Sustainability of ROE

ROE multiplied by the percentage of earnings retained by the company will give you an indication of the sustainable growth rate of the company. However, unless a company has a strong competitive edge and there are barriers of entry to its market, an abnormally high ROE is not sustainable over the long term. The generation of supernormal profits will attract competition and thus ROE will be driven towards a 'normal' level, that is, the cost of equity capital over time.

The second reason is that companies with higher ROEs tend to expand their investment bases more quickly than others, which causes the denominator of the ROE to increase. Of course, if they can earn returns on the new investments that match the returns on the old ones, then the level of ROE would he maintained.

However, firms generally have difficulty pulling that off. Thus, the resulting behavior of ROE and other measures of return on investment is characterized as 'mean-reverting: firms with aboveaverage or below-average rates of return tend to revert over time to a 'normal' level within no more than 10 years.

A study that tracked the ROEs of US companies from 1979 to 1998 found that the most profitable group of companies, those with average ROEs of 27 per cent, experienced a decline to 17 per cent within three years. By year 10, this group of companies had an ROE of 14 per cent.

Meanwhile, those with the lowest initial ROEs (-33 per cent) experience an increase in ROE until they reach a level of 13 in year 10. This is what the economics of competition would predict. The tendency of high ROEs to fall is a reflection of high profitability attracting competition; the tendency of low ROEs to rise reflects the mobility of capital away from unproductive ventures towards more profitable ones.

Despite the general tendencies of mean reversion, there are some firms whose ROEs may remain above or below normal levels for long periods. In some cases, the phenomenon reflects the strength of a sustainable competitive advantage, but in others, it is purely an artifact of conservative accounting methods.

Good examples of this are pharmaceutical companies in the US, whose major economic assets (the intangible value of research and development) are not recorded on the balance sheet and are, therefore, excluded from the denominator of ROE.

For those companies, one could reasonably expect high ROEs more than 20 per cent - over the long run, even in the face of strong competitive forces.