Financial Accounting: In an Economic Context

ROE EXERCISE: USING THE RIGHT EARNINGS NUMBER

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). A key question addressed by analysts using the ROE model involves choosing the most appropriate earnings number. Since the ROE model is designed to explain ROE, and earnings represent the numerator of that ratio, the quality of ROE analysis can be no better than the quality of the chosen earnings number. “Bottom-line” net income, as discussed in this chapter, includes components that vary in terms of the extent to which they reflect a change in the company's wealth as well as their persistence, and consequently may not be the best choice in all cases.

While no hard-and-fast rules exist covering how to choose an appropriate earnings number, in most cases it is best to use a number that is both a reasonable measure of the wealth change experienced by the company and expected to persist in the future. Some analysts believe that after-tax operating earnings are best in this regard. Conducting several ROE analyses using several earnings numbers (including and excluding special charges like restructurings, assert impairments, gains and losses on asset sales, etc.) is often a useful practice. It can help to ascertain whether the conclusions are sensitive to the choice of the earnings number and to what extent. Finally, ...