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.