Return on Equity (ROE) measures the return per dollar of equity investment. This is the summary to calculate of profitability from all business activities. The price to book ratio is greater than one if and only if expected Return on Equity (ROE) is greater than the cost of equity capital. That is to the level that equity calculates the amount invested by shareholders and Return on Equity (ROE) measures the profitability of that investment, firms generate value if and only if Return on Equity (ROE) is greater than the cost of equity capital. Because the cost of equity capital depends on the riskiness of the investment when analyzing profitability Return on Equity (ROE) should be interpreted in relation to equity risk.
In addition to measuring historical performance, Return on Equity (ROE) helps predict future earnings changes, especially because of its mean-reversion property. That is high Return on Equity (ROE) is on average followed by lower Return on Equity (ROE) and therefore earnings declines and low Return on Equity (ROE) is on average followed by higher Return on Equity (ROE) and earnings increases.
The mean reversion tendency of Return on Equity (ROE) is due to both economic forces and accounting effects. Competition among firms’ entry and exit of firms and diffusion of new ideas or practices drive abnormal levels of profitability to the mean. Earnings reinvestment and the infusion of new capital cause further convergence. When the profitability is unusual, reinvested earnings and new capital investments are likely to earn more normal levels of profitability compared to existing capital, driving future Return on Equity (ROE) toward the mean. This reflects the profitability of both new and existing capital. The trend of ROE (Return on Equity) to revert toward the mean is also due to transitory earnings items such as one time economic shocks, realized gains and losses mark to market gains and losses, and leverage effects. These items which often cause an abnormal level of Return on Equity (ROE) in a given year generally have smaller effects on subsequent Return on Equity (ROE) due to their transitory nature.
Return on Equity (ROE) is measured as follows:
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For low Return on Equity (ROE) mean reversion is due to real options and accounting distortions in addition to the above factors. Abandonment options and other real options allow firms to discontinue or restructure low profitability projects, reducing the duration of negative 124 profitability shocks. In contrast firms generally do not discontinue or restructure successful projects. Accounting distortions inducing Return on Equity (ROE) reversion include the impact of conservatism and big bath charges. It is accounting convention which requires an immediate recognition of losses but delayed recognition of profits; losses are often recognized when anticipated while profits are recognized when earned. Big bath charges are often recognized by managers in periods of particularly low performance or following management change to facilitate the reporting of higher earnings in future periods. These items cause mean reversion in Return on Equity (ROE) because they result in transitory declines in earnings followed by subsequent earnings increases. For instance an insurer may overstate a restructuring reserve and later release it into earnings or it may write down DAC to lower future amortization. Moreover the reduction in equity the denominator used in future Return on Equity (ROE) calculations further contributes to the subsequent increase in Return on Equity (ROE). Consistent with these arguments mean reversion is empirically stronger for low Return on Equity (ROE) compared to high Return on Equity (ROE).
Although Return on Equity (ROE) reverts toward the mean the revision is protracted and incomplete with cross sectional differences in profitability often persisting for many years. This is due to cross sectional differences in risk, the impact of accounting conservatism, conservative accounting principles increase steady state Return on Equity (ROE) due to the understatement of equity and persistent differences in economic profitability.
The pace of Return on Equity (ROE) mean reversion varies significantly across firms and over time. Therefore to effectively utilize the mean reversion property of Return on Equity (ROE) in predicting earnings and estimating equity value, it is important to consider factors that affect the rate of Return on Equity (ROE) mean reversion. The tendency of Return on Equity (ROE) to revert toward the mean is particularly strong under the following circumstances:
In addition to measuring historical performance, Return on Equity (ROE) helps predict future earnings changes, especially because of its mean-reversion property. That is high Return on Equity (ROE) is on average followed by lower Return on Equity (ROE) and therefore earnings declines and low Return on Equity (ROE) is on average followed by higher Return on Equity (ROE) and earnings increases.
The mean reversion tendency of Return on Equity (ROE) is due to both economic forces and accounting effects. Competition among firms’ entry and exit of firms and diffusion of new ideas or practices drive abnormal levels of profitability to the mean. Earnings reinvestment and the infusion of new capital cause further convergence. When the profitability is unusual, reinvested earnings and new capital investments are likely to earn more normal levels of profitability compared to existing capital, driving future Return on Equity (ROE) toward the mean. This reflects the profitability of both new and existing capital. The trend of ROE (Return on Equity) to revert toward the mean is also due to transitory earnings items such as one time economic shocks, realized gains and losses mark to market gains and losses, and leverage effects. These items which often cause an abnormal level of Return on Equity (ROE) in a given year generally have smaller effects on subsequent Return on Equity (ROE) due to their transitory nature.
Return on Equity (ROE) is measured as follows:
Although Return on Equity (ROE) reverts toward the mean the revision is protracted and incomplete with cross sectional differences in profitability often persisting for many years. This is due to cross sectional differences in risk, the impact of accounting conservatism, conservative accounting principles increase steady state Return on Equity (ROE) due to the understatement of equity and persistent differences in economic profitability.
The pace of Return on Equity (ROE) mean reversion varies significantly across firms and over time. Therefore to effectively utilize the mean reversion property of Return on Equity (ROE) in predicting earnings and estimating equity value, it is important to consider factors that affect the rate of Return on Equity (ROE) mean reversion. The tendency of Return on Equity (ROE) to revert toward the mean is particularly strong under the following circumstances:
- The gap between current and normal profitability is large
- The relative magnitude of transitory items is high
- The relative magnitude of reinvested earnings and new capital investments is high
- Profitability is low (mean reversion from below the mean is generally faster than reversion from above the mean)
- Return on Equity (ROE) is highly volatile which implies that abnormal levels of Return on Equity (ROE) are likely due to temporary shocks