This discussion has 2 parts:
- You are working as a financial analyst at a brokerage firm and a colleague says to you “the Potts Corporation had a return on equity (ROE) of 20% last year. We should recommend the stock to our clients.” How would you respond to your colleague? (Note: Your response for this question should be no more than 100 words)
- A corporation’s earnings and associated ratios, such as earnings per share, are metrics that investors and other stakeholders use when making decisions. The SEC recently began investigating corporations for manipulating earnings via rounding errors. In the early 2000s, it became clear that corporation’s rarely missed earnings estimates provided by financial analysts. Offer your opinion on the ethics underlying these practices, any possible broader implications of such behavior, and any real-life experiences you may have come across that are similar.
- See Assigned Readings “Related to agency theory and the goal of financial management”
- Your initial post for each question should be approximately 100 to 200 words (unless the discussion question specifically provides a different guideline), formatted and cited in current APA style with at least one source other than the required textbook. Your initial posts are worth 8 points each.
- You should respond to two of your peers by extending, refuting/correcting, or adding additional nuance to their posts. Your reply posts are worth 2 points (1 point per response.)
4 Posts by classmates are:
Note1: Response to Colleague
As one of the brokerage firm’s financial analysts, I would respond to my colleagues by pointing out that higher ROE is considered positive for a firm, but there should be a close Examination when it increases. For instance, if the value of an item decreases more than the net income, the ROE will increase though this is not positive for a firm. The firm can respond by issuing a debt to repurchase equity, which reduces the item value of equity and increases the ROE ( Steger, 2017). However, it also increases the risk of the firms’ shares because of financial leverage.
Note 2: Opinion on Corporation’s practices
According to SEC, companies are allowed to round up the earnings of the estimates to the next whole numbers if the digit following the decimal is five and above. The figures less than four have to be reported in the lowest integers. The regulators, therefore, probed whether companies have been unlawfully rounding up the earnings. The agency theory is concerned with different stakeholders that have different ideas which do not match the company’s growth. The managers of various companies are trying to gain personal wealth by projecting the companies in a better way to increase market values.
The investment managers are also continually looking for institutional investors to increase their bonuses at the end of each year. A higher dividend per share translates to a confident forecast in a company’s future cash flow. Unfortunately, this idea will not last, and the investors will be forced to offload shares first which will lead to an intense reaction because of unrealistic expectations. All the works against financial management goals, which is to increase a company’s profit and market share, make the practices unethical (Tae-Il Yoon & Hae-Young Byun, 2015). In case the investors are unable to trust the financial reports of various companies, there is a high probability that they will move money to safer instruments. This, in turn, affects the company when it tries to raise revenues for expansion and therefore affects the economy as a whole.
Steger, D. (2017). The Returns of Private Equity Funds: A Swiss Perspective. The Journal Of Private Equity. https://doi.org/10.3905/jpe.2017.2017.1.059
Tae-Il Yoon, & Hae-Young Byun. (2015). Investor Relations, Corporate Governance Practices and Firm Value. The Journal Of International Trade & Commerce, 11(3), 107-127. https://doi.org/10.16980/jitc.11.3.201506.107
- As a financial analyst, I would respond to my colleague by saying that the ROE of 20% of the Potts Corporation is good, but we need to gather more information. I would also clarify to my colleague that if the book value is decreasing more rapidly than net income, ROE will increase, and that is not beneficial for the firm. Also, I would say that recommending a stock based on just ROE would not be such a suitable method, and even if this is done, the firm’s past ROE and the industry-average ROE should also be compared.
- Manipulating earnings via rounding errors is an unethical business practice. When a corporation decides to manipulate their corporate profits, they run the risk of the company failing. This action can lead to people losing jobs and a substantial impact on the economy. Companies manipulate corporate earnings to attract investors and lenders and receive large amounts of money to continue their business operations. Corporations have also been guilty of manipulating earning per share or EPS. An EPS value is crucial because it indicates the profitability of a company. Corporations know this and sometimes engage in unethical behavior to manipulate their share value. In turn, this behavior causes investors and people who trade in the stock market to invest in the company and eventually end up losing their money and devoted time. In conclusion, manipulating earnings via rounding errors can have serious implications and should be closely monitored to ensure that shareholders and investors are protected.
Moyer, R.C., McGuigan, J. R., & Rao, R. (2018). Contemporary financial management (14th ed.) Mason, OH: Cengage-Southwestern.
Nievergelt, Y. (2000). Rounding errors to knock your stocks off. Mathematics Magazine, 73(1), 47.
As a financial analyst at the brokerage firm, I would ask my colleague for more information about Potts Corporation than just ROE percentage, which is good at 20%. I will say that that’s a good indicator, but as a financial analyst, we have to gather more info about the companies that we present to our customers. Also, I would analyze the numbers more in detail because some wrong reasons could make the ROE go higher. At the same time, as high debt tends to inflate the ROE, I would check if the company has lots of obligations in the future.
A company’s earnings and associated ratios, such as earnings per share, are metrics that investors and other stakeholders use when making decisions. The SEC recently began investigating corporations for manipulating earnings via rounding errors. In the 2000s, it became evident that companies rarely missed those earnings estimates from their financial analysts.
Most of the time, investors buy shares of companies that beat analyst expectations and sell shares of those that miss. Based on this, firms have a strong incentive to report strong earnings. Unfortunately, very often, companies use accounting techniques to produce financial reports that present an overly positive view of a company’s business activities and financial position.
The SEC began investigating companies that have rounded up their earnings per share to the next highest cent. I think that earnings management is not a good practice because the managers can use any forms of earning manipulations, have only their best interest in mind, and do not consider the long-term viability of a company.
How to Analyze ROE of a Company. (2015) Retrieved from: https://www.equityfriend.com/articles/117-how- (Links to an external site.)to-analyse-roe-of-a-company.html
Moyer, R. C., McGuiGan, J. R., & Rao, R. P., (2018). Contemporary financial management. Boston, USA: Cengage Learning.
As a financial analyst at a brokerage firm, I respond to that colleague by saying that a higher ROE is usually a good thing for the firm. However, it is also wise to monitor such changes. A common shortcut for investors to consider a return on equity near the long-term average of the S&P 500 (14%) as an acceptable ratio and anything less than 10% as poor (Hargrave, 2019). Occasionally a very high return on equity is good if the net income is very substantial in comparison to equity since the performance of a company is strong. But, oftentimes an awfully high return on equity is a result of a small equity account in comparison to net income, which suggests that there is a risk. A high ROE may indicate inconsistent profits, excess debt and most importantly a high ROE could be a result of negative net income and negative shareholder equity that may cause a ROE to be artificially high. A high ROE may not always be positive. In every case, very high or negative ROE levels should be seen as an indicator of something that warrants an examining.