The Most Profitable S&P 500 Companies (Case Study)

A.               Describe some of the advantages and disadvantages of ROE as a measure of corporate profitability.  What is a typical level of ROE, and how does one know if the ROE reported by a given company reflects an adequate return on investment?

B.               Define the profit margin, total asset turnover, and financial leverage components of ROE.  Discuss the advantages and disadvantages of each of these potential sources of  high ROE.

C.               Based upon the findings reported in Table 11.3, discuss the relation between P/E ratios and profit margins, total asset turnover, and financial leverage.  In general, which component of ROE is the most useful indicator of the firm’s ability to sustain high profit rates in the future?

CASE STUDY SOLUTION

A.               For successful large and small firms in the United States and Canada, ROE averages roughly 10 to 15% during a typical year.  This average ROE is comprised of a typical profit margin on sales revenue of roughly 5-10%, a standard total asset turnover ratio of 1.0 times, and a common leverage ratio of roughly 2:1.  ROE is an attractive measure of firm performance because it shows the rate of profit earned on funds committed to the enterprise by its owners, the stockholders.  When ROE is at or above 15% per year, the rate of profit is generally sufficient to compensate investors for the risk involved with a typical business enterprise.  When ROE consistently falls far below 10% per year, profit rates are generally insufficient to compensate investors for the risks undertaken.  Of course, when business risk is substantially higher than average, a commensurately higher return is required.  When business risk is somewhat lower than average, a somewhat below-average profit rate is adequate.

This naturally suggests an important question: How is it possible to know if business profit rates in any given circumstance are sufficient to compensate investors for the risks undertaken?  The answer to this difficult question turns out to be rather simple: just ask current and potential shareholders and bondholders.  While it is difficult to accurately assess business risk, and the problem of accurately measuring profit rates is always vexing, shareholders and bondholders implicitly inform management of their risk/return assessment of the firm’s performance on a daily basis.  If performance is above the minimum required, the firm’s bond and stock prices will rise; if performance is below the minimum required, bond and stock prices will fall.  For privately held companies, the market’s risk/return assessment comes at infrequent intervals, such as when new bank financing is required.  If performance is above the minimum required, bank financing will be easy to obtain; if performance is below the minimum required, bank financing will be difficult or impossible to procure.  Therefore, as a practical matter, firms must consistently earn a business profit rate or ROE of at least 15% per year in order to grow and prosper.  If ROE consistently falls below this level, sources of financing tend to dry up and the firm withers and dies.  If ROE consistently exceeds this level, new debt and equity financing is easy to obtain, and growth by new and established competitors is rapid.

Finally, while ROE may indeed be the most useful accounting indicator of business profits, other accounting data should also be used to compare profit rates across different lines of business, companies, and industries.  In particular, investors must be cautious in evaluating companies that report lofty ROE, but only moderate profit margins and low ROA.

B.               When profit margins are high, robust demand or stringent cost controls, or both, allow the firm to earn a significant profit contribution.  Holding capital requirements constant, the firm’s profit margin is a useful indicator of managerial efficiency in responding to rapidly growing demand and/or effective measures of cost containment.  However, rich profit margins do not necessarily guarantee a high rate of return on stockholders’ equity.  Despite high profit margins, firms in mining, construction, heavy equipment manufacturing, cable TV, and motion picture production often earn only modest rates of return on equity because significant capital expenditures are required before meaningful sales revenues can be generated.  Thus, it is vitally important to consider the magnitude of capital requirements when interpreting the size of profit margins for a firm or an industry.

Total asset turnover is sales revenue divided by the book value of total assets.  When total asset turnover is high, the firm makes its investments work hard in the sense of generating a large amount of sales volume.  Grocery and apparel retailing are good examples of industries where high rates of total asset turnover can allow efficient firms to earn attractive rates of return on stockholders’ equity despite modest profit margins.

Leverage is often defined as the ratio of the book value of total assets divided by stockholders’ equity.  It reflects the extent to which debt and preferred stock are used in addition to common stock financing.  Leverage is used to amplify firm profit rates over the business cycle.  During economic booms, leverage can dramatically increase the firm’s profit rate; during recessions and other economic contractions, leverage can just as dramatically decrease realized rates of return, if not lead to losses.  Despite ordinary profit margins and modest rates of total asset turnover, ROE in the automobile, financial services and telecommunications industries can sometimes benefit through use of a risky financial strategy that employs significant leverage.  However, it is worth remembering that a risky financial structure can lead to awe-inspiring profit rates during economic expansions, such as that experienced during the mid-1990s, but it can also lead to huge losses during economic contractions or recessions, such as that experienced during 2003.  In the financial services sector, high rates of financial leverage can boost profits during periods of declining interest rates, but cause extreme financial distress during period of rapidly fluctuating interest rates.

C.               Using a simple ordinary least squares regression approach to investigating the P/E-profit ability relation, there is no simple and obvious positive effect of ROE on P/E ratios.  These results are perhaps surprising because it is commonly perceived that ROE is the most attractive accounting measure of the firm’s wise use of operating and financial leverage.  Perhaps the distortions to ROE numbers caused by significant corporate restructuring in recent years have reduced the utility of those numbers for investors.

A high degree of correlation between P/E ratios and profit margins is clearly evident for this sample of consistently profitable corporate giants found within the S&P 500.  The statistically-significant slope coefficient in the simple P/E = f (profit margin) relation suggests that investors more highly capitalize reported earnings for high profit margin firms.  Neither total asset turnover nor financial leverage has a similarly consistent and positive effect on P/E ratios.  Similarly, profit margins are the only component of ROE with a statistically significant effect on P/E ratios in a multiple regression model approach.  Apparently, investors tend to rely upon high profit margins as useful indicators of the firm’s ability to sustain above-average profits in the future.