The relation between earnings components and stock return in vietnam stock market

Abstract This study examines the information of earnings quality which is reflected by the persistence of earnings and then investigates the link of earnings quality and stock returns of

CHU THI KIM HUONG

THE RELATION BETWEEN EARNINGS COMPONENTS AND STOCK RETURN

IN VIETNAMESE STOCK MARKET

A THESIS OF MASTER OF FINACE AND BANKING

Ho Chi Minh City - 2015

CHU THI KIM HUONG

THE RELATION BETWEEN EARNINGS COMPONENTS AND STOCK RETURN

IN VIETNAMESE STOCK MARKET

Major:

Code:

Finance-Banking

60340201

A THESIS OF MASTER OF FINACE AND BANKING

Supervisor: Dr Vo Xuan Vinh

Ho Chi Minh City - 2015

Contents

Contents

Abstract

List of Figures

List of Tables

CHAPTER ONE: INTRODUCTION 1

1.1 Background 1

1.2 Research questions 3

1.3 Purpose of study 3

1.4 Structure of the thesis 4

CHAPTER TWO: LITERATURE REVIEW 5

2.1 Vietnam Stock Market 5

2.2 Theoretical framework 9

2.2.1 Market efficiency 9

2.2.2 Random walk 11

2.3 Prior empirical studies 12

2.3.1 Cash flows and accruals information in earnings 12

2.3.2 Definition of earnings quality 14

2.3.3 Measuring earning quality 15

2.3.4 Link between earnings persistence and market pricing 17

SUMMARY 18

CHAPTER THREE: METHODOLOGY 19

3.1 Hypotheses Development 19

3.2 Hypothesis testing framework 20

3.3 Theoretical Methodology 21

3.3.1 Design 21

3.3.2 Data Collection 24

3.3.3 Variables computation 25

3.3.4 Testing of hypothesis 28

3.3.4.1 Testing of Hypothesis 1 28

3.3.4.2 Testing of Hypothesis 2 29

3.4 Statistical Methodology 32

SUMMARY 33

CHAPTER FOUR: EMPIRICAL ANALYSIS AND RESULTS 34

4.1 Descriptive statistic 34

4.2 Test of Hypothesis 1: Earnings persistence result 36

4.2.1 Steps for Analyze 36

4.2.2 Result 37

4.3 Test of Hypothesis 2: Stock return result 41

4.3.1 Steps for Analyze 41

4.3.2 Result 42

SUMMARY 47

CHAPTER FIVE: RESEARCH EVALUATION 48

5.1 Reliability 48

5.2 Validity 49

CHAPTER SIX: CONCLUSION 50

6.1 Practice Implications 50

6.1.1 Implication for investors 50

6.1.2 Implication for researcher 50

6.1.3 Implication for policy maker 50

6.2 Further Study 51

References

APPENDIX

Abstract

This study examines the information of earnings quality which is reflected by the persistence of earnings and then investigates the link of earnings quality and stock returns of 245 listed firms in Vietnam stock market beginning from 2007 to

2013 The results are given in research show the earnings persistence rate is average 0.627, meaning that 62,7% current earning will contribute to the next year’s earnings Moreover, the study finds that the cash flow component is more persist than the accruals component in earnings Finally, stock price in Vietnam stock market appears that it do not reflect fully the different contribution of cash flow component and accruals components in earnings

List of Figures

Figure 2.1 Vietnam's inflation - Source : World Bank* 5

Figure 2.2 Market cap in % of GDP - Source : Bloomberg 6

Figure 2.3 Price/Earnings ratio – Source: Bloomberg 7

Figure 2.4 Number of listed companies – Source: HSX and HNX 8

Figure 2.5 VN-index history data – Source: VNDIRECT company 9

Figure 3.1 The Framework for the Hypothesis 1 20

Figure 3.2 The Framework for the Hypothesis 2 20

Figure 3.3 The Logical Structure of the Quantitative Research Process (Alan (1988)) 23

Figure 3.4 Steps of Estimation Procedures for Hypothesis 1 29

Figure 3.5 Steps of Estimation Procedures for Hypothesis 2 32

List of Tables

TABLE 3.1 Variables Definition 27TABLE 4.1 Descriptive statistics on earnings, the accrual and cash flow components of income and abnormal stock returns for a sample of 1,470 firm-year observations obtained from VN-Index and Bloomberg terminal during period 2007

to 2013 35 TABLE 4.2 Ordinary Least Squares regressions analyzing the persistence of the current earnings into the future earnings Sample consists of 1,470 firm-year observations obtained from Bloomberg terminal during period 2007 to 2013 38

TABLE 4.3 Wald Test for Ho: α1 =1 38

TABLE 4.4 Ordinary Least Squares regressions analyzing the persistence of the accrual and free cash flow components of earnings Sample consists of 1,470 firm-year observations obtained from VN-Index and Bloomberg terminal during period

