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Wednesday, November 8, 2017
5 Healthcare Verticals Among Top Industries For Return On Equity
These Types Of Businesses Have The Highest Returns
A friend recently described how his teenage son who mows lawns to earn cash around the neighborhood had decided against adding leaf raking to his services. The young man had figured out that mowing a lawn was a more straightforward and predictable way for a solo operation to generate a few bucks than is raking, gathering and disposing of leaves that may or may not still be falling as he raked.
Anyone investing in a business follows that same process. Evaluating the return or the reward for the effort, time or cash involved is important to determine whether you are making a “good” investment. As my friend’s son quickly understood, some tasks or industries generate better returns than others do.
Sageworks, a financial information company, recently conducted a financial statement analysis of privately held companies to determine which U.S. industries have generated the highest return on equity (ROE) over the last 12 months. Service businesses such as those offered by lawyers, dentists, accountants, physicians and employment services firms, were among industries that topped the list. Auto repair, advertising and public relations firms, home health care and food trucks/carts also ranked among the 15 industries with the highest ROE.
Sageworks - Industries with highest returns on equity (privately held firms)
ROE helps owners and potential investors see how efficiently a company is generating profits from the owners’ equity, and it helps shed light on the business’s ability to continue growing without the need for additional outside debt or equity investment. It is reportedly Warren Buffet’s favorite metric. It helps gauge, as The Motley Fool says, “whether a company is an asset creator or cash consumer.” If ROE is 59 percent, as the average is for automotive repair and maintenance firms in Sageworks’ database, it means these firms on average create 59 cents of assets for every dollar invested.
It’s a fairly easy calculation – annualized net income divided by total equity, which is the difference between assets and liabilities. And reviewing a single firm’s ROE against the industry average can help evaluate performance against peers.
However, average ROE for some industries is higher than for others, for various reasons, and this can be good information to know before investing in, loaning to or starting a new business. For example, an industry or company that borrows a lot of money will have proportionately less equity (the number in the denominator) because of the greater liabilities. High ROE can be driven by low equity, strong net income, or a combination of both factors.
“ROE is different from profitability, but it's definitely related, which is why many on this list also achieve top spots in our profitability report,” said Sageworks analyst Libby Bierman. “Because of their high profit margins and barriers to entry, there are several professional industries -- where certifications and advanced degrees are necessary - that make this list.
For example, the long-term operating costs for a law firm may be low and allow firm owners to make a greater return than other industries, but at some point, that owner likely had to pay a large law-school bill.”
The same probably applies to dentists, other health practitioners (a category that includes optometrists, physical/occupational/speech therapists and chiropractors), physicians and accountants – all of which rank among the highest industry ROEs. One industry that stood out slightly from others on the list was Special Food Services, NAICS 7723. “This industry can include firms like food trucks so it's interesting to see them ranking well for ROE compared to other restaurants,” Bierman said. “That may be a sign that, for firms like food trucks, entrepreneurs can make a return with relatively low investment.”
Private-company ROEs calculated by Sageworks also include some notable differences from returns for publicly traded companies. The average ROE for the last 12 months for companies in Sageworks’ database is 38 percent, while NYU finance professor Aswath Damodaran’s study of 7,330 publicly traded companies in 2017 found the average ROE was 10.4 percent.
“Sageworks looks at pre-tax rather than after-tax net profit when calculating ROE because we think it gives a more accurate reading of private companies’ operational performance," said Bierman. "It’s how we avoid comparing apples to oranges in a database of companies from different states with different tax structures or with different tax-management practices.”
The private-company analysis also includes in net profit the owner compensation that is in excess of market-rate salaries, another adjustment aimed at providing a more accurate picture of the companies’ operational performance. As a result, Bierman says, “It’s possible that our ROE numbers are slightly higher than other industry averages available or even public-company standards. It is fair to look at directional trends in this data and benchmark it to measure change over time, but it would be important to make sure any comparisons include similarly adjusted net profit.”