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Which return ratio should you use?

There are a bunch of different ratios used to evaluate the return generated by a business including:

  • Return on Assets (ROA)
  • Return on Equity (ROE)
  • Return on Invested Capital (ROIC)
  • Return on Capital Employed (ROCE)
  • Return on Tangible Capital Employed (ROTCE)

I know, you are already tearing your hair out screaming they all sound the same - how do I know which to use. Just relax and I will walk you through it (where possible I will use the definitions from Corporate Finance Institute for the sake of consistency).

Return on Assets (ROA)

Return on Assets (ROA) is the amount earned per dollar of assets. A higher Return on Assets value indicates that a business makes more efficient use of its assets and may be more profitable. It is calculated as:

Return on Assets (ROA) = Net Income / Average Assets

where:

  • Net Income is equal to net earnings or net income in the year, and
  • Average Assets is equal to ending assets minus beginning assets divided by 2

Net income is the amount earned after deducting all the costs of doing business. It includes all interest paid on debt, income tax due to the government, and all operational (including cost of goods sold (COGS), production overhead, administrative and marketing expenses, amortization and depreciation of fixed assets) and non-operational expenses.

Income arising from investments and those not directly resulting from primary operations, such as proceeds from the sale of fixed assets are also included in Net Income which can cause distortions unrelated to the underlying business efficiency.

Net income/loss is found at the bottom of the income statement and divided into total assets to arrive at ROA.

Return on Equity (ROE)

Return on Equity (ROE) measures the profits made for each dollar from shareholders' equity, allowing:

  • Investors can see if they are getting a good return on their money
  • Companies can evaluate how efficiently they are deploying shareholder equity.

It is calculated as:

Return on Equity (ROE) = Net Income / Shareholders’ Equity

where Shareholders' Equity = Assets minus Liabilities.

In other words the difference between Return on Assets and Return on Equity is the later takes into account the liabilities (leverage) of the company.

Source: Corporate Finance Institute

I prefer to use Return on Equity over Return on Assets because all companies carry liabilities and how well they manage those liabilities impacts the returns I earn as an investor. But before I invest I check to make sure I believe the company can pay those liabilities off in the normal course of business in good times and bad. Also I take a view on how easy it will be for the company to refinance any loans they have when they come due.

But be careful - adding more leverage to a company can increase both Return on Equity and RISK - watch out for RISK.

Return on Invested Capital (ROIC)

Return on Assets (ROA), Return on Equity (ROE), and Return on Invested Capital (ROIC) are all used to determine a firm’s ability to generate returns on its capital. Return on Invested Capital (ROIC) is a little more complicated to calculate, but I prefer it for the reasons I will outline below.  It is calculated as:

Pro Tip: NOPAT is equal to EBIT x (1 – tax rate)

where the Invested Capital equals:

Source: Source: Corporate Finance Institute

Return on Assets ROA is calculated by taking net income over total assets. However, Return on Assets (ROA) can be substantially skewed either higher or lower based on a firm’s cash balance. So a company that is sitting on a bunch of cash that it could return to shareholders will rank worse than a company without that cash.

Return on Equity (ROE) is calculated as net income over shareholders’ equity and is used to compare firms with the same capital structure. However, ROE can be positively impacted by actions that reduce shareholder equity (e.g., write-downs, share buybacks), but that does nothing to net income. Another limitation of Return on Equity (ROE) is that a firm may take on excess leverage and still look as if they are handling things well.

Return on Invested Capital (ROIC) addresses the issues with Return on Assets (ROA) and Return on Equity (ROE) in calculating profitability because:

  • Cash is netted out when calculating Invested Capital addressing differences in cash balances between companies.
  • It backs out Goodwill which is a past sunk cost, but unlike other assets the company does not keep investing in as it grows organically.
  • It backs out interest expense to reflect the actual profits available to a buyer separate from the buyer's financing decision.

Now lets break apart Return on Invested Capital (ROIC) and dig a little deeper to see what its drivers are:

Source: Corporate Finance Institute

When searching for Moats and competitive advantages, this break down shows a company could have a high Return on Invested Capital (ROIC) because it has a high profit margin or because it is able to generate more sales for each dollar of capital invested because:

  • NOPAT/Sales measures profit margin
  • Sales/Invested Capital measures capital efficiency.


This post first appeared on Searching For The Best Stocks At The Best Prices, please read the originial post: here

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Which return ratio should you use?

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