ROA
Investors often look for a ratio that will identify a great stock out of all of the stocks available. This magic number doesn’t exist. However, when you are considering stocks to buy, there are certain metrics and numbers that are more important than others. They can’t be used as the sole qualifier to determine great stocks, but you can use them to eliminate companies that are likely to not bring you the chingle chingle. You must always look at the big picture when considering a stock and that means considering a number of different ratios.
The ROA
Return on Assets is one of the handful of really important metrics every investor should know.
Return on Assets (ROA) tells you how efficiently a company turns assets into a net income. This basically calculates the profitability, of a business. What it also does is calculate the efficiency of them converting capital into profits.
Companies that make more money are worth more than companies that don’t make as much money.
ROA is made up of two components: net margin and asset turnover. When used together, these two metrics tell an important story.
Companies that make more money are worth more than companies that don’t make as much money.
ROA is made up of two components: net margin and asset turnover. When used together, these two metrics tell an important story.
So here is how you calculate the ROA
ROA= Net Margin * Asset Turnover
Net Margin= net income/sales (Percentage of each dollar in sales that it retains)
Asset Turnover= sales/assets (Caculation of the ratio of producing Sales from its assets)
ROA= Net Margin * Asset Turnover
Net Margin= net income/sales (Percentage of each dollar in sales that it retains)
Asset Turnover= sales/assets (Caculation of the ratio of producing Sales from its assets)
Once you have net margin and asset turnover, multiply them together to determine ROA. You now have an idea how well a company can convert assets into profits.
The lower the profit per dollar of assets, the more asset-intensive a business is. The higher the profit per dollar of assets, the less asset-intensive a business is. All things being equal, the more asset-intensive a business, the more money must be reinvested into it to continue generating earnings. This is a bad thing. If a company has a ROA of 20%, it means that the company earned $0.20 for each $1 in assets. As a general rule, anything below 5% is very asset-heavy (manufacturing, railroads), anything above 20% is asset-light (advertising firms, software companies).
There are exactly two ways a company can raise an ROA, therefore improving efficiency. Companies can raise prices and create high margins or rapidly move assets through the company.
The lower the profit per dollar of assets, the more asset-intensive a business is. The higher the profit per dollar of assets, the less asset-intensive a business is. All things being equal, the more asset-intensive a business, the more money must be reinvested into it to continue generating earnings. This is a bad thing. If a company has a ROA of 20%, it means that the company earned $0.20 for each $1 in assets. As a general rule, anything below 5% is very asset-heavy (manufacturing, railroads), anything above 20% is asset-light (advertising firms, software companies).
ROA is an important measure to use and understand, but its flaw is that the metric does not consider the effect of borrowed capital.