2007 to 2013 40TABLE 4.5 Wald test for Equality of coefficient cash flow and accrual 41TABLE 4.6 Summary coefficients 41TABLE 4.7 Iterative Weighted Non-linear least squares estimation of the stock price reaction to information in current earnings about future earnings Sample consists of 2,940 firm-year observations obtained from VN-Index and Bloomberg terminal during period 2007 to 2013 43

TABLE 4.8 Wald test for Test of market efficiency Ho: α 1 = α 1 * 44TABLE 4.9 Iterative Weighted Non-linear least squares estimation of the stock price reaction to information in the accrual and cash flow components of current earnings about future earnings Sample consists of 2,940 firm-year observations obtained from VN-Index and Bloomberg terminal during period 2007 to 2013 45

TABLE 4.10 Wald test for Test of market efficiency Ho: γ1 = γ 1

CHAPTER ONE: INTRODUCTION

How the earnings quality of listed firms in stock market is and whether stock price correctly reflects the information of earnings are the questions which have been attracted numbers of researchers It is interesting and practical to identify the quality of earnings and how do investors response with this information that indicates in the stock price in Vietnamese stock market The answer is meaningful

to not only researchers, but also the market involvers who would like to understand and make an investment decision It helps investors see the full picture of market and successfully set up investment strategies

The purpose of this research is to analyze the quality of reporting earnings and test the relation of earnings quality and stock return of listed firms in Vietnam stock market Through the thesis, you may have some information about a new emerging market as Vietnam This chapter presents the background of the topic, the research questions, the purpose of the study and the structure of the thesis

1.1 Background

The first question is why earnings quality should be analyzed Apparently, participants in financial market are aware that numbers of earnings can be manipulated Despite the shortcomings of earnings, a majority of the market is looking at earnings; therefore, earnings quality issue still makes sense in study work In investors’ perspective, before making an investment decision, except the stock price variable, the best pick would be earnings to look at the value of a security in one financial year or in a quarter Sloan (2006) presented that future earnings are more informative than intrinsic value for those interested in forecasting stock returns over the next 3–12 months

Studying earnings quality is also important because it affects investors’

buy-hold-sell action This variable is an indicator to decide which firm is good and bad

In Vietnam stock market context, the quality of financial information of listed companies is an existing issue With earnings reports, a bulk of firms are determined has not recorded properly to estimate of interest to be paid, do not transfer the entire business management costs incurred during the period in the income statement report Many enterprises also use accounting policies as "the valves" to adjusted earnings, such as changing depreciation from 15 years to 25 years to reduce depreciation expense, as consequence make an increase in their earnings

The case of Vitaly Joint Stock Company (code: VTA) is an example In the first half of 2010, to avoid the risk of being delisted, VTA leaders did everything possible to "create" numbers to the lowest losses In the first- half financial year report, VTA were stopped depreciating of 5 production lines with a total cost estimated at 5.99 billion VND Thus, if they added depreciation cost, the after-tax losses on the income statement in 6 months of 2010 would be loss 29.09 billion VND instead of 19.34 billion VND

Following is another example: SaiGon Beverages Joint Stock Company (TRI) In the 9 months of 2010 business result, TRI posted 10.6 billion profits; however, many investors remained cautiously with this information, since TRI was named "erratic" stock Because investors were cheated the same case in 2008, TRI released profit at 750 million in 9 months of 2008 but in the fourth quarter of 2008, they announced an unexpected loss of over 146 billion Subsequently, in 2009, TRI set profit target at 17 billion, but they announced a loss at 82.29 billion in the end of this year The story still happened in the first 6 months of 2010, the parent company announced the loss of nearly 40 billion, but in the consolidated financial statements, they posted nearly 42 billion profits, thanks to the transfer of financial investments

in subsidiaries Tribeco Binh Duong and Northern Tribeco right on 30th June

Within three years, the story of the profit and loss of TRI like a quirky film that investors did not know what they should act with that code And the sad ending of this story was that TRI delisted on 9th April, 2012

Therefore, getting the knowledge of earnings number and underlying of that number is the need for researchers and the investors either in the emerging market

as Vietnam stock market

1.2 Research questions

According to the problem background, it raises questions how the earning quality of Vietnam stock market listed firms is and whether stock price is reflected correctly the information of earnings, specifically the components of earnings These answers for the following questions can give us some perspectives of the market It can also provide us a better understanding on the Vietnam stock market

It can be interesting and useful to set up short and long investment strategies The research questions are as followed:

 How is the earnings’ quality of listed firms in Vietnam stock market?

 Which components of earning play the major role to contribute to net

income?

 Do investors use information of earnings quality to apply for their

investment action?

