Profitability Effects of Firm Size for DJIA Companies (Case Study)
A. Based on the findings reported in Table 10.2, discuss the relation between firm size and profitability, and the link, if any, between firm size and profit rates. In general, does a large firm size increase profitability?
B. Using a spreadsheet, sort the DJIA according to profit rates and firm size. Use firm-specific information found on company websites or invest
ment portals, like Yahoo! Finance or MSN Money, to
explain the superior profitability of these corporate giants.
C. What other important factors might be included in a more detailed study of the determinants of corporate profitability?
CASE STUDY SOLUTION
A. Using a simple ordinary least squares regression approach to investigating the firm size-profit rate relation, there is no apparent profit advantage to large firm size. These results are perhaps surprising because it is commonly perceived that larger firms enjoy revenue and cost advantages when compared with smaller companies. Perhaps long-held notions of large firm advantages are no longer relevant in the globally competitive twenty-first century.
A high degree of correlation between profitability and firm size is clearly evident for corporate giants found within the DJIA. The statistically-significant size coefficient in the profit = f (sales) relation suggests the unsurprising fact that profits rise with sales revenue. Similarly, a statistically-significant size coefficient in the profit = f (net worth) relation confirms that profits rise with the amount of capital invested in the firm,
the book value of stockholders’ equity.
It is important to recognize that such relations do not mean that large firms have a competitive advantage
stemming from their large firm size.
These linkages mean only that
big firms make big profits.
There is no high degree of correlation between profit rates and firm size for corporate giants found within the DJIA. The lack of a statistically-significant size coefficient in the profit margin (MGN) = f (sales) relation suggests that profit margins do not rise with sales revenue. Similarly, the lack of a statistically-significant size coefficient in the return on equity (ROE) = f (stockholders= equity) relation confirms that profit rates are not systematically related to the amount of capital invested in the firm. Big firms make big profits, but there is no evidence here that big firms make big profit rates.
B. Profits and profit rates vary on a year-by-year basis for the corporate giants found within the DJIA. Wal-Mart, Exxon, and GM are commonly found among the very largest corporate giants when size is
using sales. Notice that Wal-Mart’s
enviable rate of return on stockholder’s equity is despite very low-profit
margins and low markups over cost. It
has beco me popular recently to
criticize this retailing giant, but the fact remains that millions of loyal
shoppers crave the wide selection and low prices featured in clean and
convenient Wal-Mart stores. Despite its
huge size, integrated oil industry giant Exxon finds that its profit rates ride
up and down with the price of oil, and OPEC, not Exxon, sets oil prices. Over the last 50 years, investors in Exxon
have failed to keep up with the market averages. Still, the profit rates earned by Exxon
compare favorably with those recorded by GM, another favorite target of
corporate activists. Plain and simple,
GM has not produced an enviable rate of return for decades.
Among the DJIA companies with the highest profit rates, a handful stands out year after year. Merck is known for producing effective and innovative drug therapies. Proctor & Gamble continues to write the book on how to develop and promote valuable consu
while Coca-Cola sets the standard for global marketing of beverage
products. Firms with the highest profit
rates tend to have records of outstanding custo mer
service and product develop ment.
C. A number of other important factors might be considered in a more detailed study of the determinants of profitability for corporate giants. For example, rapid firm growth can be expected to give rise to profitability over ti
me. Similarly, both advertising and research and
develop ment (R&D) expenditures
are made on the premise that such spending gives rise to current and future
profits. Each of these variables can be
expected to increase profitability.
Profitability also varies widely from one industry to another, so
controlling for the number and size distribution of competitors, barriers to
entry, economies of scale and other such factors is likely to be
worthwhile. Likewise, it is worth
considering the effects of effective tax rates, environ mental
and other regulations, and so on.