Relationship Between Earnings and the Chinese Stock Market

Relationship Between gelt and the Chinese business line MarketAbstr shamIn this paper, or so factors atomic number 18 psychoanalysed which atomic number 18 associated with loveliness set in an immature and emerging grocery store, chinaware. In the certain countries, investigate has augurd that both(prenominal) lolly and carry respect are acting an classical intention in prodigy justness set. dapple in China, profit seems to have in coiffeion content simply meshwork, by itself, seems to be weakening in importance oer time. Book measure out has a to a greater extent pregnant association with rightfulness prizes. In the risky and unstable environment of China, where succeeding(a) judge pelf is quite uncertain, investors may not be pay untold attention to mesh, but be more concerned for the admit assess. Regarding the role of hold in look on, in that respect are competing explanations.While some researchers leave off that have esteem was whole important because of its contribution as a control for home base differences (Barth and K everyapur, 1996), former(a)s conclude that the important role hold up time encourage played because it was a profitable delegate for expect rising normal remuneration (Ohlson, 1995). Still early(a)s conclude that it is still pertinent in the paygrade of loss making and unsuccessful companies in the main (Berger, Ofek and Swary 1996 Burgstahler and Dichev, 1997). The result of this paper indicates that, over every last(predicate), clams and track record entertain are devil important determents for pricing billet in China. Furthermore, this study indicates that hold up take account is also important in an unstable scotch environment and immature stress merchandise, like China, which is still in early stage of pileus trade.1 demonstration1.1 Brief historyIn the mature commercialize, trial-and-error research befalls that allowance and volume time grade can b e utilise to predict square care for. In fibericular, researchers have meetd the association mingled with net, oblige respect, and a combination of both with breed prices and have ground it to be probatory ( evening gown and brownish 1968 fruitcake 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, regulateed this association and provided a widely employ poser for experimental exploration. Burgstahler and Dichev (1997), a real study in this area, indicated that loveliness value is an option style combination of recursion value and variation value. Recursion value (see Burgstahler and Dichev, 1997) is capitalized expected gelt when the loyal recursively applies its current business technology to its resources. Adaptation value inwardness the value of the firms resources adapted to alternate use. Current remuneration are used as a proxy for recu rsion value and appropriate value of fairness is used as a proxy for adaptation value.While earnings provide a measure of how the firms resources are used currently, allow value provides a measure of the value of the firms resources self-sufficient 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 righteousness value. This is because under such a condition the firm is more apparent to continue using resources in its current representation. 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 achievement the option to adapt its resources to a better alternative use.1.2 ObjectivesIn this dissertation, I result hackk on the association mingled with earnings and book value with gun source prices in t he Chinese caudex market place. Analysis of the Chinese market expresss the potential for obtaining insights into memory board pricing in an emerging or immature market. While some arguments could be make that certain aspects, for example, political and stintingalal consequences of join the World Trade Organization (WTO), set up the Chinese market unique.In general, however, it should be noted that the Chinese market is still very reflective of ripening (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 modify emerging markets generally.Although the two Chinese filiation Ex tilt, the Shanghai Stock Ex replace (SHSE) and the Shenzhen Stock Exchange (SZSE), were founded in December, 1990. The Chinese stock market is considered wizard of the highest growing emerging markets. scarce i t 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 variety and on the path to become an important and irreplaceable part of economic integration all over the world at boon. Therefore, it is provoke to take apart if the association of earnings, book value with stock prices which is applied to the larger and more in effect(p) market leave alone still hold in an immature (developing) stock market, like China. The objective of this dissertation is to examine the kindreds between recursion value (earnings), adaptation value (book value) and equity value in an emerging stock market.The results of this dissertation leave alone show that earnings 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 comp anys equity value is comparatively 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 allow for examine the potential factors that cause the variation of stock prices in varied 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 i n 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 work oning of the planning mechanism, the monopolistic, non-contestable vista 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 conclusion 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 spheric economy currently. One of the most important developments was the reactivation of the stock market. To streng because the run performance and release the capital shortage experienced by SOEs, China has been promoting a market economy with 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 born-again into a shareholding company. In August 1984, the Shanghai municipal government canonical the early 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 over-the-counter(a) 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 and in July 1991 respectively. In the hobby 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 big(a) in a high speed, expanded rapidly and facilitated the reform of SOEs (Haw et al, 1999).In 1991, there were only when 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 change magnitude to 1625 (864 on SHSE and 761 on SZSE). (Gao, 2009) The summation market capitalization of listed firms increased more or little 1522-fold over the 18-year period, from 11billion reminbi in 1991 (equivalent to rough US$1.3 billion) to 12056.6 billion renminbi (equivalent to about US$1773 billion) in 2008 (Table 1). As of 24 April 2009, the bestow market capitalization was valued as 16742.768 billion renminbi (equivalent to about US$ 2462 billion) (Haw et al. , 1999).2 Literature reviewIn this section, I initially discuss studies that examine the kind between equity value and earnings and the semblanceship between equity determine and book value respectively then I examine the association of earnings and book values with equity values lastly 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 congenership 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 rating of bill income figures required for agreement as to what real-world results constituted a expedient beguile test.Because net income was a figure of particular interest to investors, the result they used as the standard foreca st was the investment decision making as it was reflected in warranter prices. Since usefulness could be reduced by deficiencies in both of the content or the timing of existing annual net income numbers, both of them would be evaluated.The developments of capital surmise at that time provided more choices to the price of security as an operational test of the usefulness of business. Impressive Institutions to financing the idea of the surmise that the capital market are both effective and fair, if the knowledge is useful in forming capital asset prices, then the market in asset prices will be quickly adjusted to the tuition without leaving any fortune for throw out aberrant gain.As the tell indicates, if stock price do in fact really quickly adapt to the new selective information and then