The Surprisingly High ROEs of Large Companies
Economic theory suggests that abnormally high returns on equity or ROEs cannot be sustained in the face of competition. Reality however, begs to disagree.
The ROE of the Dow Jones Industrial Average
Recent data from Dow Jones indicates that the average P/E ratio of the 30 companies in the Dow Jones Industrial Average was 16.63 as of November 30, 2013. And the Price to Book Value ratio was 3.01.
The ROE of the DOW can be calculated from the above using the following formula.
ROE =earnings/equity = price/book equity divided by price/earnings.
Therefore the DOW ROE is 3.01/16.63 = 0.181 = 18.1%.
In a world where short term interest rates are close to 0% and a 30-year US. government bond earns 3.9%, an 18.1% ROE is a staggeringly high return. And this is no anomaly, the ROE on the DOW has been at similar levels for many years. Below I will discuss some possible reasons for this high ROE.
The ROE of Selected large Companies
Here are the recent ROEs, as well as P/B and P/E data, of some (mostly) large companies:
|Canadian National Railway Company (CNR,
Toronto CNI, New York)
|Canadian Western Bank (CWB, Toronto)||13%||2.2||17.4|
|Stantec Inc. (STN, Toronto)||18%||3.7||20.2|
|Canadian Tire (CTC.a, TO)||11%||1.6||14.6|
|MELCOR DEVELOPMENTS LTD. (MRD,
|Alimentation Couche-Tard Inc., ATD.B||20%||3.9||19.3|
|FIRSTSERVICE CORPORATION (FSV,
Toronto) (FSRV, NASDAQ)
|Wal-Mart (WMT, New York)||23%||3.5||15.1|
|Microsoft (MSFT, NASDAQ)||33%||4.6||13.8|
|Berkshire Hathaway Inc. (BRKB, New
|Boston Pizza Royalties Income Fund (BPF.un,
|Costco (COST, N)||18%||4.7||25.6|
|Wells Fargo (WFC, United States)||14%||1.6||12.0|
|Toll Brothers Inc. (TOL, New York)||5%||2.0||38.4|
|RioCan Real Estate Investment Trust (REI.UN,
|Bank of America Corporation
(BAC, New York)
|Dollarama Inc. (DOL, Toronto)||27%||6.9||26.3|
|Constellation Software Inc. (CSU,
|Liquor Stores N.A. Ltd. (LIQ, Toronto)||7%||1.0||15.4|
|eBay (eBay, NASDAQ)||13%||3.2||24.1|
This table shows a few companies with low ROEs, however many of them are very high. Unfortunately the companies with high ROEs also tend to have prices that are high multiples of book value.
How do Some Companies Sustain High ROEs?
Since competition is supposed to prevent abnormally high ROEs, the usual way to sustain a high ROE is to avoid intense price-based competition.
Some companies avoid competition by producing unique products that are protected by patents or intellectual property laws.
Some companies avoid intense price-based competition simply because existing customers find it quite inconvenient to switch to another provider. This may be the case in basic banking services. cell phone service and in software.
Some companies avoid intense price-based competition through the power of brand loyalty. This includes Coke and Starbucks.
Some companies achieve a high ROE in spite of facing intense price-based competition. This can be done by being the low cost producer. This includes Costco and probably some commodity producers. Sometimes the largest company in an industry achieves economies of scale that others cannot achieve.
One possible explanation for the high ROEs of large established companies is that they have land, buildings, factories, know how and other assets that are on their “books” at a fraction of the price that new competitors would have to pay to obtain similar assets. This is certainly part of the explanation. However, it appears that large companies are also making relatively high return on equities on new investments. Consider that a company making an 18% return on equity and dividending out half of its earnings is retaining and reinvesting 9% of equity each year which will double its book equity in just eight years and quadruple its book equity in sixteen years. These large companies could not sustain high ROEs for very many years unless they were also making high ROEs on reinvested earnings.
It appears that large companies have often found ways to protect themselves from intense price-based competition and are therefore able to sustain high ROEs.
Wise investors will focus their investments on such companies.
Shawn C. Allen, CFA, CMA, MBA, P.Eng.
January 5, 2014
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