.
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Dhakal (2007) studied the elements of share prices in Nepalese commercial banks and
observed correlations between MPS and financial indicators like book value, EPS and
DPS. However, insufficient understanding of the share market among Nepalese investors
was identified as a hindrance to advancement of capital market in Nepal.
In investigation into considerations influencing share prices in Nepalese commercial
banks, Dhakal (2018) discovered a strong positive correlation between MPS and EPS,
DPS, and BVPS. Likewise, there was a negative correlation found among MPS and P/E
ratio.
As per Dhamala's 2003 investigation on the causes influencing share prices in Nepalese
financial markets, the country's stock market was ineffective at determining market price
per share based on financial performance. Dhungel (2005) tracked monthly changes in
share volume, price, and market capitalization without a discernible relationship between
volume and stock price. He also examined the financial performance of Nepalese listed
firms in connection to changes in stock prices. In Nepal's financial sector, the study
sought to understand how firm-precise and macroeconomic factors related to market price
per share are determined. Specifically, it focused on BVPS, EPS, DPS, and P/E ratio in
Nepalese insurance companies.
Research Gap
Generally, studies stated above have relied on technical and statistical methodologies like
regression analysis, correlation coefficients, and trends observed in the Nepal Stock
Exchange (NEPSE) for their assessments. However, none of these studies have
incorporated variable analysis, which is essential for evaluating financial institutions.
Hence, the researcher has chosen variable analysis tools such as price-earnings ratio and
dividend distribution patterns to assess the financial situation of the chosen insurance
companies. Consequently, this research seeks to investigate the correlation between EPS,
P/E ratio, DPS, DPR, and DYR alongside other influential factors influencing the market
price of share.
Numerous quantitative and qualitative elements contribute to the formation of share
prices. While many studies emphasize the significance of dividend and earnings per share
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in determining share prices, factors like information accessibility, political stability,
government policies, and broader macroeconomic indicators also hold pivotal roles in
influencing price variations. These factors collectively impact share price formation and
are fundamental considerations in the analysis conducted in this study.
Despite the extensive examination of dividend policy within banking sectors, relatively
less attention has been directed towards its implications within companies related to life
insurance. Therefore, this research target to fulfill this gap in this study. For the analysis,
four insurance companies have been randomly selected using a probability sampling
technique.