1.3 Purpose of study

The objectives of the research are:

- To figure out the quality of earnings of listed firms in Vietnam stock market;

- To find out which part of earnings is major contribution to earnings;

- To find out how investors react toward the information of earnings and toward the information of components of earnings;

- To suggest some implications to participants in Vietnam stock market, especially researcher, investors and policy makers

1.4 Structure of the thesis

Chapter Two: An introduction to Vietnam stock market, reviews relevant

literature relating to the definition of earnings quality, the content information of cash flow and accruals A review of the concept of random walk, market efficiency which are also present which is a basis for measuring the two tested hypotheses

Chapter Three: I focus on the theoretical and statistical methodology I then

explain how I approached the research and present the process for measuring the two hypotheses based on the literature

Chapter Four: Provide steps to analyze hypothesis and display results of

tested regressions I find the evidence to support my predictions of persistence of earnings I also find interesting results from the pricing equation

Chapter Five and Six: The two last chapters summarized the key findings

and strategy conclusions made in the thesis A recommendation for further studies and self-evaluation of the research is also included

CHAPTER TWO: LITERATURE REVIEW

2.1 Vietnam Stock Market

This part shall give you a better overlook on Vietnamese market Vietnam keeps maintain developing of the land’s economy on GDP (Gross Domestic Product) and to control the inflation The inflation rate is peak in 2008 and 2011 at 22.7% and 21.3% respectively The recent tightening of monetary policy had some impact in cooling the economy; inflation slowed down in 2012 and dropped sharply

to 4.8% in 2013(World Bank1)

To control the inflation into single digits, stabilize the macro economics, and

to grow the stock market are among the priority goals of Vietnam

Vietnam’s stock market capitalization represented nearly 23% of GDP in

2013, it is a low market cap/ GDP 2relative to ASEAN nations This is a positive sign for the economy and suggests that the stock market still has strong

development potentials In the meantime, The Ministry of Finance has planned to change numbers of security decrees and circulars to create system of legal documents for the local stock market in the coming time in hopes of attracting more foreign funds The changes would help promote liquidity on the market, such as allowing investor to open many transaction accounts, and buy and sell the same stock on the same single session

Vietnam’s overall Price/Earning ratio3

is relatively low — just over 12 as of December, 2013 It is below in relative with Asian nations such as Thailand (14.59), and Indonesia (19,72) etc

Vietnam hosts two large stock exchanges; the Ho Chi Minh City Stock Exchange (HOSE), the Vietnam's largest stock exchange, and the Hanoi Stock Exchange (HNX)

Established in 2000, HOSE currently lists 301 companies as of December

2013 Originally, it was named the Ho Chi Minh City Securities Trading Center (HoSTC) The exchange was officially inaugurated on July 20, 2000, and trading commenced on July 28, 2000 Initially, two companies were listed, Refrigeration Electrical Engineering Joint Stock Corporation (REE) and Saigon Cable and

Telecommunication Material Joint Stock Company (SACOM) At the beginning, an overall foreign ownership is limited of 20% for equities and 40% for bonds were implemented In July 2003, in a bid to improve liquidity, the government raised the foreign ownership limitation for equities to 30% and totally removed the foreign ownership limitation of a particular issuer’s bonds On 8th August 2007, HoSTC was renamed and upgraded to the Ho Chi Minh Stock Exchange

Hanoi Stock Exchange (HNX), formerly the Hanoi Securities Trading Center (Hanoi STC), was launched in March 2005 and handles auctions and trading of stocks and bonds The Hanoi STC was renamed to the Hanoi Stock Exchange in

2009 It was the second security trading center to open in Vietnam after Ho Chi

Figure 2.3 Price/Earnings ratio – Source: Bloomberg

Minh City Securities Trading Center The HNX hosts 377 companies by the end of December 2013

According to the historical data, I noted that Vietnam market has had many changes and volatiles in the past 13 years In the first three years 2000-2003, firstly market grew up strongly; VN-Index heated to the top of 571.04 points at June 25

2001, and fell deeply to 203.12 after 14 weeks, on October 5 2001 The downtrend period took place with the lower Index at 180.73 points at March 11, 2002 and down to 139.64 points in April 1, 2003 The second period 2004-2005, VN-Index was moved between 213.4 and 307.05 points (Feb 6, 2004 to 307,05points on Dec

30, 2005) In the period 2006-2009, VN-Index reached to top on Feb 02 2007 at 1167.36 points before financial crisis The lowest level felt on Feb 24, 2009 at 235.5 points Index was at 504.63 on Dec 31, 2013

Figure 2.4 Number of listed companies – Source: HSX and HNX

2.2 Theoretical framework

2.2.1 Market efficiency

Numbers of researchers have studied and mentioned about ―efficient market‖ What it actually means in financial theory and its perspectives which concerned to the research can be considered by the below literature

The concept of market efficiency is mentioned by Haugen A (2001) that if new information becomes known about a particular company, how quickly do market participants find out about the information and buy or sell the securities of the company? How quickly do the prices of the securities adjust to reflect the new

