Disaggregating the Rate of Return on Common Shareholders' Equity: A New Approach

Several textbooks have suggested a disaggregation of the rate of return on common shareholders' equity (ROCE) into profit margin, asset turnover, and capital structure leverage ratio components. This disaggregation purportedly shows the enhanced return to common shareholders from using debt in the capital structure. The method mixes operations and investment decisions with financing decisions. A proposed alternative disaggregation of ROCE separates more clearly the effects of operations and investment decisions and financing decisions. The problem commonly encountered of mixing financing costs with operating costs is solved by assigning the financing cost to a separate component of ROCE: the common's share of operating earnings (CSOE) ratio. CSOE correlates positively with return on assets (ROA) and negatively to capital structure leverage. An empirical analysis reveals that most of the year-to-year variability in ROCE relates to changes in ROA and not to either CSOE or capital structure leverage.