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Financial Accounting: In an Economic Context by Jamie Pratt

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DETERMINANTS OF VALUE CREATION: ANALYZING RETURN ON EQUITY

Because the comparison between ROE and the cost of equity is the indicator of shareholder value creation, analysts are very interested in changes in ROE across time for a given firm, as well as ROE comparisons across similar firms (e.g., in the same industry) as of a point in time. Changes in ROE across time for a firm indicate whether a company's value creation is improving or deteriorating; ROE comparisons across similar firms indicate which companies are creating the most value. Analysis can also include both simultaneously—that is, how does a company's value creation across time compare to that of other companies?

Analysts not only use ROE to track and compare value creation, but they are also interested in why value creation changes across time and why one company's value creation exceeds another's. What features about a company's operating, investing, and financing decisions drive changes in value creation or explain why one company creates more value than another? These features are called value drivers, and the identification and analysis of key value drivers is an important objective of financial statement analysis. Managers can use the same tools to predict and explain how their actions will lead to future value creation.

A well-known framework designed to identify value drivers, by analyzing changes in ROE across time and differences in ROE across companies, is called the DuPont (ROE) model, which is described ...

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