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Back to Basics – Investment Return Ratios

April 24, 2012 | About:
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GuruFocus

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GuruFocus will also add investment return ratios to the new valuation summary page we are working on. This is in addition to the Earnings Yield ratio, the basic valuation ratios and the intrinsic values we are going to add.

Return on Equity (ROE)

Return on Equity is calculated as follows:

Return on Equity (ROE) = Net Income / Total Shareholder Equity

In the calculation of annual return on equity, the net income of the last fiscal year was used. The Total Shareholder Equity is from the end of year data. Strictly speaking, average Total Shareholder Equity should be used. In calculating the quarterly data, the result was multiplied by 4 to annualize the rate. Return on equity is displayed in the 10-year financial page.

Guru Explains:

Return on Equity (ROE) measures the rate of return on the ownership interest (shareholders' equity) of the common stock owners. It measures a firm's efficiency at generating profits from every unit of shareholders' equity (also known as net assets or assets minus liabilities). ROE shows how well a company uses investment funds to generate earnings growth. ROEs between 15% and 20% are considered desirable.

The factors that affect a company’s Return on Equity (ROE) can be illustrated with the Du Pont Formula:

Return on Equity (ROE)

= Net Income / Total Shareholder Equity

= (Net Income / Sales) x (Sales / Total Assest) x (Total Assets /Total Shareholder Equity)

= Net Profit Margin x Asset Turnover x Leverage Ratio

= Return on assets x Leverage Ratio

With this breakdown, it is clear that if a company grows its Net Profit Margin, its Asset Turnover, or its Leverage, it can grow its return on equity.

Be Aware:

Because a company can increase its return on equity by having more financial leverage, it is important to watch the leverage ratio when investing in high ROE companies. Like ROA, ROE is calculated with only 12 months data. Fluctuations in company’s earnings or business cycles can affect the ratio drastically. It is important to look at the ratio from a long term perspective. ROA can be affected by events such as stock buyback or issuance, as well as by goodwill, the company’s tax rate and its interest payment. Return on assets may not reflect the true earning power of the assets. A more accurate measurement is Return on Capital (ROC).

Asset light businesses require very few assets to generate very high earnings.Their ROEs can be extremely high.

Return on assetss (ROA)

Return on assetss (ROA) is calculated as:

Return on assetss (ROA) = Net Income / Total Assets

In the calculation of annual return on assetss, the net income of the last fiscal year is used. The Total assets are from the end of year data. Strictly speaking, average total assets over the fiscal year should be used. In calculating the quarterly data, the result was multiplied by 4 to annualize the rate. Return on assets is displayed in the 10-year financial page.

Guru Explains:

Return on assets (ROA) measures the rate of return on the total asset (shareholder equity plus liabilities). It measures a firm's efficiency at generating profits from shareholders' equity plus its liabilities. ROA shows how well a company uses what it has to generate earnings. ROAs can vary drastically across industries.Therefore, return on assets should not be used to compare companies in different industries. For retailers, a ROA of higher than 5% is expected. For example, WalMart (WMT) has a ROA of about 8% as of 2012. For banks, ROA is close to their interest spread. A bank’s ROA is typically well under 2%.

Similar to ROE, ROA is affected by profit margins and asset turnover. This can be seen from the Du Pont Formula:

Return on Assets (ROA)

= Net Income / Total Asset

= (Net Income / Sales) x (Sales / Total Asset)

= Net Profit Margin x Asset Turnover

Be Aware:

Like ROE, ROA is calculated with only 12 months data. Fluctuations in the company’s earnings or business cycles can affect the ratio drastically. It is important to look at the ratio from a long term perspective. ROA can be affected by events such as stock buyback or issuance, and by goodwill, a company’s tax rate and its interest payment. ROA may not reflect the true earning power of the assets. A more accurate measurement is Return on Capital (ROC).

