© 2000 John Petroff

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5)- Return on equity and size of firms

Now we look at profitability on the basis of return on equity. Table T-13.18 presents the median values of return on equity in eight US sectors arranged by size of sales in 1999. The data is based on statistics in Robert Morris Associates "Annual Statement Studies 1999-2000".

When industry profitability is assessed with return on equity, conclusions change substantially from what was observed about profitability on the basis of net profit margin in the previous section. For the middle group of construction, wholesale and retail, where size did not matter on the basis of net profit margin, on the basis of ROE small and large firms outperform mid-size firms. The difference in profitability between large and mid-size firms is as much as 50% (i.e. (24-16)/16) for retail and 47% (i.e. (22-15)/15) for wholesale, but less for construction with 22% (i.e. (22-18)/18). (Note that comparison with the group of smallest firms is conclusive because one must suspect a upward bias in the smaller firms profitability caused by the exclusion of firms with negative net worth which are much more numerous among small firms than large firm. Naturally, a negative net worth makes the ROE ratio meaningless.)

In the group with observed probable diseconomies of scale on the basis of net profit margin analysis, only the service sector confirms this on the basis of ROE in table T-13.18 for the very small firms. (The conclusion must be once again mitigated by the suspected upward bias in ROE statistic for smaller firms. But the diseconomies of scale were already suggested by the net profit margin analysis which is not subject to upward bias for smaller firm.) For utilities, ROE of larger firms is much larger than that of small firms: 100% larger. This is explained by the larger proportion of equity used by small firms, as shown in Table T-11.15, Proportion of equity by company size in eight US sectors in 1999, (presumably because smaller utilities do not have access to a low cost bond market). For transportation, Table T-13.18 shows that ROE of larger firms is somewhat larger than that of smaller firms, but by a very small margin; yet the possibility of diseconomies of scale is not supported.

When manufacturing and information are analyzed on the basis of ROE in table T-13.18, rather than PBT/Sales as in Table T-13.12, Net Profit Margin % averages in eight US sectors by size of sales in 1999, the image appears to be very different than that of a large benefit from economies of scale. In the manufacturing sector, smaller firms outperformed large firms in 1999. The reversal is attributable to the smaller capital of smaller firms: as shown in Table T-11.15 for small firms in manufacturing, funding with equity amounts to only 10%, whereas it is four times that much, 41%, for large firms. The same is applicable for the information sector where funding of small firms is also around 10% but more than twice that much, 26%, for large firms. Consequently the difference in ROE between the second size group (i.e. 3-5 millions) and the last group (i.e. >25 millions) is only 20% in Table T-13.12, compared to 100% above. (This observation must however be mitigated by the exclusion of firms with negative net worth in table T-13.18.)

See review question Q-13D5.1.

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