Midas Touch International Journal of Commerce ...

Midas Touch International Journal of Commerce, Management and Technology Volume 2, No. 9, September- 2014 ISSN: 2320 -7787

A LITERATURE REVIEW ON RELATIONSHIP BETWEEN FINANCIAL PERFORMANCE AND MARKET CAPITALIZATION Hanuman Prasad, Professor, Mohanlal Sukhadia University, Udaipur, Rajasthan Kapil Shrimal, Research Scholar, Mohanlal Sukhadia University, Udaipur, Rajasthan ABSTRACT Capital formation is an integral part of economic growth and development and it plays an important role in the economic theory of production and distribution. It is assumed that capital accumulation can facilitate faster rate of economic growth. The growth of stock market is measured by its total market capitalization. The size of the market capitalization and its growth rate pose a major influence on the growth and development of the economy (Odogunde et al. 2006). Market capitalization has become a universally accepted indicator of business valuation. It represents the aggregate value of a company or stock. Market capitalization by taking into account the current market price, which reflects the current value and the total number of shares which reflects the size, gives a clear picture of the market value of a company. The success or failure of imperative decisions like mergers, acquisitions and takeovers has great impact on the value of a company. Similarly acceptance of new projects also has a bearing on its value. Various studies have been done by researchers to formulate the relationship between firm’s financial performance and market capitalization. In India some of the studies on macro economical factors and market capitalization while some studies have been done for financial performance only. In this paper review of various pieces of literature was made under the heads Market capitalization and firm performance also to study the empirical relationship between firm’s financial performance and its market capitalization. The study concludes that some studies have established a positive relationship between value and market capitalization and few analytical studies have highlighted the close connect between firm performance and market capitalization. Key Words: Financial Performance, Market Capitalization, Market Value and Performance. 1. INTRODUCTION Now-a-days market capitalization has become a universally accepted indicator of business valuation. It represents the aggregate value of a company or stock (Jaya & Sundar 2012). Market capitalization by taking into account the current market price, which reflects the current value and the total number of shares which reflects the size, gives a clear picture of the market value of a company. The success or failure of imperative decisions like mergers, acquisitions and takeovers has great impact on the value of a company. Similarly acceptance of new projects also has a bearing on its value. Thus, management takes any decision not only on the project’s viability but also on the changes it is expected to bring in the value of a company. The efficient performance of a company as reflected by its continued earnings results in better valuation of market capitalization. Capital formation is an integral part of economic growth and development and it plays an important role in the economic theory of production and distribution. It is assumed that capital accumulation can facilitate faster rate of economic growth. Traditionally economic growth rate depends upon growth of industrial, agricultural and service sector but stock market has also become one of major contribution for capital formation and straight impact on the economy across the world. Stock market in developing economies such as India is also growing very fast and it is estimated that stock market is a trillion dollar industry. Recently the Indian stock market is witnessing heightened activities and is increasingly gaining importance. Market capitalization makes a remarkable contribution to contribution to company’s management, index calculation, classification of companies, a desideratum for the investment strategies for investor and measuring and overall growth of the stock market. Many studies have been undertaken and various models have been designed and put into effect. A brief account on the available literature

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pertinent to the present study is obtainable in this study. The review of related literature is made to study the relationship between financial performance and market capitalization. And also bridge the gap left by the earlier researchers. The performance of a business is express by the overall profits and losses over a specified period during that time. Analyzing the financial performance of a business helps decision makers to judge the results of business strategies and activities in objective monetary terms. 2. OBJECTIVES OF THE STUDY Ø To review the various studies on relationship between financial performance and market capitalization. Ø To identify the major financial indicators on market capitalization. 3. EMPIRICAL STUDIES WHICH ANALYZE THE RELATIONSHIP BETWEEN FINANCIAL PERFORMANCE AND MARKET CAPITALIZATION Many researchers have been done different studies which focused on the relationship of financial performance and market capitalization in all over the world. The present study elaborates the relationship of financial performance and market capitalization on two parameters. They are: I. Studies focused on financial performance. II. Studies focused on financial performance and market capitalization. STUDIES FOCUSED ON FINANCIAL PERFORMANCE Charles (2013) emphasized the need for a legal framework to enforce alignment with CMA Guidelines to safeguard members of the public from losing their savings and also ensure stability of the financial sector to enable the country attain targeted economic growth at 10 percent per annum. The purpose of the Capital Markets Authority’s (CMA) Guidelines on good corporate governance was to improve governance practices in the corporate sector, as well as attract and retain investors for sustained economic growth. A rampant trend of commercial banks placed under receivership between 1990 and 2005 inspired this study. As at the time of the study, the Guidelines had been operational for about eight years. The results show that listed and unlisted commercial banks were significantly different in terms of board size, proportion of executive and non-executive directors, gender composition, cost of board maintenance, composition of audit committees, frequency of financial disclosures and more importantly, financial performance. Sarkar & Goswami (2012) throw some light on the financial performance of Indian Aviation sector means of a comparative study between Air India and Kingfisher Airlines, the two key companies in infrastructure sector. The financial performance has been analyzed with the help of some key measures relating to the efficiency in working capital management on the overall financial performance of the selected companies during the period from 2000-01 to 2006-07. Finally the study ends with some valid suggestions which deserve the attention of the management of both the concerned companies under study and Government. Pachori & Totala (2012) explored the effect of financial leverage on shareholders’ return and market capitalization of automotive cluster companies of Pithampur (M.P.), India. The seven major automotive public companies were undertaken for representation of the cluster. Simple linear regression analysis was carried out to judge the impact of financial leverage on shareholders’ return and market capitalization individually to find out the state of influence of the leverage. The study discussed the probable causes of the findings opening the new avenues of research. They suggested that bankers and debt providers should help the industry out by charging lower cost of debt. Choudhary (2011) identifies the determinants of firm’s financial performance (both capital market based and accounting based) in Indian context. In his study the data of a sample of 233 companies is