Figure 2.5 VN-index history data – Source: VNDIRECT company

information? If prices respond to all relevant new information in a rapid fashion, we can say the market is relatively efficient

The word ―efficient‖ refers to how fast the market prices change when new information is released Thus an efficient market is one in which the prices of the stock fully reflect available information ―All the empirical research on the theory of efficient markets has been concerned with whether prices fully reflect particular subsets of available information‖ (Fama et al (1969))

To definite the efficient market in the relationship among ―dividend announcement, security performance and capital market efficiency‖, Pettit has mentioned that in an efficient market, current prices fully and without bias reflect all published, widely available information.‖ It also implies that the return expected from a security in one period is independent of all information available in the previous periods since the price of stock already reflects the effect of this information (Petit and Richardson ( 1972))

The market is neither strictly efficient nor strictly inefficient The question is how efficient the market is In order to measure what types of information, encompassed by the total set of all available information, are reflected in stock prices, Haugen A (2001) grouped ―Information‖ into three groups which related to the main three different forms of hypothesis First, it represented all information relevant to the valuation of a particular stock that is currently ―knowable‖ This includes publicly available information about company, its industry, the domestic and world macro economy Second, information represents the part of the information set that has been publicly announced and publicly available, for examples the information of the accounting reports, the report of firms, announced information relating to the state of the economy or information relevant to the valuation of the firm Third, represents any information relevant to the valuation of the stock that can be learned by analyzing the history of market price of the stock

2.2.2 Random walk

An efficient market implied a random According to G.Burton (1999) ―a random walk is one in which future steps or directions cannot be predicted on the basis of the past actions‖ When we apply it to the stock market, it means that there

is a short run changes in stock market prices that cannot be predicted Following to G.Burton (1999), the technical analysis, earnings predictions or chart analysis are useless in the random walk hypothesis

G.Burton (1999) argued that ―if the flow of information is unimpeded, then tomorrow’s price change in speculative markets will reflect only tomorrow’s

―news‖ and will be independent of the price change today But ―news‖ by definition

is unpredictable and thus the resulting price changes must also be unpredictable and random‖ ―Random walk‖ characterizes that the stock price changes are randomly from previous prices and the investment returns are serially independent ―The earliest empirical work on the random walk hypothesis generally found that stock price changes from time to time were essentially independent of (or unrelated to) each other Their probability distributions are constant through time.‖

The attempt to predict accurately the future stock price in order to sell or buy

in appropriate time is one of the investor’s most persistent endeavors Technical or fundamental analysis which is the two methods we have known up to now While fundamental analysis is the technique of applying the tenets of the firm-foundation theory to the selection of individual stocks by attempt to estimate the stock’s intrinsic value The technical analysis is essentially the making and interpreting of stock charts They interest on the past, and both the movements of stock prices and the volume of trading, for a clue to the direction of future change Most of chartists believe that the market is only 10 percent logical and 90 percent psychological, oppositely fundamental analysis believe the market to be 90 percent logical and only 10 percent psychological (G.Burton (1999):117)

Following to the personal point of view, numbers of investors also claim that the stock market adjusts so quickly and perfectly to new information that the amateurs buying can do just as well as the professionals This idea has certainly not been believed by numbers of professional advisers or portfolio managers or researchers who believe and support to the non-random walk theory A presence or

an absence of random walk has important implications for not only researchers but also for investors, trading strategies, portfolio or fund manager, assets pricing models and consequently for financial and economic development

With the development of the above theories, some contradicting studies of anomalies have existed Numbers of studies on the information of accounting earnings and the link of this information to stock returns have been investigated for more than two decades The results indicated that stock prices are found that failing

to reflect fully information contained in earnings and in accrual and cash flows components of earnings Those studies verified mainly in the US market ( Bernard and Thomas (1990); Sloan (1996); Richardson (2005))

Whether the application of ―random walk‖ theory is also valid in the emerging markets as Vietnam or not is also a question That is if the information of earnings and its components do not effect to share prices in Vietnam stock market

as United States markets The test of earnings and earnings components in related with stock price in Vietnam stock market has not been extensively researched

2.3 Prior empirical studies

2.3.1 Cash flows and accruals information in earnings

Capital market researchers have examined the empirical question as whether cash flows or accrual component is to improve or reduce the ability of earnings to measure firm performance Major studies are tested whether stock prices accurately reflect the economic performance of a firm by the earnings information

Early research focused on whether accruals have information content Ball and Brown (1968) find that the association between security returns and earnings is higher than the association between security returns and operating cash flows Since the difference between earnings and cash flows equals accruals, this result suggest that accruals improve the ability of accounting income to reflect firm performance

