The Accounting and Economic Return on Equity

Many valuation models calculate a firm’s stock price as a function of the economic return on equity (ROE) the firm is expected to earn in the future. Ideally, a firm’s historical accounting ROE, adjusted for changing conditions, can be used as a starting point when forecasting its future economic ROE. To guide investors and analysts in this process, this article shows how to identify the direction and magnitude of the potential difference between a firm’s historical economic and accounting ROE. By doing so, this paper empowers financial statement users to distinguish between scenarios in which a firm’s accounting ROE is likely to approximate, understate, or overstate the economic ROE generated by its historical investments.