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used to evaluate the financial performance measured in terms of shareholders’ value, growth and profitability using a set of independent variables during the period ranging from 1996 to 2008. Bhattacharyya & Saxena (2009) analyzed the manufacturing firms’ data from the steel and Electrical & Electronics (EE) sectors for the period from 2004-05 to 2006-07. The result showed that the firm’s size affected current profitability: positively in steel sector and negatively in the other. Bank credit was found negatively significant in both the industries. Market share of firms and industry concentration ratio were the other significant determinants of firms’ performance. Firms’ market value was found positively significant for other industries. This signified that high market value of firms reflected their goodwill, knowledge stock and prospective investment opportunities which positively influenced the firms’ performance. Interestingly, the impact of size was affected by firms’ market value: firm size positively affected profitability both in steel and EE. A study by Prasetyantoko & Rachmadi (2008) spotted the factors determining corporate performance of listed companies in Indonesia especially in the aftermath of the 1997 financial crisis. The study concludes that a firm’s size was positively related to firms Profitability, but it was related to market capitalization. It implied that the size of a firm mattered on the fundamental value of the firms but it could not be an important variety for market value of the firms. By employing panel data of 238 listed companies in Jakarta Stock Exchange (JSX) in the period 1994-2004 as the sample the study establish the macro factors are more significant variables inducing firm performance that the firmspecific factors. Result also indicated that ownership firm mattered significantly on the a firm by demonstrating that firm with majority foreign ownership registered a higher performance on firm measure viz., return on asset (ROA) and market capitalization growth than domestically owned firms. Singhania (2008) who studied the various determinants equity share prices in chemical industry with reference to Indian stock Market during the period 2000 to 2007 concluded on the basis of correlation regression analysis that earning per share, price earnings ratio, book value, dividend yield were the variables which played a pivotal role in determining share prices followed by dividend cover and dividend per share. Chander & Aggarwal (2007) brought about the determinants of growth of selected 50 companies in drugs and pharmaceutical industry for a period of ten years from 1995-96 to 2004-05. The growth of firms was measured in terms of growth in average total assets and average total sales. In order to study the determinates of growth, ten explanatory variables size, profitability (ROCE, RONW, OPR, NPR), age , advertising expenditure, retention ratio, liquidity, efficiency, ratios, long-term finance, market share and research and development expenditure were chosen for empirical investigation. Multiple regression analysis was used to develop a model to identify determinants of growth of firms in the industry. The result revealed that size, advertising expenditure, age, efficiency ratio, profitability and research and development were statistically significant in determining the growth of firms. Kakani et al. (2001) attempted to study the determinants of Indian firm’s financial performance across various dimensions like shareholder value, accounting profitability and its components, growth and risk of sample firms. The study used financial statements and capital market data of 566 large Indian firms over a time frame of eight years divided into two sub-periods (viz., 1992-96, and 1996-2000). It revealed that even on the same data, the determinants of market based performance measures and accounting-based performance measures differ due to influence of Capital Market Conditions. It found that size, marketing expenditure, and international diversification had a positive relation with a firm’s market valuation. As far as the determinants of shareholder value in Indian firms were concerned, the study identified age, leverage, market expenditure and international diversification as significant determinants of firm value studied across shareholder value dimension.