Research by Wilson (1986) , Rayburn (1986), Bowen et al (1986),Wilson (1986), Bernard and Skinner (1996)and Livnat and Zarowin (1990) showed that the accrual and cash flow components of earnings have information content in evaluating earnings

Ali (1994) extends this previous research by allowing for nonlinear relations between returns and the performance variables earning, accruals and cash flows Ali (1994) shows nonlinear relations between returns and earning, accruals and cash flows

Dechow (1994) results demonstrate that cash flows and accruals are the measure of firm performance with hypothesis that the cash flow and accrual components of earnings should have similar forecasting information Sloan (1996) challenges this hypothesis, suggesting that accruals may be less informative than cash flows because they are less reliable In support of this hypothesis, Sloan shows that accruals are, on average, less informative than cash flows in forecasting future earnings The results indicate that earnings performance is contributed by the accrual component of earnings lower persistence than earnings performance contributed by the cash flow component of earnings However, stock prices do not fully reflect information in accruals and cash flows about future earnings

The research discussed up till now examines whether cash flows and accruals are significant in a regression where abnormal stock returns are the dependent variable

2.3.2 Definition of earnings quality

The purpose of financial reporting is to provide information that is useful for business and investment decisions Given the focus on decision usefulness, the quality of financial reporting is of interest of those who use financial reports for contracting purposes and for investment decision making A major interest in financial reporting is the earnings quality, which is part of the overall financial reporting quality

Lev (1989) see quality as the characteristic of earnings and studies following Lev (1989) finds that research on earnings quality is useful for equity valuation model The literature holds several definitions of earnings quality and some authors see persistence of earnings is indicator of earning quality Persistence has to be understood in the sense that the company can maintain its profit in the long term, in other words that current earnings provide a good indication of future earnings Sloan (1996) can be seen as the leader in this field and subsequent researches provide evidence support for his work Beneish and Vargus (2002) define earnings quality in terms of persistence; Scott A Richardson et al (2001), (Li et al., 2011) and Richardson (2005) see earnings quality in terms of persistence, but more precisely the persistence of accruals; Ahmed et al (1999) are aware of that earnings persistence is a measure of earnings quality; Lev and Nissim (2004) interpret earnings quality in terms of earnings persistence.; Hanlon (2005) finds that the persistence of earnings is used to infer earnings quality A number of survey papers

of earnings quality predate this review: Healy et al (1999); P.Dechow and D.Skinner (2000); McNichols (2000); Fields et al (2001); Imhoff (2003);Penman (2003);Schipper and Vincent (2003); Dechow et al (2010); …

Persistent earnings are often referred to as sustainable or core earnings, where sustainable earnings are considered high quality earnings Penman and Zhang (2002)for instance define earnings quality:

“Reported earning is of good quality if it is a good indicator of future earnings Thus we consider high-quality earnings to be “sustainable earnings” Correspondingly, when an accounting treatment produces unsustainable earnings,

we deem those unsustainable earnings to be of poor quality.”

In this research, when earnings quality is mentioned, it will be understood that earning persistence as implication of earnings quality

2.3.3 Measuring earning quality

There are several constructs that attempt to reflect earnings quality in finance research One construct typically used in financial accounting research to examine earnings quality is related to the time series properties of earnings (e.g.Kormendi and Lipe (1987), Sloan (1996)), in another word, it is earnings persistence

Persistent earnings are associated with investor responses to reported earnings Earnings persistence is a value relevant characteristic of earnings as made explicit in the Feltham and Ohlson (1995) valuation model

It is commonly suggested in the finance literature that the time series behavior of earnings are well estimated by a "random walk" model, that is, changes

in earnings cannot be predicted Freeman et al (1982) is one of the first studies that examined this idea Freeman et al (1982) show that current book rate-of-return provides a basis for predicting future earnings changes A low rate-of-return implies that earnings are "temporarily depressed"; similarly, a high rate-of- return implies that earnings are ―unusually good‖ The evidence thus suggests that, the "random walk hypothesis" is quite robust with the use of the past earnings information, and earnings are considered to be predictable This study suggests that future earnings are predictable

Ou and Penman (1989) expand this analysis by showing that not only return-on-assets determines future earnings They find that a large set of financial

statement items determine future earnings They outline a method of financial statement analysis by extracting figures from financial statements The measure is

an indicator of the direction of future earnings This suggests that future earnings can be predicted by analyzing financial statements

Kormendi and Lipe (1987) use firm-level regressions of current earnings on last year’s earnings to estimate the slope-coefficient estimates of earnings persistence Kormendi and Lipe (1987) use firm-level regressions of current earnings on last year’s earnings to estimate the slope-coefficient estimates of earnings persistence Kormendi and Lipe (1987) uses the following equation:

Where:

Earn(j,t) : Firm’s net income in year t; and

Earn(j,t-1) : Firm’s net income in year t-1

The measure capturing earnings persistence is based on the slope- coefficient estimated (δ1, hereafter, Persist) Value of δ1 close to one (or greater than one) indicates highly persistent earnings while values close to zero imply highly transitory earnings Persistent earnings are viewed as higher quality, while transitory earnings are viewed as lower quality

Sloan (1996) evaluates whether cash flow from operations and accruals have different implications for the persistence of future Sloan tested the ability of earnings and earnings components to forecast future earnings While, to measure persistence, researchers generally estimate a regression of the future value of the variable on its current value (Dechow et al (2006), Richardson (2005) etc.)

