The Market Reaction to ROCE and ROCE Components

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The Market Reaction to ROCE and ROCE Components

• Eli Amir
• London Business School
• Itay Kama
• London Business School

February 2006
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Financial Ratios

• Perhaps the most common tool in financial
  statement analysis.
• Summarizing financial data, analyzing current
  performance and financial position and comparing
  performance and financial position across
  companies and over time.

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Financial Ratios

• Investors, lenders, rating agencies and
  regulators use them to analyze company
  performance, strategy, the probability of default
  and risks.
• Analytical auditing, imposing debt restrictions
  (covenants), comparison with industry norms and
  company budgets, and equity valuation.

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ROCE
Indicator of profitability
For the common shareholders, the profitability
of their investment is the accounting ROCE (S.H.
Penman)
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ROCE The DuPont Decomposition

• Interesting and popular because it captures the
  three main activities of a company net
  profitability, efficiency in investing and
  financing.
• The ratios identified are tied together in a
  structured way that explains how they sum up as
  building blocks of net income.
• Establishes hierarchy tradeoff between
  components.

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Notwithstanding the Importance

• Previous research has not examined immediate
  market reaction to ROCE and its components.

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Motivation

• An increase in one of the ROCE components,
  holding the other constant, leads to an increase
  in ROCE (assuming positive NI), but the market
  reaction to ROCE may depend on the source of ROCE
  the components.
• Investigating market reaction around quarterly
  earnings announcement dates is potentially useful
  in identifying ratios that are important for
  investors, used in practice and are relevant for
  valuation.

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Research Questions

• What is the role of ROCE and ROCE components in
  explaining stock returns?
• Do ROCE and ROCE components have an incremental
  effect on stock returns after controlling for
  earnings and revenues surprises?
• Is there a dominant component or does the market
  reacts to each component in a similar fashion?
• Does the market react differently to ROCE
  depending on the source of income?

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Implications

• Answering these questions will extend our
  understanding of the role financial ratios play
  in financial statement analysis.
• It may also assist internal and external
  financial statement users in analyzing firm
  performance.

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Related Literature

• Nissim and Penman (2001)
• Fairfield and Yohn (2001)
• Soliman (2004)
• Penman and Zhang (2004)
• Fairfield at al. (2005)

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Related Literature

• Nissim and Penman (2001) Identify financial
  ratios that are linked to MV (e.g. RNOA and LEV).
  Document the behavior and persistent of this
  ratios over the last three decades.

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Related Literature

• Fairfield and Yohn (2001) Decomposing the change
  in RNOA assist in forecasting change in RNOA.
• Penman and Zhang (2004) Changes in profit margin
  and asset turnover forecast stock returns only
  one year ahead, and RNOA assists in forecasting
  stock returns two years ahead.

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Related Literature

• Soliman (2004) Decomposing RNOA into NPM and ATO
  assist in predicting RNOA. Further, NPM and ATO
  revert to industry average hence, using
  industry-adjusted ratios improve the prediction
  power of ratios.
• Fairfield at al. (2005) Industry analysis have
  only marginal incremental information over
  firm-specific figures for forecasting RNOA, ROCE
  and growth in NOA. However, industry analysis
  assist in predicting future sales growth.

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Contribution

• Measuring the market reaction to key financial
  ratios around the announcement of quarterly
  earnings. Focus on the traditional DuPont model
• Examine whether this reaction is associated with
  components of ROCE and not just on unexpected
  earnings and revenues.

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Prediction 1 Market reaction is stronger for
increases in NPM than to ATO or LEV

• Changes in ATO or LEV are more likely to be
  perceived by the market as temporary.
• Changes in NPM are perceived by investors to be
  more permanent.
• NPM contains more valuable information about the
  firm cost structure and its ability to handle
  changes in demand.

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Prediction 1 Market reaction is stronger for
increases in NPM than to ATO or LEV

• The reaction to NPM is expected to be stronger
  because this ratio includes more information on
  NI.
• Financial analysts have long considered NPM as a
  critical variable that constrains the increase in
  ROCE and thus the perceived growth in expected
  dividends (Babcock 1970, Reilly 1997).

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Prediction 1 Market reaction is stronger for
increases in NPM than to ATO or LEV

• Managers usually refrain from changing resources
  in response to economic shocks that are perceived
  to be temporary (Anderson et al. 2003).
• ATO and LEV depend on the amount of resources
  invested in the production of sales.
• Changes in ATO or LEV are more likely to be
  perceived by the market as temporary.

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Prediction 1 Market reaction is stronger for
increases in NPM than to ATO or LEV

• NPM provides information about the sensitivity of
  NI to product price and cost structure changes
  (Bruns 1992).
• As NI contains a large component of variable
  cost, NPM may not change dramatically as a result
  of change in sales volume.
• Changes in NPM are perceived by investors to be
  more permanent.

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Prediction 1 Market reaction is stronger for
increases in NPM than to ATO or LEV

• NPM reflects the entire cost structure (variable
  and fix costs).
• ATO and LEV are largely affected by fixed costs.

