Merck is one of the largest pharmaceutical firms in the world, and over an extended period of time in the recent past, it consistently earned higher ROEs than the pharmaceutical industry as a whole. As a pharmaceutical analyst, what factors would you

Question

consider to be important in making projections of future ROEs for Merck? In particular, what factors would lead you to expect Merck to continue to be a superior performer in its industry, and what factors would lead you to expect Merck's future performance to revert to that of the industry as a whole?

Answer 1

Factors contributing to Merck continuing to be a high ROE performer:
• Barriers to competition. Merck can enjoy superior ROEs for long period of time if it builds high entry barriers such as patents, economies of scale arising from large investments in R&D, and a strong brand name due to advertising or past performance.
• Artifacts of accounting methods. The tendency of high ROEs may be purely an artifact of accounting methods. At Merck, major economic assets, such as the intangible value of research and development, are not recorded on the balance sheet and are therefore excluded from the denominator of ROE.
Factors causing Merck to revert to the industry mean:
• The economics of competition. Abnormally high profit attracts competition. Increased competition may lower Merck's high ROEs.
• Increase of investment base. Firms with higher ROEs expand their equity bases more quickly than others, which causes the denominator of the ROE to increase. Of course, if firms could earn returns on the new investments that match the returns on the old ones, then the level of ROE would be maintained. However, firms have difficulty pulling that off. In the face of competition, one would typically not expect a firm to continue to extend its supernormal profitability to additional, new projects year after year. It is likely that Merck's earnings growth will not keep pace with growth in its equity base, ultimately leading ROE to fall.