Understanding ROE (Part 4)

I left off Part 3 discussing some reasons it may be useful to study return on assets (ROA) as an alternative to return on equity (ROE). Today I will conclude by comparing the two metrics.

With regard to the math, ROA is:

                                Net Income * 100    
                              --------------------  
                              Average Total Assets             

Average Total Assets is the arithmetic mean between beginning and end of the year (or period). Note that ROE uses only shareholder equity in the denominator of its calculation.

ROA can mislead for companies with few physical assets (e.g. software or services) where high ROA may not fully reflect the company’s operational strength if driven by accounting artifacts or strategic underinvestment rather than true efficiency.

Accounting artifacts may include:

• Fully-depreciated [older] assets having a lower book value on the balance sheet thereby shrinking the denominator and artificially inflating ROA despite equipment being potentially inefficient or nearing its end.
• Ignoring off-balance-sheet assets like brand value, patents, or intellectual property that would otherwise lower ROA.
• A temporary spike in net income from non-recurring items (e.g. selling a subsidiary or a large asset write-down) that may make a company appear more efficient in a single period than it actually is.

Strategic underinvestment could be high ROA achieved by delaying necessary capital expenditures (e.g. not upgrading machinery or software) thereby creating a questionable short-term boost while hurting long-term competitiveness. Similarly, aggressive inventory reduction can temporarily lower total assets and raise ROA at the risk of facing stockouts and lost future sales—both signaling hidden operational fragility.

According to some, another ROA flaw is division of net income (truly belongs only to equity holders) by total assets (funded by both debt and equity). A possible fix would be to use ROIC (see Part 2) or to add back interest expense in the numerator.

While 15–20% ROE is often considered strong, a “good” ROA is typically 5–10% with < 1% indicating financial weakness.

ROA is preferred by operational managers, lenders and regulators, and acquisition analysts because it evaluates how effectively internal resources are deployed, because it assesses fundamental operational soundness and asset quality, and because it provides an apples-to-apples comparison across companies with different levels of debt, respectively.

For equity investors, ROE is preferred because it focuses directly on the return generated for shareholders despite being easily inflated by increased debt (including share buybacks).

At the risk of sounding redundant, ROA provides a grounded view of how well a company uses its entire resource base–—both debt and equity—–to generate profit.

ROA is a good metric to determine whether managers are making good use of the company’s infrastructure and technology; consistent, high ROA indicates sustainable competitive advantage.

In summary, ROE describes how much the shareholders are making whereas ROA describes how well the business is running.

Understanding ROE (Part 3)

Today I want to return to Part 1 and give a couple examples using DuPont analysis (equation [1]).

Net profit margin, the first term, is calculated as follows. Top line of an income statement is revenue (i.e. sales). Subtract from that expenses such as SG&A (selling, general, and administrative costs), COGS (cost of goods sold) and other line items to get net income before taxes (i.e. pre-tax profit). Every income statement labels things differently but a general example is Item 8 here. Subtract taxes from pre-tax profit to get net income (i.e. profit). Divide profit by revenue and multiply by 100% to get profit margin (as a percentage).

The importance of net profit margin is clear, then. All else being equal, increasing profit margin will proportionally increase ROE. For example, if ROE is 12% and net profit margin is 6%, then increasing net profit margin to 10% will increase ROE to 20%. The same can be said for the second [asset turnover ratio] and third [financial leverage] terms.

Studying asset turnover ratio helps us understand the efficiency of asset use to generate sales. Higher ratio is better and means the company is less asset intensive. Assets can include stores, acquisitions, products, and markets. The key point to investigate is whether company is investing in new assets to grow future sales.

The financial leverage ratio reflects how well the company is using debt (borrowed money) to finance asset purchase to grow sales and earnings. Assets should increase future sales and earnings more than the cost of borrowing (i.e. interest).

Studying return on assets (ROA) rather than ROE can sometimes be advantageous. This shifts the focus from shareholder returns to operational efficiency, debt usage, and asset management. ROE measures how much profit a company makes with shareholders’ capital whereas ROA indicates how effectively management uses debt and equity to generate profit.

One big advantage of ROA over ROE is independence from financial leverage (debt). As mentioned in the Part 1 penultimate paragraph, higher leverage can boost ROE. ROA is less affected by a company’s capital structure. High ROE can make a company look profitable in these cases whereas its ROA can still reveal its assets are not generating high returns.

Stated another way, high ROE with low ROA indicates that a company is using high leverage to boost returns, which is riskier. ROA is superior for evaluating management’s ability to manage assets regardless of how those assets are financed.

ROA is best for asset-heavy industries. This includes industries with substantial capital investments such as utilities, telecommunications, and manufacturing.

ROA (or ROAA: return on average assets) is preferred when studying the banking sector to measure asset utilization and operational efficiency. Anything over 1.00% (1.25%) may be considered good (excellent).

I will continue next time.