• NPM contains more valuable information about the
  firm cost structure and its ability to handle
  changes in demand.

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Prediction 1 Market reaction is stronger for
increases in NPM than to ATO or LEV

• The market reacts more strongly to NI than to any
  other financial variable.
• The reaction to NPM is expected to be stronger
  because this ratio includes more information on
  NI.
• Financial analysts have long considered NPM as a
  critical variable that constrains the increase in
  ROCE and thus the perceived growth in expected
  dividends (Babcock 1970, Reilly 1997).

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Prediction 2 Nonlinear relation between LEV and
stock returns

• Trade-off between tax shield from borrowing and
  expected costs of financial distress.
• Other factor that might influence capital
  structure Agency cost, personal taxes,
  asymmetric information.

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Interaction between ROCE components

• 3) When NPM is relatively low an increase in ATO
  will not lead to higher stock returns.
• 4) When ATO is relatively high, market reaction
  to NPM is stronger than when it is low.
• 5) When NPM is relatively low the market reaction
  to an increase in LEV is more negative.

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Prediction 6 NPM and ATO are associated with
stock returns incrementally to earnings and
revenues surprises.

• Earnings surprise is, on average, a dominating
  factor over revenues surprise (Ertimur et al.
  2003, Jegadeesh and Livnat 2004(.
• Asset turnover capture the companys ability to
  use its assets more efficiently.

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Predictions

1. Market reaction is stronger for increases in NPM
   than to ATO or LEV.
2. Nonlinear relation between LEV and stock returns.
3. When NPM is relatively low an increase in ATO
   will not lead to higher stock returns.
4. When ATO is relatively high, market reaction to
   NPM is stronger than when it is low.
5. When NPM is relatively low the market reaction to
   an increase in LEV is more negative.
6. NPM and ATO are associated with stock returns
   incrementally to earnings and revenues surprises.

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Sample and Variables

• Sample 318,102 quarterly observations for 11,268
  different companies over the period 1972-2004.
• Variables
• SAR Size-Adjusted Returns
• LW 50 day return window (days -2 through
  47).
• SUE Standardized Unexpected Earnings
• SURG Standardized Unexpected Revenues

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Variables (cont.)
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Median Annualized ROCE and NPM over 1972-2004
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Percentage of Companies with Negative Earnings
per Share in Each Year
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Median ATO and LEV over 1972-2004
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Correlation Matrix
ROCE LEV ATO NPM
0.62 -0.15 0.03 NPM
0.11 -0.01 -0.10 ATO
-0.20 0.05 -0.27 LEV
-0.02 0.26 0.81 ROCE
The Table presents Pearson (above diagonal) and
Spearman (below diagonal) correlations
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Market Reaction to ROCE and to ROCE Components
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Mean SAR for LEV Quintiles (Raw Data)
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Interaction between NPM and ATO
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Interaction between NPM and ATO
UNPM5 UNPM1 NPM5 NPM1 NPM 5 NPM 1
3.17 3.61 0.98 -2.63 ATO 1
5.57 6.20 3.54 -2.66 ATO 5
2.56 -0.03 ATO5 ATO1
2.60 2.55 UATO5 UATO1
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Interaction between NPM and LEV
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Interaction between NPM and LEV
NPM 5 NPM 1
1.76 -2.47 LEV 1
1.91 -3.05 LEV 5
0.15 -0.58 LEV5 LEV1
-0.01 -0.43 ULEV5 ULEV1
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Market Reaction to ROCE, NPM, SUE and
SURGRegression Analysis - Short Window
Adj-R2 N SURG SUE NPM UNPM ROCE UROCE Spec.
0.05 1.36 2.59 0.66 0.09 Coeff. 1
185,382 19.14 20.26 6.03 0.72 t-stat.
0.06 1.16 2.92 6.17 81.25 Coeff. 2
185,382 16.76 34.22 1.80 11.28 t-stat.
0.06 1.28 2.66 4.26 0.66 82.80 -0.33 Coeff. 3
185,382 17.98 22.66 1.21 5.81 11.70 -2.84 t-stat.
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Market Reaction to SUE, SURG, ROCE and its
components Long Window
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Market Reaction to SUE, SURG, ROCE and its
components Long Window
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Market Reaction to SUE, SURG, ROCE and its
components Long Window
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Conclusions

• Focusing on the traditional DuPont decomposition.
• The influence of each component on market
  reaction depends on the value of the ROCE as a
  whole and its other components.
• NPM is the most dominant component. The market
  reaction to high (low) NPM is positive (negative)
  regardless of the levels of ATO or LEV.

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Conclusions (cont.)

• An increase in NPM is rewarded more strongly by
  the market when ATO and/or LEV are relatively
  high.
• An increase in ATO is not rewarded by the market
  when ROCE and/or NPM are relatively low.
• The relation between LEV and market reaction has
  an inverted U shape.
• The level of ROCE and its components explain
  stock returns in addition to earnings and
  revenues surprises.