Thursday, September 2, 2010

Understanding ROA/ROE/ROIC

When you go through company annual or quarterly reports, you will encounter things like ROA/ROE and ROIC. It is important to have an inkling what they are especially when you have thousands of dollars vested in them.

Return of Assets (ROA). It is basically a measure of a company efficieny in translating assets into profits.

ROA = Net Margin * Asset Turnover where

Net Margin = Net Income / Sales and
Asset Turnover = Sales / Assets

Net Margin tells you how much each dollar of sales a company keeps as earnings after paying all the cost of doing business
Asset Turnover tells us roughly how efficient a company is at generating sales from each dollar of asset.

With ROA, there are two routes to operation profitability either by charging higher prices (high net margin) or turning over assets quickly. But ROA if fine if companies are just a pile of assets but in reality, many companies are partially finance by debt, which gives their return a leverage component which need to be taken into account.

Return on Equity (ROE)
Return on Equity is a measure of a company's profitability based on its efficiency with which the company is using shareholder's equity.

ROE = ROA * Financial Leverage where

Financial Leverage = Assets / Shareholder's Equity

Financial Leverage is a measure of how much debt a company carries relative to shareholder's equity.

Hence, ROE = Net Margin * Asset Turnover * Financial Leverage

There are three levers that can boost ROE - Net Margin, Asset Turnover an Financial Leverage. Utilities, is a good example of companies using Financial Leverage to boost ROE (CitySpring, SP Ausnet in my portfolio are all classic examples)

Return on Invested Capital (ROIC)
ROIC improves on ROA and ROE because it put the debt and equity financing on an equal footage. It removes the debt-related distortion that can make highly leveraged company looks very profitable when using ROE.

ROIC = Net Operating Profit After Taxes (NOPAT) / Invested Capital

Invested Capital = Total Assets - Non-interest bearing current liabilities (ie A/P) - Excess Cash (not needed in day-to-day ops) - Goodwill

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