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Institute of Management Sciences

Topic: - Comparison of Stock Valuation of Textile Industry of Pakistan (Through CAPM and Fama & French) Submitted by: Muhammad Ismail MBA(B&F) Group A 4th Semester Roll no 18

Submitted to:

Dr. Attah ullah Shah

Table of Contents

Introduction Literature Review Methodology Data Population Sample Size Sampling Limitation Purpose and Objective of the Study Scope of the study References

Introduction: - In finance we generally used two models for stock


valuation, one is called the CAPM (Capital asset pricing model) and the second one is called FAMA & FRENCH three-factor model.

CAPM (Capital Asset Pricing Model) CAPM model was introduced by Jack Treynor (1961, 1962), William Shape (7964), Joh Lintner (1965) and Jan Mission (1966) independently. The earlier work done by Harry Markowitz on this model, this model was called by him as modern portfolio theory. With the help of CAPM model we calculate require rate of return (RRR) of a security or asset, on the basis of their risk. The model is often represented by a tool called beta () in the finance. To calculate the RRR for a common stock the CAPM uses three variables.

RRR = Rf + (Rm - Rf)


Rf is called Risk free rate on T-Bills. It is also called RFR rate. Beta () Beta gives a measure how much returns of a security vary when the return on market portfolio varies. Beta shows the risk of the individual security. It is the also called systematic risk. Beta is calculated using regression analysis, and we can say that beta is the tendency of a security's returns to respond to change or move in the market. A beta of 1 indicates that the security's price will move with the market. Beta of less than 1 means, that the security will be less volatile than the market. Beta of greater than 1 indicates that the security's price will be more volatile than the market. Rm shows the return of the whole market. We also need three variables to implement the CAPM model. We need three variables for implementing CAPM model: Security returns Return on Market portfolio Risk free rate Security returns = (Dividend +capital gain)/Po Return on Market Portfolio = (Index1-Indexo)/Indexo Risk free rate = T-bill rates Fama and French Three Factor Model Fama-French three factor model is a model invented by Eugene Fama and Kenneth French to explain stock returns. This is an alternative method to the CAPM model. CAPM only used one factor in his model for calculating the (RRR) for a stock of security that is beta, to explain the return of the stock with the market. On the other hand the Fama and French used three factors in his model. In this model two extra factors are used to describe the return of the stock. These factors are size of the firm and book to market value of the firm. To calculate the (RRR) the Fama and French uses the following formula.

(RRR) =Rf+ B1 (Rm-Rf) + B2 (RSMB) +B3 (RHML)


Rf is Risk free rate on the T-bill. Beta () Beta gives a measure how much returns of a security vary when the return on market portfolio varies. Beta shows the risk of the individual security. It is the also called systematic risk. Beta is calculated using regression analysis, and we can say that beta is the tendency of a security's returns to respond to change or move in the market. A beta of 1 indicates that the security's price will move with the market. Beta of less than 1 means, that the security will be less volatile than the market. Beta of greater than 1 indicates that the security's price will be more volatile than the market.

