Theplusesand minusesofthis approacharevisiblein the
table.Theapproachmuchmoreaccuratelycapturesthetrue
reinvestmentinthefirmbyfocusingnotonwhatwasretained
butonwhatwasreinvested.Thelimitationoftheapproachis
that the ingredients that go into the reinvestment—capital
expenditures, working capital change, and net debt
issued—are all volatile numbers. It is usually much more
realistictolookattheaveragereinvestmentrateoverthreeor
five years, rather thanjust thecurrent year. We returnto
examinethisquestioninmoredepthwhenwelookatgrowth
in operating income.
Determinants of Return on Equity
Both earnings per share and net income growth are
determined,in part,by thereturnonequityof afirm.The
returnonequityisaffectedbytheleveragedecisionsofthe
firm.Inthebroadestterms,increasingleveragewillleadtoa
higherreturnonequityifthepre-interest,after-taxreturnon
capital(ROC)exceedstheafter-taxinterestratepaidondebt.
This is captured in thefollowingformulation ofreturn on
equity:
The derivation is simple.