Disaggregating Return on Common Equity (ROCE) into operating and financing components
provides significant advantages for financial statement analysis and equity valuation.
First, it distinguishes the business performance (operations) from financing effects.
According to Modigliani and Miller (1958), value is created through business operations, while
financing activities generally have a net present value of zero. Financial assets and liabilities are
typically measured close to market value, meaning they are expected to generate little to no
residual income. In contrast, net operating assets (NOA) are often carried at book values that
differ from market values, implying that abnormal value returns in excess of the cost of capital
largely originate from operations (Penman, 2013).
Second, this decomposition helps in understanding the drivers of profitability and improving
diagnostic power for decision-making. Algebraically, ROCE can be separated into Return on
Net Operating Assets (RNOA) and the financial leverage effect (FLEV × SPREAD). RNOA
captures profitability from core operations, while the leverage effect represents the incremental
gains or losses from financing decisions (Nissim & Penman, 2001). This distinction enables
analysts to evaluate whether a company’s profitability stems from operational efficiency or
financial structuring.
Third, disaggregation simplifies forecasting and valuation. If financial assets and liabilities are
measured at fair value, valuation can focus on forecasting residual operating income (ReOI)
while excluding financing effects. This reduces complexity in forecasting tasks and aligns with
the assumption that financing activities do not generate long-term residual income (Penman,
2013).
Fourth, the operating-financing breakdown provides useful information for investors and
analysts. Empirical evidence shows that operating profitability has a stronger association with
stock returns than financing profitability (Nissim & Penman, 2001; Soliman, 2008). This
supports proposals by the Financial Accounting Standards Board (FASB) to classify financial
statement items into operating and financing categories, thereby enhancing transparency.
Fifth, disaggregation clarifies the relationship between cost of capital and risk. By separating
operating and financial risks, analysts can better estimate the cost of capital for operations (ρF or
WACC) and equity (ρE). Since equity risk combines both operational and financial risk, this
separation provides a clearer understanding of the sources of risk exposure (Penman, 2013).
Finally, operating and financing components exhibit different sustainability characteristics.
Operating profitability is generally more persistent and reliable than gains arising from leverage,
which are sensitive to changes in financing conditions (Nissim & Penman, 2001). This
distinction allows analysts to emphasize more sustainable components of earnings in valuation
and forecasting.
In summary, disaggregating ROCE into operating and financing components offers deeper
insights into the drivers of profitability, supports more accurate valuation, and enhances
investment decision-making by highlighting the quality and sustainability of earnings.
References
Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the
theory of investment. The American Economic Review, 48(3), 261–297.
Nissim, D., & Penman, S. H. (2001). Ratio analysis and equity valuation: From research
to practice. Review of Accounting Studies, 6(1), 109–154.
Penman, S. H. (2013). Financial statement analysis and security valuation (5th ed.).
McGraw-Hill.
Soliman, M. T. (2008). The use of DuPont analysis by market participants. The
Accounting Review, 83(3), 823–853.
