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2012-11-02 09:55:27
April 11 2010| Filed Under Accounting, Fundamental Analysis, Investing
Basics, Stock Analysis, Stocks
With all the ratios that investors toss around, it's easy to get confused.
Consider return on equity (ROE) and return on assets (ROA). Because they both
measure a kind of return, at first glance, these two metrics seem pretty
similar. Both gauge a company's ability to generate earnings from its
investments. But they don't exactly represent the same thing. A closer look at
these two ratios reveals some key differences. Together, however, they provide
a clearer representation of a company's performance. Here we look at each ratio
and what separates them.
ROE
Of all the fundamental ratios that investors look at, one of the most important
is return on equity. It's a basic test of how effectively a company's
management uses investors' money - ROE shows whether management is growing the
company's value at an acceptable rate. ROE is calculated as:
Annual Net Income
Average Shareholders' Equity
You can find net income on the income statement, and shareholders' equity
appears at the bottom of the company's balance sheet.
Let's calculate ROE for the fictional company Ed's Carpets. Ed's 2009 income
statement puts its net income at $3.822 billion. On the balance sheet, you'll
find total stockholder equity for 209 was $25.268 billion; in 2008 it was
$6.814 billion.
To calculate ROE, average shareholders' equity for 2009 and 2008 ($25.268bn +
$6.814bn / 2 = $16.041 bn), and divide net income for 2009 ($3.822 billion) by
that average. You will arrive at a return on equity of 0.23, or 23%. This tells
us that in 2009 Ed's Carpets generated a 23% profit on every dollar invested by
shareholders.
Many professional investors look for a ROE of at least 15%. So, by this
standard alone, Ed's Carpets' ability to squeeze profits from shareholders'
money appears rather impressive. (For further reading, see Keep Your Eyes On
The ROE.)
ROA
Now, let's turn to return on assets, which, offering a different take on
management's effectiveness, reveals how much profit a company earns for every
dollar of its assets. Assets include things like cash in the bank, accounts
receivable, property, equipment, inventory and furniture. ROA is calculated
like this:
Annual Net Income
Total Assets
Let's look at Ed's again. You already know that it earned $3.822 billion in
2009, and you can find total assets on the balance sheet. In 2009, Ed's
Carpets' total assets amounted to $448.507 billion. Its net income divided by
total assets gives a return on assets of 0.0085, or 0.85%. This tells us that
in 2009 Ed's Carpets earned less than 1% profit on the resources it owned.
This is an extremely low number. In other words, this company's ROA tells a
very different story about its performance than its ROE. Few professional money
managers will consider stocks with an ROA of less than 5%. (For further
reading, see ROA On The Way.)
Watch: Reture On Assets
The Difference Is All About Liabilities
The big factor that separates ROE and ROA is financial leverage, or debt. The
balance sheet's fundamental equation shows how this is true: assets =
liabilities + shareholders' equity. This equation tells us that if a company
carries no debt, its shareholders' equity and its total assets will be the
same. It follows then that their ROE and ROA would also be the same.
But if that company takes on financial leverage, ROE would rise above ROA. The
balance sheet equation - if expressed differently - can help us see the reason
for this: shareholders' equity = assets - liabilities. By taking on debt, a
company increases its assets thanks to the cash that comes in. But since equity
equals assets minus total debt, a company decreases its equity by increasing
debt. In other words, when debt increases, equity shrinks, and since equity is
the ROE's denominator, ROE, in turn, gets a boost. At the same time, when a
company takes on debt, the total assets - the denominator of ROA - increase.
So, debt amplifies ROE in relation to ROA.
Ed's balance sheet should reveal why the company's return on equity and return
on assets were so different. The carpet-maker carried an enormous amount of
debt - which kept its assets high while reducing shareholders' equity. In 2009,
it had total liabilities that exceeded $422 billion - more than 16 times its
total shareholders' equity of $25.268 billion.
Because ROE weighs net income only against owners' equity, it doesn't say much
about how well a company uses its financing from borrowing and bonds. Such a
company may deliver an impressive ROE without actually being more effective at
using the shareholders' equity to grow the company. ROA - because its
denominator includes both debt and equity - can help you see how well a company
puts both these forms of financing to use.
Conclusion
So, be sure to look at ROA as well as ROE. They are different, but together
they provide a clear picture of management's effectiveness. If ROA is sound and
debt levels are reasonable, a strong ROE is a solid signal that managers are
doing a good job of generating returns from shareholders' investments. ROE is
certainly a hint that management is giving shareholders more for their money.
On the other hand, if ROA is low or the company is carrying a lot of debt, a
high ROE can give investors a false impression about the company's fortunes.
by Ben McClure
Ben McClure is a long-time contributor to Investopedia.com.
Ben is the director of Bay of Thermi Limited, an independent research and
consulting firm that specializes in preparing early stage ventures for new
investment and the marketplace. He works with a wide range of clients in the
North America, Europe and Latin America. Ben was a highly-rated European
equities analyst at London-based Old Mutual Securities, and led new venture
development at a major technology commercialization consulting group in Canada.
He started his career as writer/analyst at the Economist Group. Mr. McClure
graduated from the University of Alberta's School of Business with an MBA.
Ben's hard and fast investing philosophy is that the herd is always wrong, but
heck, if it pays, there's nothing wrong with being a sheep.
He lives in Thessaloniki, Greece. You can learn more about Bay of Thermi
Limited at www.bayofthermi.com.