Return on equity is the measure of profitability on the investment of the shareholders of a business. Equity is the total amount of money that the company has raised as capital from shareholders. Output growth, on the other hand, is the increase in the volume of production relative the costs of production. Forecasting of returns on equity involves predicting the likely future earnings attributable to the equity of shareholders in relation to the future growth of output. Forecasting of future profits relative to growth is generally conducted during different quarters of the year to compare and apply past performance trends to predict the likely profits by the year's end. The predicted information is also used to determine interim dividends.
Subtract the corresponding quarterly output growth of the second previous year from that of the first previous year, and that of the first previous year from that of the current year to establish a trend. For example, if you are conducting the forecast during the third quarter, then your corresponding quarterly output growth will be the second quarter results of each of the three years.
Take the total earnings of the previous year and divide it by the total shareholder's equity for that year, then multiply the result by 100 to determine the percentage returns on equity for the second previous year. Calculate the returns on equity on the first previous year using the same formula to establish and compare the trends of profitability relative to output growth in the two years.
Take the total earnings of the respective quarter of the current year and divide it by the total shareholder's equity for the year, then multiply the result by 100 to determine the percentage returns on equity for the quarter. Compare these earnings with the earnings of the corresponding quarters of the two previous years.
Subtract the percentage of the quarterly returns on equity of the second previous year from that of the first previous year, and that of the first previous year from that of the current year. Treat the difference as the percentage by which returns on equity are affected by output growth in the respective quarters.
Apply your established trends of past returns on equity relative to output growth to predict the likely levels of shareholder earnings that will be generated by output growth in the remaining quarters. Acknowledge that your forecasting calculations were based on the assumption that all factors will remain constant. This will guide the users of the information to understand that your forecasts are susceptible to change in unpredictable circumstances.
Always take note that any increases in output have direct bearing on the returns on equity. This means that any upward or downward movements in output growth will similarly translate to increases or decreases in returns on equity, respectively.
Apply the same procedure to annual financial results covering the previous years and the current years if you are forecasting several years ahead.
Do not expect that your forecasts will be the exact outcome, because the accuracy of the forecasts will be affected by unforeseen changes beyond the control of the company.
- Bradford Delong; Asset Returns and Economic Growth; Dean Baker, et al.; March 2005
- “Fundamentals of Financial Management”; Eugene F. Brigham, et al.; 2009