Fundamentals (Part Deux)
To follow up on Part 1 of this series on Fundamental Analysis tools, throughout this post I’ll touch on Return on Assets (ROA), Return on Equity (ROE) & Return on Total Capital (ROTC) & explain their importance along with how to use these measurement tools. If you haven’t checked out the first part of this series, I’d definitely recommend it prior to jumping into this post.
A couple terms to be familiar with prior to this post:
- Earnings – Profits the company makes that are not distributed to shareholders (profits – dividends paid)
- Earnings can be distributed to shareholders (dividends or share-buybacks) or reinvested into the company (capital expenditures).
- Reinvested earnings enhance solvency & provide a cushion against short-term problems.
- Assets – a resource a company owns that is expected, in the future, to generate cash flows, reduce expenses or improve sales (e.g. Cash & equivalents, buildings or machines & patents or trademarks to name a few)
- Shareholders’ Equity – The amount of assets remaining after subtracting the company’s liabilities (in other words, after paying off the company’s debts).
Important to note that ROA, ROE & ROTC could all be categorized as Profitability Ratios. Profitability Ratios reflect a company’s competitive position in the market & by extension, reflect the quality of a company’s management. One of managements most important responsibilities is deciding how to utilize it’s resources. As an investor, if a company is reinvesting earnings rather than distributing them proportionately to investors, it is important to make sure the companies you invest in are at least earnings great returns on that reinvestment of capital. So, management’s efficiency in deciding where to allocate the company’s resources is definitely important to the short-term returns a company can generate, along with the long-term potential & health of the company as well.
Return on Assets (ROA)
ROA = Net Income ÷ Total Assets
In technical terms, Return on Assets is largely an indicator of a company’s profitability relative to it’s total assets. In simpler terms, Return on Assets measures how much earnings were generated from the assets the company has. Furthermore, this illustrates how effective the company is at converting the money it has invested into it’s business (assets) into net income. A higher ROA = earning more money on assets (more efficient). It is important to note that it is best to utilize ROA to compare a company against it’s historical standard or it’s competitors’ ROA because ROA can vary significantly across industries due to different costs to operate a business across industries.
Example:
AMZN ROA = 6.70% <– For every $1 invested into assets, Amazon earns ~7 cents. (6.7 cents technically)
WMT ROA = 2.50% <– For every $1 invested into assets, Walmart earns ~3 cents. (2.5 cents technically)
TGT ROA = 7.70% <– For every $1 invested into assets, Target earns ~8 cents. (7.7 cents technically)
Target is seemingly the best candidate amongst those 3 at converting the assets of the company into profits.
Return on Equity (ROE)
ROE = Net Income ÷ Average Shareholders Equity
In technical terms, Return on Equity is an indicator of a company’s profitability relative to it’s shareholder’s equity. In simpler terms, Return on Equity measures how well management is utilizing financing from the company’s stock to generate income. Higher ROE = earning more income off of less financing from the company’s stock. Similar to ROA, ROE is best utilized to compare a company with it’s historical standard or it’s competitors ROE since it can vary significantly across industries.
Example:
AMZN ROE = 26.70% <– For every $1 in Stockholder’s Equity, Amazon earns ~27 cents. (26.7 cents technically)
WMT ROE =6.90% <– For every $1 in Stockholder’s Equity, Walmart earns ~7 cents. (6.9 cents technically)
TGT ROE = 27.50% <– For every $1 in Stockholder’s Equity, Target earns ~28 cents. (27.5 cents technically)
Again, Target comes out on top as it is seemingly the most efficient at utilizing the financing they get from their stock to generate income.
Return on Total Capital (ROTC)
ROTC = Earnings before Interest & Taxes ÷ (Short- & long-term debt + shareholder’s equity)
In simple terms, Return on Total Capital measures profits the company earns on all of the capital that it employs. ROTC uses ‘Earnings before Interest & Taxes’ (i.e. EBIT) to assess the cash flow generation prior to the affects of interest and taxes. With ROTC, we’re more interested in the cash flow that the capital allocated into the business generates prior to the affects of interest & taxes. Similar to ROA & ROE, ROTC is best utilize to compare a company with it’s historical standard or against it’s competitors ROTC.
ROTC is considered by many important for capital-intensive sectors such as Telecoms or Utilities (sectors that have to spend a bunch of money related to the infrastructure needs of their business). This is because when these capital-intensive businesses need to expand or redo their infrastructure, it tends to be extremely costly & cost more than the company may generate via their stable revenue streams or the equity they have available, so they’re required to take on significant debt levels. ROTC takes into consideration debt & other liabilities in addition to shareholder’s equity. In general, it is preferable for a company to have stable & rising ROTC rather than volatile ROTC that is inconsistent from one year to the next.
Conclusion
Through the utilization of ROA, ROE & ROTC, an investor or analyst can gain further insight into aspects of a company’s business they otherwise would not be able to infer from simply looking at the overall revenue, sales, etc… of a company’s financial statements. Additionally, an individual can utilize ROA, ROE & ROTC against a company’s historical ROA, ROE & ROTC to look for a trend that may give further insight into what to expect in the company’s profitability going forward.
Throughout the next part of this series I’ll further touch on Profitability Ratios in what are considered ‘Return-on-Sales Ratios‘.
Cheers,
Zach Veencamp