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Going Back to Fundamentals (2): ROA

June 07, 2012 | About:
David Chulak

David Chulak

29 followers
In the first part of this series, I discussed the current ratio. These discussions, once again, are an attempt to induce the investor to really consider all the facets of each criterion or metric they are considering. Numbers are just that… numbers. But without genuinely thinking about what those numbers actually mean to the investor, they become mechanical and eventually somewhat worthless.

For instance, any investor doing some quick reading on return on assets or ROA will discover that it’s common to see a 5% to 20% benchmark. Why? Is it really a problem if it’s less than that? Certainly, a number greater than 20 cannot be a problem. Can it? Bigger is better… right? Once again, the answer is maybe. Let’s take a closer look. What exactly is return on assets?

It can be described as a measure of management’s ability to squeeze out profits from the assets the company owns or how well or efficient is management using the assets to increase profit? As cautioned before, always know exactly what you are looking at. For instance, most definitions for return on assets indicate that you simply divide net income by total assets or:

Net Income/Total Assets

The problem is that there are many variations of this criterion and prudence teaches us that we should know what we are looking at or at least we should be comparing apples to apples.

An often suggested definition of the above and deemed by others to be superior is:

Net Income/Average Total Assets

Why take average of the assets? You may have some newly added assets that were just purchased that haven’t made their way into the system to earn profits and may skew the numbers drastically. The average is just a safer or more conservative number to use. This is one reason you will see different numbers displayed on various websites. For instance, taking the latest total assets number is somewhat misleading in that the net income was actually produced from the assets owned in the prior years.

Other alternate definitions preferred by investors are below. Just remember to know exactly what you are looking at:

EBIT/Total Assets

Net Income + Interest Expense/Average Total Assets

Net Income/Total Assets – Intangible Assets

Earlier, I mentioned a benchmark of 8% to 20%. This benchmark does not include banks or financial firms, which seek to attain a return on assets of greater than 1.5%. The year-over-year return on assets is a key criterion in the F-Score or the Piotroski score. Piotroski liked looking at the trend of ROA and so should you. A steady or growing ROA indicates value while a descending number can indicate trouble ahead. Also, remember that earnings can be manipulated, so meeting the benchmark is important to companies, so study the numbers closely as to how they got there. A higher number may not indicate any problem, but it could also indicate manipulation.

Financial auditors have also used this metric in finding companies that are engaged in deceptive activity. Note that while an ROA under 5% doesn’t mean that the company is necessarily going out of business, it does indicate lack of efficiency and can indicate future problems ahead. As a reminder as to the importance of this criterion, observe the return on assets from the following companies:

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I do not like merely looking for the return on asset ratio or percentage because it doesn’t tell you the entire story. Below is the method I prefer because it tells you more about the company. Return on assets can also be defined as Net Margin multiplied by the Asset Turnover. Observe the numbers from two publicly traded companies:

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What this allows you to see is that there are two ways at arriving at a higher ROA. These are two companies in a highly competitive market with very low margins. Companies can increase their ROA by one of two ways: either increasing their net margin or increasing their asset turnover or both.

The company at the top has pretty steady margins that have slightly increased over the last couple of years, but they have increased. They have also been able to slightly increase their asset turnover ratio which has led to a higher return on assets ratio. This is what you want to see, especially in tough times like we are currently facing. In a highly competitive business, unable to raise prices, the ability to manage your inventory can be critical for increasing your return on your assets.

The second company has noticeably decreasing margins and slightly increasing asset turnover, ultimately leading to lower ROA. So which company would you prefer merely based upon this one criterion? The top company indicates better efficiency. The trend line of the second company is troublesome, due to the decreasing return on assets.

Interestingly enough, the numbers from the upper company come from a company that has had serious problems mentioned in the news lately, while the lower company has had increasing positive news. Remember that this doesn’t tell the entire story, but it is extremely important in determining management’s efficiency. The top company is Walgreen (WAG) and the lower company is CVS Caremark (CVS).

Return on assets has an added strength over criterion such as return on equity. While seemingly used more often by investors, return on equity doesn’t clearly indicate whether the company has unwarranted or excessive debt to obtain the returns. Return on assets removes some of that doubt.

Disclosure: None

About the author:

David Chulak
David Chulak is a private investor that uses a value approach to investing in the styles of Graham & Dodd and Warren Buffet. Looks for that margin of safety in an effort to preserve capital and attempts to guard against short term market fluctuations by having clear rules laid down in advance for selling an equity. Likes to visit the company's where his investments are in order to understand the business better.

Rating: 3.9/5 (15 votes)

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