4 Rm is the return of the whole market. SMB is the return of a portfolio of small stock minus the return of on a portfolio of large stock HML is the return on a portfolio of stocks with high book to the market values minus the return on a portfolio of stocks with low book to market value. To calculate the (RRR) with the help of Fama and French we have to follow the following steps Calculate the size premium Calculate the B/M ratio premium Calculate risk premium on market portfolio Calculate returns for a given stock Forecasting of expected return of the stock is important for many financial decisions, such as those relating to portfolio management, capital budgeting, and performance evaluation of the individual stock. The background and pervious study shows that the academic literatures are in the favour of Fama and French model for estimating of portfolio returns, and the practitioners seems to prefer CAPM model. So the main and the important purpose of the study are to compare the performance of the Fama and French and CAPM model for the evaluation of stock of textile industry of Pakistan. To make a fair comparison, we need the best possible estimation for expected return. And with the help of these we can also find the best forecasting for the future returns. Overview of the textile Industry: Now days its a very important source of profit for millions of investor to trade in stock at stock exchange. And the textile industry is also playing vital role the economy of Pakistan. The textile sector enjoys a pivotal position in the exports of Pakistan. In Asia, Pakistan is the 8th largest exporter of textile products. The contribution of this industry to the total GDP is 8.5%. It provides employment to about 15 million people, 30% of the country work force of about 49 million. The annual volume of total world textile trade is US$18 trillion which is growing at 2.5 percent. Out of it, Pakistans share is less than one percent. The development of the Manufacturing Sector has been given the highest priority since Pakistans founding with major stress on Agro-Based Industries. For Pakistan which was one of the leading producers of cotton in the world, the development of a Textile Industry making full use of its abundant resources of cotton has been a priority area towards industrialization. At present, there are 1,221 ginning units, 442 spinning units, 124 large spinning units and 425 small units which produce textile products. The industry consists of large-scale organized sector and a highly fragmented cottage small-scale sector. The various sectors that are a part of the textile value chain are: Spinning, most of the spinning industry operates in an organized manner with in-house weaving, dyeing and finishing facilities. Weaving comprises of small and medium sized entities. The processing sector, comprising dyeing, printing and finishing subsectors, only a part of this sector is operating in an organized state, able to process large quantities while the rest of the units operate as small and medium sized units. The printing segment dominates the overall processing industry followed by textile dyeing and fabric bleaching. The garments manufacturing segment generates the highest employment within the textile value chain. Over 75% of the units comprise small sized units. The knitwear industry mostly consists of factories operating as integrated units (knitting + processing+ making up facilities). The clothing sectors both woven and knits are mainly clustering in Karachi Lahore and Faisalabad where sufficient ladies labor is available. Pakistan is the worlds 4th largest producer

5 and 3rd largest consumer of cotton. The Textile and Clothing Industry has been the main driver of the economy for the last 50 years in terms of foreign currency earnings and jobs creation. The Textile and Clothing Industry will continue to be an important engine for future growth of the economy; there is no alternative industry or service sector that has the potential to benefit the economy with foreign currency earnings and new job creation, especially if synergy is developed amongst different sub sectors and efforts are made to aggressively grow the readymade Clothing Sector. Pakistans Textile Industry had proved its strength in global market during the last four decades. It has proved its strength even in post quota era by not only sustaining its position but, also showing growth during 2005 to 2007, but declined to $11.1 billion in 2008 due to financial and economic meltdown globally. The Garment Sector & especially the Knit Garment Sector need special focus in future policies.

Literature Review:-

(Bhavna Bahl, 2006) He empirically study the

Fama and French three-factor model of stock returns along with its variants, including the one-factor Capital Asset Pricing Model for 79 stocks listed on the BSE-100 stock market index for India. These sample stocks are split into six portfolios sorted on size and book-to-market equity ratio. The factor portfolios that explain the returns are the market factor, size factor (SMB) and value factor (HML). He fined strong evidence for the market factor in all the portfolios, it being regarded with having highest explanatory power. The SMB and HML factors can not be clearly ranked in this regard. On the basis of the adjusted R, he confirmed that the three-factor model captures better the common variation in the stock returns than the CAPM, the average adjusted R being 87% for the former model and 76% for the latter model. He further carry out a joint test on the constant term in the portfolio regressions using the GRS test statistic, checking for any abnormal returns that are not captured by the factor portfolios. Using this statistic, he again find that the threefactor model of Fama and French fairs better in explaining the cross-section of returns in the portfolios than its variants and the CAPM. He has also checked for any seasonal effects that could be present in the sample and have found none.

(Jan Bartholdy, Paula Peare 2002) They studied that most practitioners
favour a one factor model (CAPM) when estimating expected return for an individual stock. For estimation of portfolio returns academics recommend the Fama and French three factor model. The main objective of this paper is to compare the performance of these two models for individual stocks. First, estimates for individual stock returns based on CAPM are obtained using different time frames, data frequencies, and indexes. It is found that five years of monthly data and an equalweighted index, as opposed to the commonly recommended value-weighted index, provide the best estimate. However performance of the model is very poor; it explains on average three percent of differences in returns. Then, estimates for individual stock returns are obtained based on the Fama and French model using five years of monthly data. This model, however, does not do much better; independent of the index used it explains on average five percent of differences in returns. These results provide a possible explanation for why CAPM is used so extensively by practitioners; the additional cost associated with Fama and French is not justified. However, they also bring into question the use of either model for estimation of individual stock returns.

