Comparing Different Industries Through Return on Equity

Introduction

Return on Equity (ROE) is a key financial metric used to measure a company's profitability in comparison to the amount invested in the business. It is a type of return-based ratio calculated by taking a business’s net income and dividing it by the average shareholders’ equity during the same year. The higher the return on equity, the more efficient and profitable a company or industry has been with the use of invested funds.

This post will compare different industries through return on equity, focusing on four major sectors: retail, technology, consumer discretionary and consumer staples. These industries have experienced rapid job growth and remained strong during the last decade and will be used to illustrate the dynamics of ROE.

Difference in Return on Equity

When considering the return on equity (ROE) of different industries, it is necessary to understand the underlying nature of these industries and their respective components in order to make an informed evaluation. The three industries we will look at are the technology industry, the automotive industry, and the food industry.

Technology Industry

As expected, the technology industry is one of the highest performing industries in terms of ROE. Technology companies tend to have relatively low levels of fixed assets and leverage due to the tendency for their products having much shorter life cycles than other industries. This results in the increased return on asset investment with equipment and research costs not need to be invested again and again into replacements. Additionally, these companies also reap the benefits of digital environment, allowing them to remain profitable while also having comparably lower overhead costs.

Automotive Industry

The automotive industry is characterized by high fixed asset investments due to the intrinsic nature of the products. Automobiles are often automobiles are long-term assets which require the investments in research and development, engineering labor, and materials which makes the investment in equipment very high. As a result, ROE for this industry is generally lower than the technology industry due to the much longer time frames for assets to be turned around and generate profits.

Food Industry

The food industry is often considered the lowest performing industry in terms of ROE. This is mainly driven by the low profits generated by the industry due the highly competitive nature of the markets and the falling margins on finished products making research and development investments virtually non-existent. The presence of private labels further worsens the process as a result of their non-existent brand loyalty and reduced margins.

Historical Performance of Different Industries

The historical performance of different industries is an important factor to consider when comparing return on equity. Factors like profitability and the strength of industries can influence ROE and should not be overlooked when making investment decisions. With this in mind, it is important to understand how different industries have performed historically and what this can tell us about how these industries are likely to perform in the future.

Profitability Over Time

Profitability plays an important role in the return on equity of an industry, as companies that are generating a high level of profits will typically have higher ROE than companies in industries with lower profits. By analyzing the historical performance of different industries, investors can gain a better understanding of the trends in profitability and how they might have impacted ROE in the past. For example, industries that have seen steady growth in profits over time may have seen a corresponding increase in ROE, while industries that have seen profits decline may have seen a decrease in ROE.

Relationship Between Industry Strength and Return on Equity

The strength of an industry can also have a significant impact on ROE. Industries that are in a position for growth and are in a state of expansion typically have higher returns on equity than those that are declining or in a state of contraction. By looking at historical performance of different industries, investors can get a better understanding of the relationship between industry strength and ROE and make more informed decisions regarding investments.

For example, industries that have seen strong performance recently due to rising demand may have high levels of ROE, while industries that have seen a decrease in demand and are contracting may have lower ROE. Additionally, industries that are deemed to have growth potential may have higher ROE than those that are deemed to have limited growth potential. Keeping up to date with industry trends and performance is an important part of making successful investment decisions.

Risk Consideration

The rate at which different industries produce returns depends on the amount of risk involved in the investment. Intuitively, higher risk leads to higher returns, but a great deal of uncertainty also means a greater possibility for loss. Therefore, a savvy investor must balance risk and return when making decisions.

Changes to the Economy that Could Cause Volatility

The economy is continuously changing, and the success of certain industries is highly dependent on internal and external factors. A recession, regulatory changes, technological advances, and resource shortages can all drastically affect the ROE of various companies and entire industries. For this reason, risk management is a key factor when comparing returns.