Understanding ROE (Part 2)

Today I will delve deeper into Return on Equity (ROE) at the risk of offending some readers with some higher-level math and accounting concepts.

As discussed in Part 1, ROE is a primary indicator of a company’s profitability and management efficiency by measuring dollars of profit generated per dollar of shareholders’ equity:

• High or rising ROE suggests management is efficiently using shareholder capital to generate earnings.
• Consistently high ROE (e.g. 15-20%+) often signifies a strong economic moat or superior business model.
• ROE may be used to determine a company’s sustainable growth rate by calculating the pace a company can grow internally generated profits.
• ROE allows investors to compare corporate performance within the same industry.

Beware of potentially “bad things” that can mislead by resulting in a high ROE. The third term of (1) in Part 1 has shareholders’ equity in the denominator. Since that equals assets minus liabilities, taking on excessive debt minimizes this term thereby boosting ROE. Share buybacks reduce shareholders’ equity resulting in higher ROE even when net income remains flat. Large asset write-downs also reduce shareholders’ equity potentially inflating future ROE. Years of negative earnings can deplete shareholders’ equity thereby resulting in artificially high ROE noticed when profitability is finally realized.

Follow these tips to use ROE effectively. First, compare a stock against industry average because ROE can vary dramatically (e.g. tech companies often have higher ROE than asset-heavy utilities). Second, ensure ROE is sustainable by looking at a 5-10-year average and trend [stable or increasing is good] rather than single quarter. Third, DuPont Analysis [(1) in Part 1] is good to see what is driving the return. Finally, cross-referencing with return on invested capital (ROIC) can help understand if high ROE represents operational strength or just cheap debt.

ROIC = NOPAT / Invested Capital

In the numerator, NOPAT is Net Operating Profit After Tax and represents profit a company would have without debt or excess cash. NOPAT = EBIT * (1 – tax rate) where EBIT [may be substituted by operating income] is earnings before interest and taxes. NOPAT strips out the effects of leverage or different financing structures.

In the denominator, Invested Capital may be calculated two ways. The financing approach sums up the sources of capital: Total Equity + Total Debt – Cash & Equivalents, which simplifies to Total Equity + Net Debt. Alternatively, the operating approach focuses on assets used in operations: Total Assets – NIBCL. Non-Interest Bearing Current Liabilities (NIBCL) usually includes accounts payable and accrued expenses.

By ignoring how the business is funded, ROIC enables comparison of business quality—the ability to generate high returns on capital over a long period protected by a competitive advantage not easily disrupted by rivals—even if one is debt-free and the other is highly leveraged.

Bonus math for today: compare ROIC to Weighted Average Cost of Capital (WACC) for a true sense of value creation. If ROIC is 12% and WACC is 5%, then the company is creating 7% of value for every dollar it touches.

In reality, doing this comparison is not so simple. I would really make enemies today if I presented the WACC equation with its six different inputs. Many of these inputs are subjective and it’s not uncommon to have analyst disagreement up to 1.5%. While that may not impact the just-mentioned “true sense of value” so much, it’s also used as the discount rate in discounted cash flow models where a 1% WACC difference can change a stock’s intrinsic [or “fair”] value by 10-20%.

Please take a breather! If not for you, then take it for me.

Understanding ROE (Part 1)

Return on Equity (ROE) is a metric I have long since understood to be an important part of stock analysis. Outlier cases are what bring me to write about it today and I will get to those at the end of the mini-series. I will start by defining ROE and discussing why it’s worth studying.

ROE is a financial ratio measuring a company’s profitability (efficiency) by calculating net income per dollar of shareholders’ equity. This breaks down to the triple product of net profit margin, asset turnover ratio, and financial leverage:

Net Income * 100       Sales              Assets                   Net Income * 100
----------------  *  ---------  *  ----------------------   =   ----------------------  (1)
     Sales             Assets       Shareholders' Equity         Shareholders' Equity

Another way to calculate ROE = earnings per share / book value per share.

That ends the heavy math for today’s post.

Reasons to analyze ROE include:

• To show how effectively management uses investors’ money to produce earnings: a high ROE often suggests competitive advantage (per Investopedia).
• To compare profitability between companies within the same industry (per TD Bank).
• To indicate potential growth as companies with consistently high ROE are able to reinvest profits for growth rather than having to take on more debt or issue more shares.
• To evaluate management quality as consistently high ROE is a sign of strong, efficient management (per SmartAsset).

When starting with an isolated look at ROE, over 15% is good and over 20% is exceptional. Look closer if it seems too good to be true. Also look closer if it’s [hugely] negative especially if profitability for the company seems acceptable.

After looking in isolation, evaluate ROE against peer and industry averages for more complete context. Net or pretax profit margin is another metric to compare with peers and the industry: comparatively higher is better.

As debt-to-equity can artificially inflate ROE, make sure to look at that too.

I will end here to keep my promise regarding the heavy math. Prepare for a longer post next time.