2.3.4 Link between earnings persistence and market pricing

An important question to analyst is how investors behave with information of future earnings by pricing equities in stock market Follow up with Dechow et al (2010), the empirical evidence is mixed in the literature:

The first prediction is the more persistent earnings will yield a higher equity market valuation and, therefore, persistence will yield positive equity market returns Early research by Collins and Kothari (1989), Kormendi and Lipe (1987), and Easton and Zmijewski (1989) provide evidence that more persistent earnings have a stronger stock price response

The second prediction is the researcher attempts to find that whether investors are aware of the differential contribution of components on earnings persistence A key result is of Sloan (1996) who shows that investors are not fully aware of the differing persistence levels of the accrual and cash flow components of earnings Follow up Sloan, a number of researches have extended his work by providing more evidence of Sloan’s result such as Scott A Richardson et al (2001); Richardson (2005); Dechow et al (2006)

At this date, and to the best of my knowledge, there are not many published papers investigating the relationship between earnings quality and stock return in Vietnam context

SUMMARY

Chapter two give an attractive view of Vietnamese stock market, in which inflation rate is controlled at low rate, price/earnings ratio is compelling in compare with ASEAN nations and the developing of securities regulations and laws

This chapter also reviews relevant literatures that show that the content of cash flow and accruals is informative in earnings Moreover, definition of earnings quality is discussed and also given the measurement of this parameter A review of the concept of random walk, market efficiency which are also present which is a basis for measuring the two tested hypotheses

CHAPTER THREE: METHODOLOGY

3.1 Hypotheses Development

Analyzing components of earnings is important in context of financial statement analysis Dechow (1994) offers evidence that earnings is a good measure

of firm’s performance In addition, Dechow (1994) finds that information of

earnings’ components are cash flow and accruals explains well for future earnings Follow up Dechow (1994), Sloan (1996) provides evidence on his research by showing that the cash flow component of earning is more persistent than the accrual

component of earnings This leads to form my first testable hypothesis

Hypothesis H1: Earnings of listed companies in Vietnam stock market are contributed from cash flows are persistent than earnings that are contributed from accruals

Refer to the pricing of cash flows component of earnings and accrual component of earnings Sloan (1996) shows that investors overvalued of accruals component and undervalued of cash flows component because they fixated on reported earnings and fail to distinguish between level persistence of accrual and cash components of earnings Following Sloan (1996) hypothesis, I predict that investors fail to take into account the different levels of persistence of the two earnings’ components

Hypothesis H2: Stock prices in Vietnam stock market response differently with contribution of cash flow component and accruals component

to earnings

3.2 Hypothesis testing framework

The first part is to examine the persistence of earnings by testing the relation

of future earnings and cash flows, accruals components in current earnings By taking this test, I will find out the level of earnings quality

The second part of my research is based on market efficiency theory, specific

in ―random walk‖, to test whether the market can anticipate the different portion of the cash flow component and accruals in earnings It is interpreted as the second hypothesis is whether stock prices response differently with contribution of the two components of earnings

Figure 3.1 The Framework for the Hypothesis 1

Figure 3.2 The Framework for the Hypothesis 2

3.3 Theoretical Methodology

3.3.1 Design

There are many factors to be considered when choosing an appropriate research methodology At the beginning phase of the research process which was namely ―literature review‖, the researcher should have some idea of the field of study, and the area of his or her interest in which the research is to be carried out (Remenyi et al (1998)) The topic and the specific research question are among the primary drivers in the choice of methodology To choose a design is a basic foundation for planning how a research shall be followed Creswell (2009)) states that ―Research designs are plans and the procedures for research that span the decisions for broad assumptions to detailed methods of data collection and analysis, and interpretation.‖

Design is focused on methods of collecting evidence A research design is a plan for collecting evidence that can be used to answer a research question The main seven types of research design are document analysis (1); secondary analysis

of data such as census data (2); naturalistic observation (3); surveys (4); interviews (5); experiments and quasi-experiments (6); participant observation (7) (Vogt (2007)) The major element in the framework is the specific research methods that involve the forms of data collection, analysis, and interpretation that the researcher proposes for the study Both quantitative and qualitative approach techniques can be handled for that any of those designs can produce evidence The choice of methods turns on whether the intent is to specify the type of information to be collected

