Financial Accounting: In an Economic Context

ROE EXERCISE: RETURN ON EQUITY AND VALUE CREATION

The ROE model, introduced and illustrated in Appendix 5A, provides a framework linking the management of a company's operating, investing, and financing activities to its return on the shareholders' investment (return on equity). The balance in the shareholders' equity section of the balance sheet represents the investment made by the shareholders, and it is management's responsibility to provide a return on that investment exceeding the return the shareholders could have generated if they chose to invest their funds in other equally risky investments. If this objective is achieved, management has “created value” for the shareholders. If return on equity (ROE) is 20 percent in a particular year, for example, and in that year other equally risky investment alternatives generate a return, on average, of 15 percent, management has achieved value creation.

Transactions that influence the shareholders' equity balance have a direct influence on ROE (net income ÷ average shareholders' equity) because they directly affect the denominator used in its calculation. A stock issuance, for example, increases the shareholders' investment, which immediately reduces ROE, placing pressure on management to manage the cash collected from the issuance in a way that generates a return that more than offsets the drop in ROE. Similarly, reported net income increases shareholders' equity, and if retained in the business, represents an additional investment ...