Magazine article The CPA Journal

Financial Websites as Financial Advisors

Magazine article The CPA Journal

Financial Websites as Financial Advisors

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Comparing Returns on Equity Found on the Internet

Return on equity (ROE) provides a useful indication of how well managers are employing the funds invested by the firm's shareholders to generate returns. Recent research suggests that in the long run the value of a company's equity is determined by its ROE and its cost of equity capital. That is, companies that are expected over the long run to generate ROE in excess of the cost of equity capital should have market values in excess of book value and vice versa.

The entrance of many unsophisticated investors into the marketplace has made the assessment of a company's ROE more important. Investors from many diverse backgrounds are increasingly responsible for making investment decisions. While advocates cite the long bull market of 1982-2000 as evidence for the benefits of this shift, the three-year-old bear market has raised obvious concerns about investment decisions made by holders of contributory retirement accounts.

Financial advice has become a critical factor in the construction of a successful retirement investment portfolio by the average worker-investor. Many investment advisors have constructed financial websites that purport to offer analytical and objective advice. The Internet also offers an array of information on fundamentals, historic market trends, and financial planning. Certainly, there is no dearth of information available to the investor; information overload is more like it. The bigger concern is just how accurate and consistent this data and information actually is.

By focusing on a single measure of financial importance, such as ROE, it is possible to assess whether the Internet provides information helpful to the average investor. ROE was selected for the following reasons: It is a key managerial assessment tool often used as a basis for evaluating and rewarding management; as a primary accounting ratio, it should be reported by most financial websites; and it is relatively easy to calculate and understand, and should be of use to even novice investors.

There are two concerns that investors should be aware of when using Internet ROEs. First, the many differences in variable assumptions and variations in techniques can affect the ROE calculation. If each financial website reports an ROE calculated by different analysts, it is entirely possible that there would be as many different computations of ROE as there are websites. Such a lack of consensus would undermine the validity of financial websites in supporting the unsophisticated investor.

Second, when measuring ROE, a distinction should be made between current ROE and forecasted ROE. Financial websites typically report current ROE; thus, investors will often use this to make judgments about valuation. While it is convenient to focus on current returns, market value is determined by expectations of future returns on equity. To the extent that there is a strong correlation between current and future ROE, using current ROE to identify under- or overvalued companies is appropriate. Focusing on the current ROE when the competitive environment is in flux, however, can be misleading.

Calculating ROE

The authors examined the ROE as reported on four popular financial websites-Yahoo, Morningstar, Bloomberg, and SmartMoney-for the 30 companies in the Dow Jones Industrial Average (DJIA). The reported ROE on these websites was examined in early May 2003. No two websites reported the same ROE for the same company.

To determine the source of the differences in computed ROE, the authors obtained the three most recent annual and four most recent quarterly financial statements for several of the companies. Although the statements were obtained from three different sources (Compustat, Yahoo, and Smart-Money), no significant differences were noted.

Some of the variations we used in computing ROE are as follows:

* The treatment (inclusion or exclusion) of nonrecurring items (e. …

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