Three types of the technical approach in research design are: qualitative, quantitative, and mixed methods (Creswell (2009)) ―Quantitative research is often conceptualized by its practitioners as having a logical structure in which theories determine the problems to which researchers address themselves in the form of hypotheses derived from general theories‖ (Alan (1988)) The different designs or

research have its own strong and weak sides Choosing the design depends on what the researcher shall search and which resources he or she has to disposition, here under time resources

The method I selected for my research issue is quantitative method Since ―In quantitative studies, one uses theory deductively and places it toward the beginning

of the proposal for a study With the objective of testing or verifying a theory rather than developing it, the researcher advances a theory, collects data to test it and reflects on it confirmation or disconfirmation by the results‖ (Creswell (2009)) Quantitative research is a means for testing objective theories by examining the relationship among variables These variables can be measured Data can be analyzed by statistical procedures or instruments In quantitative approach, the researcher shall test a theory by specifying narrow hypotheses and the collection of data to support or refuse the hypotheses (Creswell (2009))

Also, to choose a design has a relation to the subject of the research My research philosophy is positivism The analysis and conclusion based on a great amount of data, the result of the calculation and statistical tests Before doing the research, the scientific approach has to be set up In general, there are two approaches the researcher can apply, namely the deductive and inductive approach

In the deductive hypothesis, the researcher can build up a new hypothesis from a theory or retest the same hypothesis of the historical studies They shall test those hypotheses in the same environment or different environment with different periods

of time where the researcher can find the support or rejection of these hypotheses

In case of the deductive approach is adopted, they have to use some existing theories which can conduct the empirical study Conversely, if the inductive approach is applied, the researchers shall analyze the data from the previous models and use those data to develop a theory The below figure is a structure for a research process

By applying the deductive approach, I based on the relevant existing theories; the historical researches have been tested by the pioneers in other markets, such as America Also, I adopted their procedures, testing methods and re-tested those theories with the data of Vietnam market My thesis concerns to the theory of market efficiency I would like to re-test those theories whether those theories exist

in the Vietnam stock market It also means that if the Vietnam market is efficient, in consequences, the investors act rationally with information of earnings and its components in this market Thus, to choose the design as quantitative, including empirical data observation is the best way for my case to figure out evidences to support the hypothesis

Figure 3.3 The Logical Structure of the Quantitative Research Process (Alan

(1988))

3.3.2 Data Collection

There are two types of data, namely primary data and secondary data In a research study, we can use only secondary data or both of them And there are many techniques to collect it, depending on the quantitative or qualitative approaching methods Secondary data is not limited for the data research Those data come from different sources such as documents from statistic offices, research-surveys reports Document data can be found from economics bulletins, news, journals, science articles and databases

The data for the chapter of introducing on Vietnam stock market has been mostly from accessing the official Vietnamese website and many sources of secondary data that I listed in the reference

When reading articles, the session of the methods and testing are important,

it shows the way to test hypothesis and the required data related to the research questions Those data are raw data Before testing, many steps of analysis and calculating were required I shall present it in the later chapters

By accessing to the worldwide web database, I can find a great source of data

in the fields of my research; books, together with a lot of relevant scientific articles and journals are very helpful for constructing theoretical framework The key words

I have searched are as follows: earnings quality, abnormal return, cash flows and accruals components, Vietnam stock market, and many famous historical researchers in this sector as Sloan, Dechow, etc

Data from Vietnam becomes a foundation for my study My empirical test employs data of financial statement data and stock return data are obtained from Bloomberg terminal Sample covers all firm-years with available data on Bloomberg terminal the period from 2007 to 2013 To ensure consistency with sample selection criteria used in prior studies, I exclude banking, financial and insurance institutions from my analysis because the distinction between operating

and investing activities is not clear in these firms and I also eliminate firm-year observations with insufficient data in research periods

These criteria yield final sample sizes of 1,470 firm-year observations including 245 tickers within six years from 2007 to 2013

Secondly, Sloan (1996) calculates current accruals using the balance sheet data; however as Hribar and Collins (2002) point out that the use of balance sheet data can produce errors into the measurement of accruals

To eliminate these shortcomings, I obtain the definition of accruals is total net accruals This is calculated as the difference between earnings and free cash flows (FCF)

Total Net Accruals = Net Income – FCF

My study obtains definition of FCF in Dechow et al (2006) as equal to CFO plus CFI CFI is cash flows from investing activities, as reported on the statement of

cash flows

Cash flow (CF) = CFO+CFI

In order to analyze earnings quality across a large set of firms, as Sloan, I first standardize all of the measures to compare between of firms by scaling

earnings, accruals and cash flows by average total assets Hereby, each time I refer

to earnings, accruals or cash flows, it will be referred to the scaled figures

Average total asset (ATA) = ( BEG + END)/2

My abnormal stock return use data from the Bloomberg terminal monthly files Stock returns are measured using buy-hold size-adjusted returns, inclusive of dividends and other distributions Returns are calculated for beginning 4 months after the fiscal year end (the 4 month rule allows for financial statement information for the fiscal year to be made available to investors)

