The Market Reaction to Roce and Roce Components

53 Pages Posted: 3 Feb 2005

See all articles by Eli Amir

Eli Amir

Tel Aviv University

Itay Kama

University of Michigan, Stephen M. Ross School of Business

Date Written: November 2005

Abstract

This study examines investor reaction to return on common equity (ROCE) and its components around the announcement of quarterly earnings. It is an issue that the accounting literature has not examined, notwithstanding the importance of ratio analysis in general and the DuPont decomposition in particular. We consider the importance of each of the ROCE components relative to the others and show, using portfolio formation, that the influence of each component on size-adjusted returns depends on the level of ROCE as a whole and the level of the other components. We find that a higher level of NPM leads to a more positive market reaction than that for asset turnover (ATO) or financial leverage (LEV). Also, high (low) NPM yields positive (negative) size-adjusted returns, regardless of the level of the other components. Further, an increase in ATO does not lead to an increase in size-adjusted returns when NPM or ROCE are low (and negative), as improved efficiency may exacerbate shareholder losses. Consistent with trade-off theory between tax savings and costs of financial distress, we find that the relation between LEV and size-adjusted returns is an inverted-U shape, and the market reaction to an increase in LEV is more positive when NPM is relatively high. Using regression analysis, we show that unexpected NPM is significant in explaining size-adjusted returns around earnings announcements incrementally to unexpected earnings and unexpected revenues surprises. Using a 50-day window around quarterly earnings announcements, we show that ROCE and its components explain size-adjusted returns incrementally to earnings and revenues surprises. Our results are important to financial statement users who use traditional ratio decomposition.

Keywords: Return on Equity, DuPont Decomposition, Market Reaction, Ratio Analysis

JEL Classification: M41, G12, G14, G32

Suggested Citation

Amir, Eli and Kama, Itay, The Market Reaction to Roce and Roce Components (November 2005). Available at SSRN: https://ssrn.com/abstract=623161 or http://dx.doi.org/10.2139/ssrn.623161

Eli Amir

Tel Aviv University ( email )

312 Recanati Bldg.
69978 Tel Aviv
Israel
+972 3 640-8510 (Phone)
+972 3 640-7738 (Fax)

Itay Kama (Contact Author)

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States
734-763-4538 (Phone)

Register to save articles to
your library

Register

Paper statistics

Downloads
1,111
Abstract Views
5,501
rank
18,491
PlumX Metrics