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STUDIES FOCUSED ON FINANCIAL PERFORMANCE AND MARKET CAPITALIZATION The study of Jaya & Sundar (2012) adopted a time series approach in the analysis and the quarterly data have been used for the period 2003 to 2011. The sample Information Technology firms were chosen from BSE500 Index. The results of the multiple regression analysis of the market capitalization indicates that 91 per cent of the variation in the market capitalization for the study period has been explained by the variables included in the equation viz., Equity and Liquidity. The variable “equity” has more influence on the increase in the market capitalization than the variable liquidity. The results of the granger causality test establish that there is only a unidirectional relationship between equity and market capitalization while there is a bidirectional relationship between liquidity and market capitalization. Shobhana & Karpagavalli (2011) focus on the fundamental variables influencing equity prices of ‘A’ Group and ‘B’ Group shares of the banking companies listed at BSE. Correlation and multiple regression analysis were employed in the analysis of data. The findings reveal that company specific factors such as market capitalization and dividend yield have significant influence on the equity prices of ‘A’ group shares and in the case of group ‘B’ shares book value per share emerged significant. The study covers a period of ten financial years i.e. from 2000-2001 to 2009-2010. Kenneth (2009) used multiple regression analysis to determine which of several important factors yielded the best model for market capitalization. The factor included brand value, dividend, price to sales ratio and forward price earnings ratio. He founded that brand value had the high correlation with the market capitalization and the brand value of small companies and had a stronger relationship with the market capitalization than bigger companies. Kumar & Shah (2009) developed a framework to link custom equity (CE) (as determined by the customer lifetime value metric) to market capitalization (MC) (as determined by the stock price of the firm). The automatically tested the framework in an empirical field experiment with two Fortune five hundred firms in the business –to-business and business-to-consumer contents respectively. The findings showed that (1) a customer equity based framework can reliably predict the Market Capitalization of a firm and (2) market strategies directed at increasing the Customer Equity not only increases stock price of the firm but also beat market expectations. Maurice et al. (2009) examined the relationship between the liquidation values of a firm’s fixed assets and the firm’s market capitalization. Book value had served as a reasonable predictor of market capitalization in numerous accounting and financial studies and this study offered an alternative predictor which exhibited an enhanced relationship. The significance of this relationship was demonstrated by making a comparison between the book value of a firm’s fixed assets and the firm’s market capitalization. Matthew & Odularu (2009) focused on the impact of company shares on their performance using one of the largest confectionary companies in Nigeria. The study analyzed the effect of the company’s performances in terms of turnover, profit after tax and other such variables and the impact of these variables on the market capitalization. Using ordinary least square analytical technique for 20 year data, the study found out a positive relationship between the value of the company’s shares on the performance of the company and its value in terms of market capitalization also has been validated. Prasetyantoko & Rachmadi (2008) analyzed listed companies in Jakarta stock exchange for the period 1994-2004 under panel data. The main findings of the study were that size was position related to the firm’s profitability but it was not related to market capitalization. The result also showed that the ownership factor weighted heavily firm performance by proving that firms with predominant foreign staked much higher performance in both measurements namely Return on Asset (ROA) and Market Capitalization Growth than domestically owned firms. Yasnim & Yusuf (2008) stated that although market capitalization was important as a financial development indicator, it remained relatively less discussed in investment decision. The author


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discussed what market capitalization does mean and highlighted the methods that were in use in determining market capitalization. It also demonstrated how market capitalization (known as market cap) was measured in the Dhaka Stock Exchange. A formula is developed for calculating market cap of a stock market under full market capitalization method. This paper showed that the number of shares issued and price change were the two main factors responsible for changes in market capitalization. The importance in measuring index, taking cross country investment decision and its relevance for institutional investor had also been explored in paper. Ming-Chin et al. (2005) empirically investigated the relation between the value creation efficiency and firms’ market valuation and financial performance. The result supported the hypothesis that firms’ intellectual capital had a positive impact on market value and financial performance, and might be an indicator for future financial performance. Beside, the author had suggested that investor may place different values on the three different component value creation efficiency (physical capital, human capital, and structure capital). The study has proved that R & D expenditure might capture adding information on structural capital and has a positive effect on firm’s value profitability. Gopinath (2005) studied the pattern of share price fluctuation and behavior of 10 companies based on market capitalization. The study further evaluated the performance of accompany and share price movement. The empirical analysis revealed that the performance of the same companies were cyclical and showed a significant relationship between share price and price earnings ratio, market capitalization and turnover ratio book value and market return. The financial performance and share behavior are perfectly correlated. Another analytical study made by Poshakwale & Theobald (2004) segregated the companies into large cap and small cap on market capitalization. The study sought to analyze the lead/lag relationship between the two categories of companies. They arrived at the finding that cap indices were found to lead the small cap indices and the large companies tended to adjust themselves more speedily towards its index values than the smaller ones. Reinganum (1999) put forward that market capitalization one of the most important determinant of portfolios returns. Investor could successfully manage their market capitalization exposure would realize significant rewards over investor who either ignored their exposure or were unable to alter it. The author argued that current tendency to handcuff a manager to a narrow capitalization range might be a mistake. Over a time, greater flexibility in shifting market capitalization would enhance returns. He was of view that manages should be given greater flexibility to alter the capitalization exposures, or investor or their consultants should dynamically adjust allocation to different capitalization categories. In either case, the author contended that improving performance in short – run horizons would enhance long - run performance. Tobin’s q ratio, conventionally used in determining market value, is basically flawed in that replacement cost based valuation of market is suffering from bias in parts of accountant. Therefore the current trend is to phase market capitalization for determining the value of the companies. Chauvin & Hirschey (1993) sought to examine the perception of investor on calculating the market value based on advertising and R& D expenditure positively influenced market value. The relationship between aggregate dividend payment and market capitalization was addressed by Leithner & Zimmermann (1993). The study took companies from four different countries like West Germany, France, the UK, and Switzerland. It concluded by applying integration analysis that the dividend payout had a long run relationship with market capitalization for European firms except U.K firms. 4. LIMITATIONS OF RESEARCHES On the basis on the review study, most of the researchers have focused only on financial performance of the firm. Some of the studies are based on profitability while some of the studies are


