Financial ratios and stock prices : what determines the price of a stock?

Abstract

Inspired by the upswing in interest and active participation of the Generation Z demographic in the stock market in recent years, this dissertation seeks to answer the research question: “What determines the price of a stock?”. The purpose of this research is to uncover the relationship between a series of financial ratios and stock prices, with the aim of enabling retail investors to make more informed decisions regarding upcoming investments in publicly traded companies. By doing so, it seeks to minimise risks, and potentially maximise one's rewards. The gap in the literature relating to the determinants of stock prices further emphasises the importance of this research. Whereas the factors and determinants related to stock returns have been widely researched over time, there has been less focus towards the determinants of the price of a stock. Moreover, the existing literature seeking to analyse the determinants of stock prices commonly investigates companies that operate in Asian economies. In response to this, the dissertation extends its investigation into companies operating within a Western economy. Choosing a sample of 40 companies actively traded on the London Stock Exchange between 2016 – 2022, a panel data approach was employed, involving the analysis of five regressions combining a variety of fixed effect dimensions, namely – company, industry, monthly and annual level fixed effects. Since this sample may not be a statistically representative sample, the findings of this dissertation apply to the sample chosen and not necessarily to the broader population of companies actively traded on the London Stock Exchange. The fundamental findings were that Market Capitalisation (SIZE), Return on Assets (ROA) and Earning Per Share (EPS) are positive determinants of stock prices, whereas the variable Net Profit Margin (NPM) is slightly negatively related to the price of a stock, with a coefficient value being very close to zero. Furthermore, the variables Debt to Equity (DE) and the Current Ratio (CR) cannot be classified as explanators of stock prices. Lastly, seeing that the Enterprise Multiple (EM) had not yet been analysed in past research, this research ventured into carrying this analysis, however, the results show that the EM is not a significant determinant of stock prices. Lastly, the rise in Environmental, Social, and corporate Governance (ESG) awareness and regulation can lead to the accessibility of new data. Future research can contribute to this analysis by investigating ESG scores as potential new determinants of stock prices.