(Pablo Rogers, Jos Roberto Securato) This article tests and compares
three alternative models for the prediction of the expected returns in the Brazilian stock market: 1) the Sharpe-Litner-Mossin version of the CAPM; 2) the Fama and French Three-Factor model; 3) and the Reward Beta Model, presented by Bornholt (2007). The two-step test methodology for general balance models was used as empirical procedure: the first step consists of determining the models parameters based on time series regressions, and in the second step the estimated parameters are used as explanatory variables in cross section regressions. The tests were conducted on portfolios, in accordance with the Fama and Frenchs (1993) and Bornholts (2007) methodology, and applied in two sub-samples of stocks with available data in the So Paulo Stock Exchange (BOVESPA): the ex-ante sample comprises the period from July 1995 to June 2001 and the ex-post sample the period from July 2001 to June 2006. As well as other evidences found in the Brazilian market, the results tend to support the Fama and French ThreeFactor model to explain future returns, much tough the factor that captures the book-to-market effect has not revealed itself to be significant. Thus, it is indicated for prediction of expected returns in the Brazilian stock market, a Two-Factor model: 1) one that captures the market excess of return; and 2) another one that captures the size effect of the firm.

(Daniel

Suh, ) This paper conducts time-series tests on the Capital Asset Pricing Model (CAPM) and the Fama-French three-factor (FF3) model in the context of market beta estimation for the cost of equity capital. We find that the market index is by far the most consistent and powerful systematic risk factor throughout the sample period, for both large- and micro-cap stocks, in FF3 model as well as CAPM specifications, and across industry sectors. Most of market betas are statistically significant and appear to be economically consistent with the systematic risk exposure of individual stocks. Consistent with the theory, virtually all alpha estimates are statistically zero. Market volatilities are critical for beta estimates. When the market is highly volatile, beta estimates breakdown as do correlations of stock returns with the market index. For small-cap stocks and in a highly volatile market, SMB and HML stabilize the market beta and improve the statistical explanatory power; for large-cap and in a relatively stable market, SMB and HML add little to the CAPM beta. Model diagnostics show that the CAPM and the FF3 model are practically equivalent. Parameter estimates of the CAPM are generally superior to those of the FF3 model, except for some small-cap stocks and in a highly volatile market. On the other hand, statistical explanatory power of the FF3 model is generally superior to that of the CAPM

(Zakri Y. Bello1, 2008) The goal of this study is to compare the CAPM to the Fama-French (FF) Three Factor Model and to Carharts extension of the FF Model with regard to (1) statistical goodness of fit, and (2) the quality of prediction. My sample consists of actively managed domestic equity mutual funds and the sample period is April 1986 to March 2006. My results indicate that each of the three regression lines explains about 71% of equity fund returns. Thus, with respect to the statistical goodness of fit, the difference between the three models is not significant. However, with respect to the quality of prediction, the FF Three Factor Model is a

7 remarkable improvement over the CAPM, and the Carhart Model is a significant improvement over the FF Model. I do not find any evidence of harmful co linearity in my analyses.

Methodology: - My research is quantitative research. This research will be


conduct on the historical data. For calculating RRR with the help of CAPM, I will use the following steps. First we I will find Security returns then return on Market portfolio and the last Risk free rate. Security returns = (Dividend +capital gain)/Po Return on Market Portfolio = (Index1-Indexo)/Indexo Risk free rate = T-bill rates And to find the RRR with the help of Fama and French I will also use the following steps. First I will calculate the size premium, and then calculate the B/M ratio premium, Calculate risk premium on market portfolio and last I will find returns for a given stock

Data: - The data required by the research, this is the historical data. Prices of the
stock of the textile industry will be taken from different sources of five years from 2005 to 2010. And the T-bill rates stock prices, market value and book value will also be taken from a source. Dividend of the stocks and the index will also be taken from Karachi stock exchange and other websites.

Population: - My population for the research is Textile industry of Pakistan


which is listed on the Karachi Stock exchange.

Sample Size: - I will select 10 firms, which trading is frequently going on the
daily basis at the Karachi stock exchange.

Sampling:
In order to collect the data, the technique of sampling i follow is the convenient sampling.

Limitation: - Limitation of my research is time.

Purpose and Objective of the Study The purpose of the study is to see
that which model is giving the true and good forecasting about the required rate of return that is very near to the actual return of stock of the textile industry of Pakistan. This study can help the investor and as well as the analyst, who are greatly interest in the textile industry of Pakistan. It will also help in portfolio management, capital budgeting, and performance evaluation of the individual stock of textile industry of Pakistan.

Scope of the study: - My scope of the study is Textile industry of Pakistan.