Warren Buffett is one of the role models for many value investors, and he has publicly shared several key stock selection principles, including ROA and ROE. This highlights the importance of these two metrics in assessing whether a company has long-term investment potential.
So, what exactly are ROA and ROE? What significance do they hold for investors? Below we will provide some introduction.
What is ROA
ROA Represents a Company’s Return on Assets
A company's assets consist of liabilities and equity. By dividing a company’s profit over a given period by its total assets, we get the Return on Assets (ROA). ROA shows how effectively a company uses its assets to generate returns.
For those unfamiliar with a company's asset structure, you can refer to the article Financial Report 101: Introduction to the Balance Sheet
Let’s use a simple example: Company A operates two restaurants: a budget restaurant ABC and a high-end restaurant XYZ. Due to different market positions, both restaurants undertook appropriate renovations and equipment purchases at the start of operations.
| (Unit: 10,000) | Budget Restaurant ABC | High-End Restaurant XYZ |
|---|---|---|
| Renovation | 250 | 500 |
| Equipment | 150 | 200 |
| Total | 400 | 700 |
Two Factors to Improve ROA: Increase Profit or Streamline Assets
| Budget Restaurant ABC | High-End Restaurant XYZ | |
|---|---|---|
| Net Profit | 1 million | 1 million |
| Asset Investment | 4 million | 7 million |
| ROA | 25% (100/400) | 14% (100/700) |
Both restaurants earned a net profit of 1 million this year, leading to ROA values of 25% for ABC and 14% for XYZ. Therefore, ABC’s ROA is superior to XYZ’s.
Based on this example, we can see that the two direct ways to improve ROA are by increasing net profit or reducing assets. If profitability remains the same, companies with lower total assets suggest higher asset efficiency.
ROA Calculation Method
Return on Assets (ROA)=Net Income After Tax ÷ Total Assets
The ROA ratio conveys the concept of how much return is generated per unit of assets. If we use the end-of-period asset value to calculate directly, companies may significantly reduce their assets by the end of period to increase their ROA, leading to a different result from our original intention for using ROA to assess performance. Since net income represents the profit accumulated over a period, it’s better to use average total assets instead of the asset value at a single point of time.
Average Total Assets = (Beginning Assets + Ending Assets) ÷ 2
Advanced ROA Calculation
For companies with large debt, interest expenses may lower net income, causing ROA to be underestimated. We can add back interest expense to adjust, leading to the following formula:
Adjusted ROA = [Net Income + Interest (1 – Tax Rate)] ÷ Average Total Assets
Additionally, some companies have intangible assets like goodwill, which can be hard to assess in terms of profit generation. Sometimes, investors may exclude intangible assets and focus on ROA for tangible assets only. Others may exclude one-time gains (e.g., asset sales) from ROA calculations to eliminate non-operating income influences.
The Significance of ROA
In summary, ROA provides three key insights for investors:
- Asset Health: ROA reflects the health of a company's assets. Well-managed assets generate stable returns, leading to higher ROA.
- Asset Utilization Efficiency: ROA shows how effectively a company uses its assets to generate consistent returns. Poor asset utilization may indicate weak profitability or high operating costs.
- Industry Comparison: ROA allows for comparison between companies within the same industry, providing insight into how efficiently each company uses its assets. Average ROA can vary across industries.
After introducing ROA and its importance, we will then be introducing ROE.
What is ROE
ROE (Return on Equity) represents the return on shareholders’ equity, showing how much profit a company can generate from each dollar of shareholder investment. Some view ROE as the measure of how efficiently a company is generating profits for its shareholders. A higher ROE indicates better efficiency in creating returns from shareholder capital.
ROE Calculation Formula
ROE = Net Income After Tax ÷ Average Shareholder Equity
Let’s see the example below:
| Company A | Company B | |
|---|---|---|
| Net Income | 1 million | 1 million |
| Shareholder Equity | 5 million | 10 million |
| ROE | 20% (1/5) | 10% (1/10) |
If Company A has a net income of 1 million and shareholder equity of 5 million, its ROE would be 20%. This means Company A generates $0.2 of net profit for every $1 of shareholder capital invested. If Company B’s ROE is only 10%, investors might favor Company A for its higher capital efficiency.
To avoid distortions, average shareholder equity should be used when calculating ROE.
Average Shareholder Equity = (Beginning Shareholder Equity + Ending Shareholder Equity) ÷ 2
The Significance of ROE
- Industry Comparison: Different industries have varying ROE standards, so ROE should be compared between companies within the same sector. For example, public utilities or capital-intensive industries may have lower ROE, while asset-light companies may exhibit higher ROE.
- Management and Profitability: ROE reflects the efficiency of management in capital allocation and profitability. A high ROE suggests that management is adept at converting shareholder capital into profits, while a low ROE may signal inefficiencies.
- Long-term Trends: Changes in ROE over time can indicate trends in profitability and operational efficiency. Factors such as improving cost controls, higher leverage, or sector trends can influence a company’s long-term ROE trajectory. Afterall, it is also important to consider the characteristics of the industry in which the company operates, as well as the stage of development of the industry.
Summary
- ROA: Measures how well a company converts assets into profits over a period.
- ROE: Measures how effectively a company uses shareholder equity to generate profits.
- Higher ROA reflects better asset utilization, while higher ROE indicates stronger capital efficiency.
Both metrics should be compared within the industry and analyzed over time to better assess a company's performance.