Return on Capital (ROC)

Return on Capital (ROC) is calculated as follows:

Return on Capital (ROC) = (Net Operating Profit – Adjusted Taxes) / (Book Value of Debt + Book Value of Equity – Cash)

Guru explains:

Return on Capital measures how well a company generates cash flow relative to the capital it has invested in its business. The reason book values of debt and equity are used is because the book values are the capital the company received when issuing the debt or receiving the equity investments.

There are four key components to this definition. The first is the use of operating income rather than net income in the numerator. The second is the tax adjustment to this operating income, computed as a hypothetical tax based on an effective or marginal tax rate. The third is the use of book values for invested capital, rather than market values. The final is the timing difference; the capital invested is from the end of the prior year whereas the operating income is the current year’s number.

Why is Return on Capital important?

Because it costs money to raise capital. A firm that generates higher returns on investment than it costs the company to raise the capital needed for that investment is earning excess returns. A firm that expects to continue generating positive excess returns on new investments in the future will see its value increase as growth increases, whereas a firm that earns returns that do not match up to its cost of capital will destroy value as it grows.

Be aware:

Like ROE and ROA, ROC is calculated with only 12 months data. Fluctuations in company’s earnings or business cycles can affect the ratio drastically. It is important to look at the ratio from a long term perspective.

Related:

Return on Assets (ROA), Return on Equity (ROE)

Return on Capital - Joel Greenblatt

Joel Greenblatt defined Return on Capital differently in his book The Little Book That Still Beats the Market (Little Books. Big Profits). He defines Return on Capital as follows:

Return on Capital = EBIT / (Net fixed Assets + Working Capital)

EBIT stands for Earnings Before Interest and Taxes. Fixed Assets are also known as non-current assets. They include the property, plant, and equipment that the firm needs in its operation. GuruFocus calculates working capital as: (Accounts Receivable + Inventory + Other Current Assets) – (Accounts Payable + Other Current Liabilities).

So Joel Greenblatt’s Return on Capital can be restated as:

EBIT / (Receivables + Inventory + Other Current Assets + PPE) – (Payables + Other Current Liabilities)

Guru explains:

The way Joel Greenblatt defines Return on Capital is a more accurate measure of how efficient the company generates returns on what they have in the company in its business operation. EBIT is used instead of net income because the tax and interest payment may be affected by factors other than the core business operation. Intangible assets are not included in the calculation because they don’t need to be replaced.

Joel Greenblatt uses his definition of Return on Capital and Earnings Yield (Joel Greenblatt) to rank companies.

Be aware:

In this definition of Return on Capital, the problem of one-year’s operating data exists. A good year, or a business at the peak of its business cycle may have good Return on Capital numbers. It also favors companies that are light in asset requirement in their operations. Investors need to make sure that the business is predictable, and its future returns will be similar to its past returns. Ranking companies based on their Return on Capital and Earnings yield works best for companies that have predictable businesses.

Related:

Return on assets (ROA), Return on Equity (ROE), Return on Capital (ROC), Earnings Yield (Greenblatt).

About the author:

GuruFocus
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Comments

benethridge
Benethridge - 1 year ago
I think you should make this important point, that many investors miss:

You, as a buyer of the stock, don't "own" that nice ROE, unless the Price / Book Value is 1.0

Ben
gurufocus
Gurufocus premium member - 1 year ago
Very good point, Ben!
avi_g
Avi_g - 1 year ago
To ben and gurufocus: can you elaborate on this point ?

Thank you.

Avi_g.
uashraf
Uashraf premium member - 1 year ago
why cash is out of the ROC equation? If company keeps lots of cash on its balance sheet that will reduce ROC.
john777
John777 - 1 year ago


can we use ROI values in tthe stock screener as a proxy for the ROC described above?

if not what s the exact definition of the ROI in the screener?

jamit05
Jamit05 - 6 months ago


Could one look at the EPS growth instead? That should give a very clear picture. To get a better estimate, we could do EBITDA/Number of shares. How does ROC, ROE or ROA fare better than just the EPS?

Amit Jain

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