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done on other financial indicators like working capital, liquidity and other ratios, financial leverage etc. In India still there is huge scope to study the relationship and effects of financial performance on market capitalization and more studies can be done on model development on prediction of market capitalization on the basis of financial performance of various industries, since this research area is in still grey in India, whoever some models are developed on macro economical factors and market capitalization. 5. FINDINGS AND CONCLUSION The reviews relevant to financial performance and market capitalization have focused that some studies have established a positive relationship between value and market capitalization. While few analytical studies have highlighted the close connect between firm performance and market capitalization. That the firm size is closely linked to market capitalization has been unearthed by a striking of studies. The influence of variables like advertisement, research and development, dividend and intellectual capital on market capitalization has been conclusively proved by many researchers. Customers equity based strategy could reliably predict the market capitalization. It is clear from the aforesaid pieces of literature relating to market capitalization and firm performance that the influence of various variables such as return on equity (ROE), P/E ratio, return on asset (ROA), profitability etc. over market capitalization has been undertaking independently. However, the overall impact of the individual variables over market capitalization is still an unexplored area warranting research. The present research seeks precisely to find the gap and to suggest for further studies have been done in India by developing a suitable model on financial performance and market capitalization. Present study finds that literature pertaining measuring the linkage between market capitalization and firm’s performance variable is very limited in India. Therefore, the researcher has consulted writings relating to corporate firm performance to spot out the variables can be incorporated into the study. There is absolutely no study conducted in the Indian context investigating the influence and difference performance variables on market capitalization. So there is a wide scope of further study on relationship between financial performance and market capitalization in Indian market. REFERENCES: · · ·

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Agustinus, Prasetyantoko and Rachmadi, Parmono. (2010). Determinants of Corporate Performance of Listed Companies in Indonesia. MRPA Paper No. 442: 10 January 2010. www.Mpra.Ub.Uninyebcgeb,De/6777. Alsharkas Adef. (2004). The Dynamic Relationship between Macro Economic Factors and Jordanian Stock Market. International Journal of Applied Econometric and Quantitative Studies, 1.1; 97-114. Bambang Soedaryono, M. A. (2012). Effect Intellectual Capital (Value Added Intellectual Capital) to Market Value and Financial Performance of Banking Sector Companies Listed in Indonesia Stock Exchange. The 2012 International Conference on Business and Management, (pp. 89-106). Phuket - Thailand. CA Sachchidanand Pachori, D. N. (2012). Influence of Financial Leverage on Shareholders Return and Market Capitalization: A Study of Automotive Cluster Companies of Pithampur, (M.P.), India. 2nd International Conference on Humanities, Geography and Economics, (ICHGE'2012) (pp. 23-26). Singapore: ICHGE. Choudhary, K. (2011, July). An Exploration Of Financial Performance’s Determinants: Evidences From Indian Corporate Sector. JBFSIR, Volume 1 (Issue 4), 1-15. Eliza Sharma, D. M. (2012). Impact Of Macroeconomic And Financial Market Indicators On The Banking Sector: Some Evidence From India. IJRFM, Volume 2 (Issue 2), 172-185. Gopinath N. (2005). A Study An Empirical Analysis On Share Price Behavior Of Top Ten Companies In NSE Based On Market Capitalization. Diss University Of Madras.


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· AUTHOR’S PROFILE:

Dr. Hanuman Prasad is Professor at Mohanlal Sukhadia University, Udaipur, Rajasthan Kapil Shrimal is Research Scholar, at Mohanlal Sukhadia University, Udaipur, Rajasthan


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