The Market Reaction to ROCE and ROCE Components

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.