Systematic Risk of Different Industries

Different industries face vastly different levels of risk. Unfortunately, evaluating the risk of an industry or an individual company requires comprehensive research and deep knowledge of a variety of factors. Higher risk industries such as natural resources, commodities, and specialized technology carry more potential for both gain and failure as opposed to utilities and consumer staples, which generally have lower volatility in the long-term.

• Natural Resources – Carry high potential risk and return
• Commodities – Market changes can lead to huge rewards or losses
• Specialized Technology – Can lead to groundbreaking technological advances, or complete failure with nearly no returns
• Utilities – Generally consistent, modest returns
• Consumer Staples – Relatively consistent, low-risk returns

Projected Return on Equity

Projecting a company's potentially level of return on equity (ROE) is a detailed process of forecasting, which takes into account historical financial data, industry research, economic trends, and more. It is important to note that ROE forecasts are only an estimated outcome, as there are numerous factors that can influence the actual results.

Predictions Based on Historical Data

When predicting the potential for ROE, one can analyze historical financials, comparing the past results of one industry with another. By assessing five to ten years' worth of financials, a deeper understanding of each company and sector can be achieved. Analyzing the financials of companies in different industries can be a way to understand the primary differentiation between each sector in terms of their respective ROE.

Opinion Pieces

In addition to analysing historical financial data, it is useful to take into account the opinions of industry professionals. Thought pieces from experts can provide insight into potential ROE for different industries. As these pieces are often informed with data-driven research, it can be beneficial to gauge their opinion on the matter, though it should be taken with a grain of salt as the data is not guaranteed to be accurate.

By combining both historical data and expert opinion pieces, there is a greater potential to accurately project the ROE for each industry. Ultimately, ROE is an important figure for any business, and it is essential to take a multifaceted approach to predicting it.

Analysis of Factors Contributing to Variation

Understanding why there is a variance in the return on equity between industries is paramount to successful investing. There are three major factors that contribute to this condensation. Access to financing, industrial position, and tax considerations are all influential components of the return on equity.

Access to Financing

The level of access to financing has an immense influence on the return of equity. A business that is able to accurately and efficiently access capital from financiers will be able to utilize this money to enhance their return on equity. For example, if an industry has high access to debt financing, then a company can take out loans in order to finance its operations, resulting in higher returns since the principle does not need to be paid back if the investment is successful.

Industry Position

The economic position of the industry in which a company is competing affects the return on equity. For instance, if other companies in the same industry have a higher level of profits, then firms in the same sector are likely to have higher returns on equity as well. Furthermore, if the industry is facing a decline, then the rate of return may diminish.

Tax Considerations

The tax implications of operating in a certain industry can also have an effect on the returns. If the sector is subject to favorable tax regulations, then businesses can benefit from the lower rate of taxation and may enjoy higher ROE. Conversely, if the sector is subject to high tax rates, then the return on equity may be negatively impacted.

Considering the various factors that influence the return on equity of firms in different industries is essential for any investor. Access to financing, industry position, and tax considerations are three of the most influential contributors to the variability of ROE across different sectors.

Conclusion

Return on equity (ROE) is an important metric for investors attempting to compare different industries as it offers insight into how effectively a company is using equity and how efficiently it is growing. By determining the average ROE of a particular industry, investors can determine how well the industry performs in comparison with others.

Summary of Key Takeaways

• The return on equity metric is one of the most important measures of profitability and indicates how effectively a company is using its equity.
• The industry average for ROE can vary heavily, but typically ranges from 10-25%.
• ROE can help investors compare companies within the same industry and determine which have the most potential for growth and profits.
• ROE should always be considered along with other metrics in order to get a holistic view of the industry's performance.

Summary of Differences in Return on Equity of Different Industries

As seen from the comparison above, different industries have widely varying ROE averages. Technology companies tend to have the highest ROE, while banking and retail companies typically have the lowest. Pharmaceutical companies tend to fall somewhere in the middle. It is important to keep in mind that ROE alone is not a perfect measure of performance as other factors must be taken into account in order to accurately make comparisons.