The Market Reaction to ROCE Components: Implications for Valuation and Financial Statement Analysis

This study examines investors' reaction to return on common equity (ROCE) and its components around the announcement of quarterly earnings. In spite the importance of ratio analysis in general and the DuPont decomposition in particular, the accounting literature did not examine the immediate market reaction to ROCE and its components. Our study highlights the importance of each of ROCE components relative to the other components and show that the influence of each component on market reaction depends on the value of ROCE and the other components. We find that net profit margin (NPM) is the dominant component, as low (high) NPM yields negative (positive) abnormal return, regardless the value of the other components. In addition, an increase in NPM leads to stronger effect on market reaction when asset turnover (ATO) and/or financial leverage (LEV) are relatively high. Further, an increase in ATO does not lead to an increase in abnormal return when NPM and/or ROCE are relatively low. Consistent with the trade-off theory, we show that the relation between LEV and abnormal return has an inverted U-shaped form, and the market reaction to an increase in LEV is more positive when NPM is relatively high. Overall, our results may assist financial management and financial statement users in analyzing firm's performance and value according to its specification as reflected by ROCE components.