Industry
and Sector Averages
A
firm does not operate in a vacuum. The sector
or sectors it operates in have well established
characteristics that influence both how the
firm performs and the returns it posts. In
other words, it is much more difficult for
a firm to sustain high returns in a mature
sector with lots of competition than it is
for an otherwise similar firm in a growing
sector with significant barriers to entry.
In this section, we consider differences in
returns across sectors and why they might
exist in the first place. We also look at
why firms within sectors may stand out, at
least in the short term, and what happens
to their returns over time.
Sector
Averages
Returns
on capital and equity vary widely across sectors,
with some sectors earning returns that significantly
exceed their costs of capital and others earning
less than their costs. Table 11, at the end
of this paper, summarizes the returns on capital
and equity by sector in the United States
in 2006. Figure 8 presents the distributions
of returns on capital and equity across firms
for the same period:
While
the median return on capital across all sectors
is about 12%, the best performing sectors
generate returns that significantly exceed
that number while the laggards deliver negative
returns on capital. Koller, Murrin and Wessels
(2005) note that while the median return on
capital has not changed much over the last
few decades, the differences in returns across
sectors have widened.28
There are many reasons for these differences.
a.
Life Cycle: Return differences can be traced
to where firms are in their life cycle in
the sectors, with firms early in the life
cycle and in decline reporting low returns.
Early in the life cycle, firms often have
made large investments and have little to
show in terms of earnings, leading to low
or even negative returns on capital. Later
in the life cycle, margins are compressed
while revenues level off, leading to declining
returns. Sectors with high returns tend to
have a preponderance of young firms generating
high returns, relative to capital invested,
whereas sectors with sub-standard returns
tend to either have more mature firms in declining
businesses or younger firms with heavy infrastructure
investments.
b.
Accounting Inconsistencies: As we noted earlier
in this paper, returns on capital and equity
can be affected significantly by whether accountants
classify operating, capital and financial
expenditures consistently. The high returns
on capital and equity in consumer product
companies may be as much a reflection of the
failure of accountants to deal with investments
in brand name (advertising is treated as an
operating expense, for instance) as it is
a measure of the quality of the investments.
Similarly, the high returns reported by technology
firms and pharmaceutical firms can be traced
at least partially to the treatment of R&D
expenses in conventional accounting.
c.
Barriers to Entry: If returns on capital (equity)
are measured correctly and are much higher
than costs of capital (equity) in a sector,
there must be significant barriers to entry
in that sector. Some of these barriers may
be legal (patents in the pharmaceutical business),
some may arise from regulation (financial
service firms and regulatory barriers to new
entrants) some may come from natural scarcity
(commodity and mining companies) and some
may arise from large infrastructure and investment
needs. The greater the barriers to entry into
a sector, the more likely it is that the sector
will report high returns.
Knowing
why a sector earns the returns that it does
is almost as critical as knowing what those
returns are, if we are faced with using those
sector averages in forecasts. Sector returns
that are sustained by strong barriers to entry
are more likely to be sustained than sector
returns that are created by accounting anomalies
and short term advantages.
28
Koller, T., M. Goedhart and D. Wessels, 2005,
Valuation: Measuring and Managing the Value
of Companies, John Wiley and Sons (Fourth
Edition).
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