The Market Reaction to Return on Equity Components: Implications for Valuation and Financial Statement Analysis

Abstract

Kusuma Waty, Hetty (2005). The Market Reaction to Return on Equity Components: Implication for Valuation and Financial Statement Analysis. Yogyakarta: Accounting Department. International Program. Faculty of Economics. Universitas Islam Indonesia. This study examines investor reaction to return on common equity (ROE) and its components around the announcement of yearly earnings. It is an issue that the accounting literature has rarely examined, notwithstanding the importance of ratio analysis in general and the DuPont decomposition in particular. It considers the importance of each of the ROE components relative to the others and shows that the influence of each component on market reaction depends on the value of the ROE as a whole and its other components. The researcher found that net profit margin (NPM) is the dominant component, low (high) NPM yielding a negative (positive) abnormal return, regardless of the value of the other components. In addition, an increase in NPM leads to a stronger effect on market reaction when other components (ROE, ATO, and LEV) are relatively high. Further, an increase in other components (ROE. ATO, and LEV) do not lead to an increase in the abnormal return when NPM is relatively low. Overall, these results may assist financial management and financial statement users in analyzing performance and value according to firm specification as reflected by its ROE components.