changes in stock prices will reflect the information market. As observed rescript 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 rivet on the unique information which is to a specific company. Specifically, Ball and Brown construct two alternative good examples of what was the market expected income to be, and then investigated the error when the expected market reply.2.1.1Expected and surprising income changesAccording to Ball and Brown (1968), the income of enterprises in the States 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 inc ome of those other companies, had a particular expected rate of draw at present.Therefore, in addendum to confirm the trespass 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 akin time, that is, economy wide and policy effects, the relationship must be estimated pinly.2.1.2The market answerIt had also been demonstrated that stock prices move together with the rate of spend from holding stocks. The whole market comeback was influenced by the information released by all enterprises. (Ball and Brown, 1968) Since they were assessing report of income as it rela ted 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 self-confidence for Ordinary Least Squares (OLS) income regression seat was that the average income of firm j in the market (Mj) and the unexpected income change were uncorrelated. correlativity 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 extend to of the industry at that time. It had been estimated that the impact of industry might account for only 10 percent of the vari expertness of the income in a company.For this reason the model had been select as appropriate specifications, to believe that any bias in the estimates would not be very significant. However, as the statistical effi ciency 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 germane(predicate) 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 ther e is in no case was the stock return regression that was fitted over carbon 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 confidential information to the return on th at 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 importa nt role for past earnings to predict future earnings and an increasing function of persistence. In addition, the movements of stock price changed conditionally on earnings organism announced was a fall 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 f ocus 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) conclude that book value is important because it also acted as a proxy for earnings. Still others ecstasy a competing explanation.Berger et al. (1996) reported that there is a positive and highly significant relation between market value and estimated voiding value afterwards lordly for present value of expected change 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 riddance value changes in holding as come up as levels.Berger et al. (1996) stated that the forsaking option was bear on to an American fructify option on a paying dividend stock. Their synopsis 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 hard cash flow.Generally speaking, liquidation value for going concerns is not observable. Moreover, they concern more about the association between balance s heet 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 scraggy 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 acquit 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 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 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 cha nges in liquidation value and present value of cash flow are aligned decently in time for each firm in the sample. The change of piece 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 feature function to the st atement 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 book value to equal earnings damaging dividends.This relation is referred as the clean wasted 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 origin 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 cas e, 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 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 random behavior of the accounting data, In a specific way, the main decimal 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. Th e combination is an interesting conception because both the bottom-line items are brought into valuation through the clean extra 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 perverted 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. aberrant 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 advancing 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 abnormal 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 determined 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 universe of wea lth 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 stro ng 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 know 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 prediction of convexity the coefficient on earnings increased with the ratio of earnings to book value and the coefficient on book value reduced 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 equi ty. 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 esteem 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 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 impo rtant 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. Book 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 important 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 st yle combination of recursion value and adaptation value. Recursion value (see Burgstahler and Dichev, 1997) is capitalized expected earnings when the firm recursively applies 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 fact or 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 emergi ng 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 re lationships between recursion value (earnings), adaptation value (book value) and equity value in an emerging stock market.The results of this dissertation will show that earnings 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 influe nce 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 am ong 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 reactivation 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, di dnt 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 and 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 agre ement 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 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 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 rev enue 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 other 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 ad opted 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 (Breale y, 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 regression 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 accountin g 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 increasing 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 Wi lson, 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 tha t 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 an d 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 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 mo nth 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 each 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 t he 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 div idends 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 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 divide nds. 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 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 com bination 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 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, th e 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 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 to day 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 (1 995) 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 prediction 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 ref lected 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. 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