The size-adjusted return is calculated by deducting VNINDEX return, where size is measured as the market capitalization at the beginning of the return accumulation period

Procedure to compute of abnormal stock returns (AR): abnormal returns are the differences between a single stock or portfolio's performance and the expected

return over a set period of time The size-adjusted return is calculated by deducting

the value-weighted average return for all firms in the same size-matched decile, where size is measured as the market capitalization at the beginning of the return accumulation period Returns are calculated for a twelve-month period beginning four months after the end of the fiscal year

Buy-hold return of individual stock:

In which:

BHRi : Return of individual stock in portfolio at time t

P t : Price of individual stock in portfolio at time t

P t-1 : Price of individual stock in portfolio at time t-1

Div: Dividend in year t

Buy-hold return of portfolio:

In which:

BHRp : Buy-hold return of portfolio at time t

MC i : Market capitalization of individual stock i in portfolio at time t

MC p : Market capitalization of portfolio at time t-1

Abnormal return = BHR I - BHR p

TABLE 3.1 Variables Definition

Average total assett

(ATA)

Average total assett(ATA) = (

BEG + END)/2

Average total asset for year t

Earningst (NIt) NIt/ ATAt Net income

Cash flowt (CFt) FCFt/ATAt

Note: FCFt = CFOt+CFIt

Cash flow is defined as free

cash flows Total net accrualst

(ACCt)

(NIt-FCFt)/ATAt Accruals is defined as total

net accruals measured by the difference of net income and

free cash flows Abnormal stock

return (ARt+1)

Annual buy-hold stock return calculated starting four months period after fiscal year-end less the corresponding return of VN- Index

3.3.4 Testing of hypothesis

3.3.4.1 Testing of Hypothesis 1

Hypothesis H1: Earnings of listed companies in Vietnam stock market are contributed from cash flows are persistent than earnings that are contributed from accruals

To measure H1, I followed the estimation alternative procedures of Sloan (1996) Besides, I also studied 20 articles of the former researchers as Dechow et

al (2006); Richardson (2005) to have the ideas how to measure the hypotheses

Following Freeman et al (1982), I test equation (1) to find out the relation between future earnings and current earnings:

Earnings t+1 = α0 + α1Earnings t + εt+1 ( 1)

Test of market efficiency: Ho: α1 = 0; α1 = 1

However, equation (1) implied that the coefficient on the cash flow and accrual component is equal To solve this constraint, I repeat the test of Sloan (1996) by splitting current earnings into two components : cash flow and accruals Hypothesis H1 predicts that coefficient of accruals is smaller than the coefficient of cash flow

Earnings t+1 = γ0 + γ1Accrualst + γ2Cash flow t+ εt+1 ( 2)

Ho: γ1 = γ2

Figure 3.4 Steps of Estimation Procedures for Hypothesis 1

researcher use model of Mishkin in which security prices is identical to the objective expectation of earnings based on past information

When applied to earnings, the rational expectations hypothesis will be:

E(earningst+1- earningst+1|ϕt) = 0 (3) Where :

ϕt: the information available at t,

earningst+1 : earnings for the period t+1

E(earningst+1|ϕt): the objective expectation of earningst+1conditional on ϕt for the period t+1

Assuming market efficiency:

(rt+1 – rt+1|ϕt) = β(Xt+1 - Xet+1) + νt+1 (4) Where :

εt+1 : a disturbance with the property that E(rt+1 – rt+1|ϕt) = 0

Xet+1: the rational forecast of Xt+1 at time t

β : a valuation multiplier

In context of my study, X is earnings and β is the earnings response coefficient From equation (1), equation (3) and equation (4), the efficient-markets condition is presented as equation (5):

Earnings t+1 = α0 + α1 Earnings t + εt+1 ( 1)

(rt+1 – rt+1|ϕt) = β(Earnings t+1 - α0 - α1 Earnings t) + νt+1 (5)

The expected return, r, is computed following the procedure I re-write equation (5) as:

Abnormal return t+1 = β1 (Earningst+1 - α0 + α1

*

Earnings t) + νt+1 (6) When earnings are broken down into cash flow (CF) and accruals (ACC), the forecasting and pricing equations become:

Earnings t+1 = γ0 + γ1Accrualst + γ2Cash flow t+ εt+1 ( 2)

Abnormal return t+1 = β2(Earnings t+1 - γ0 - γ1

* If the investors do not discriminate the different contribution of cash flow and accrual components, this means the two coefficients are equal γ1* = γ2

*

Test of market efficiency Ho: γ1 = γ1

* ; γ2 = γ2

* ;