“There is a company behind every share. Find out how she’s doing. ” Peter Lynch
The legendary investor’s quote hides the key issue of effective capital investment in the stock market – when making a decision, you need to focus not on the price of a share, and not on the indicators of its growth / decline dynamics.
The main thing is a comprehensive assessment of the company’s activities. Is its profit growing steadily? How sustainable is its superiority over competitors?
The answer to these questions will help to give the coefficient ROA and a group of its varieties.
What is ROA in simple terms
ROA (Return on Assets) – the coefficient of return on assets, showing the percentage of the company’s net profit to its total assets (data on the balance sheet).
In simple words, ROA is a financial indicator of business performance, which, in fact, speaks of the effectiveness of a company using its property, including credit borrowing.
ROA calculation examples
The formula for calculating the return on assets indicator:
Profitability ratio = net income / total assets * 100
Net profit is the difference between the annual revenue and the costs of the enterprise, and the material resources belonging to it are taken into account in total assets. Assets are calculated based on the average annual value (assets at the beginning and end of the year / 2).
For example, if the net annual profit is $ 1 million, and the total assets are $ 5 million, then the return on assets of the enterprise will be: 1/5 * 100% = 20%
If it becomes necessary to calculate the return on assets for a period other than a calendar year, then:
ROA = net income * (365 / n) / average annual assets * 100
Where n is the number of days for the required time interval.
Reasonable conclusions, based on the results of calculating the ROA ratio, require the following aspects to be taken into account:
- Time interval. The coefficient does not give a predicted result in terms of the profit potential on long-term investments (for example, changes in the production cycle with the introduction of new technologies may temporarily reduce ROA), therefore, it is necessary to monitor the dynamics of growth / decline.
- Unequal Numerator and Denominator Values… Profit shows the current result, and assets have been accumulating for several years, so it is necessary to add tools for assessing the market value of an enterprise to analytics.
- Risks… A high return on assets can be achieved through an aggressive strategy on the brink of a foul, so the cost structure and leverage used should be analyzed.
Two-factor ROA model
The financial condition of the company can be analyzed by “Dupont formula», Which evaluates the main factors affecting the efficiency of doing business.
The two-factor ROA calculation model takes into account net income, average assets and revenues.
ROA = ROS * Koa, where ROS is the return on sales ratio (net profit / revenue), Koa is the asset turnover ratio (revenue / average assets).
Such a calculation gives an estimate of the value of the contribution of the sales system to the creation of profit and characterizes the intensity of the use of existing assets.
The return on assets ratio (ROA) reflects the average return on all the capital available to the company (equity and debt).
You should focus on the main difference between ROA and ROE – ROE only takes into account the part of capital owned by the company’s shareholders (calculation formula: ROE = net income / equity * 100).
Comparison of ROA and ROE indicators makes it possible to assess the efficiency of the enterprise’s use of additional financial resources – how borrowed funds affect the amount of profits, and shows the dependence of one ratio on another:
- the more credit funds in the company’s assets, the greater the difference between ROA and ROE indicators;
- with an increase in credit funds, ROA shows a decrease.
ROA and ROE values will be correct only for single-industry companies, since the value of assets and the amount of borrowed funds, in different sectors of the economy, differ significantly.
In the tech sector, the ratios are roughly equal, due to low debt liabilities of companies, which can lead to inaccurate ROE data. At the same time, comparison of ROE and ROA for different industries gives significant discrepancies, due to different capital intensity of companies.
For example,% divergence of ROE over ROA between General Motors (automotive) and Walmart (retail) highest.
What ROA can be considered normal
ROA has no strictly normalized boundaries and can take on values in a wide range, depending on the type of company. What can serve as the norm for banks, for example 1%, will be considered extremely low for companies in the trade and services sector.
As a rule, the rate of return on assets of companies in the manufacturing sector is not high. there are regular expenses for updating the material and technical base.
The average ROA for large companies in the US and UK is 15%, for the European Union – 9%, Japan – 7%. ROA by industry is close to ROE, which is between 10 and 15% for the S&P 500.
Is a high ROA always good
A high ROA does not always reflect the true state of affairs in a company. If the ROA is significantly higher than the industry norms, then this may indicate that the company is not investing in asset renewal. Lack of investment in new equipment and technologies can hinder business development and affect the long-term prospects of the company.
In general, the higher the ROA, the higher the company is listed. A high return on assets means that the company is well managed and generates more profits with minimal investment.
ROA is also important when considering the possibility of lending to a company through banks.
A negative value is interpreted unambiguously – the company is unprofitable.
Varieties of the indicator
In addition to ROA, the category of multipliers reflecting the efficiency of an enterprise includes:
- ROS (Return on Sales) – coefficient of profitability of revenue. Shows the percentage of the company’s net profit to sales. With the ROS metric, investors can estimate what% of profit is accounted for for every dollar of a company’s revenue. Calculation formula: ROS = net profit / revenue * 100 (this multiplier can be calculated on the basis of gross profit).
- ROIC (Return on Invested Capital) – ratio of return on invested capital. The indicator assesses the efficiency of the company’s use of investment investments.
Instead of net profit, the numerator contains the amount of operating profit (without deducting taxes and other mandatory deductions), and the denominator is the amount of investment capital:
ROIC = Nopat / Invested Capital * 100
Nopat = operating profit * (1- tax rate)
The coefficient is not applied when calculating investments in the sale of luxury goods and services (high start-up costs can significantly reduce ROIC, and the payback period can stretch over a long period).
Analysts believe the ROS and ROIC ratios are relevant:
- when comparing single-industry enterprises;
- when studying the history of indicators of a single enterprise.
The latter statement does not share W. Buffett: “Investors should be skeptical about historical models of markets and stocks. These models, built by various clever people who use terms that only the “insider” understand (beta, gamma, sigma, and the like) can make a big impression. However, quite often investors forget to understand the assumptions behind all these models. Beware of the formula nerds. “
For a comprehensive stock market analysis, ROA, ROE, ROS and ROIC ratios are considered together.
For example, the analytics of Microsoft’s indicators, based on the current results of various profitability ratios (ROA -6.57%, ROE -20.09%, ROIC – 8.62%) made it possible to draw conclusions about the state of affairs of the company, in comparison with companies from the S&P index 500 and similar, single-industry: Microsoft management looks preferable to index companies, but inferior to companies in its sector.
Advantages and disadvantages
The ROA ratio allows you to characterize the level of professionalism of the company’s management (how well assets are used), which directly affects the size of the potential return on investment.
Its values are used to assess the reliability, solvency and competitiveness of the enterprise. The indicator is important not only for investors and analysts, but also for the company’s management, which can make adjustments in time if ROA is low in comparison with competitors, or tends to decline.
The main disadvantage of ROA and other profitability ratios lies in their dependence on accounting rules (for example, different standards – GAAP and IFRS can be applied even in enterprises of the same country).
This leads to another problem – the ability to manipulate the indicators of net profit (as a result, distorted analytics).
Even a high return on assets ratio does not reflect the company’s liquidity level (funds for dividends can only be on paper).
You should also be aware that conclusions on a company’s profitability cannot be based solely on ROA values - this is a relative indicator that requires confirmation of the trend by comparative analysis with similar instruments.
The ROA multiplier is an important analytical tool that determines the level of profitability of an enterprise and characterizes its ability to generate profit through the use of equity and borrowed capital.