Estimation of future levels and changes in profitability: The effect of the relative position of the firm in its industry and the operating-financing disaggregation

a b s t r a c t In this paper we examine how the relative position of a firm’s Return on Equity (ROE) in industries affects the predictability of the next-year ROE levels, and the ROE changes from year to year. Using Nissim and Penman breakdown into operating and financing drivers, the significant role of the industry factor is established, although changes in signs suggest subtle non-linear relations in the drivers. Our study avoids problems originating from negative signs by analyzing sorts and by making new regressions with disaggregated second-order drivers by signs. This way, our results provide evidence of some different patterns in the influence of the first-level drivers of ROE (the operating factor and the financing factor), and the second-level drivers (profit margin, asset turnover, leverage and return spread) on future profitability, depending on the industry spread. The results on the role of contextual factors to improve the estimation of future profitability remain consistent for small and large firms, although adding some nuances.