When Less is More

The return on assets (ROA) ratio is a very commonly used indicator in the financial industry and financial analysis. It is actually quite simple to calculate as well. There are two commonly used methods for calculating this number. The first method for calculating ROA is to take a company’s net income over a period of time and divide it by the average assets for that period. The second method is to take the net profit margin and multiply it by the asset turnover. This, the second method, is a little more cumbersome for conceptualizing the meaning of the number and so I’ll stick to using the first method in this post.

So what is an ROA number? Well it is a ratio. Specifically, ROA is a profitability ratio. The numerator is typically net income, but very frequently defined with the term “earnings”. As an astute investor, one should know that earnings can be very easily manipulated and therefore for different businesses “earnings” means something different. For some, earnings are the net income, but for others, certain adjustments are made such as the adding back of interest income. In either case, ROA is a profitability ratio that tells the investor how much money a company is making for each dollar worth of assets. It can tell the investor how efficient the management is at putting the assets in the firm to use for creating earnings.

The assets that are used in this ratio are compiled of both debt and equity. And so, it is important to remember that when using the ROA ratio as a comparative ratio, we must only compare within the same industry. Some industries have different capital structures and different funding requirements and, therefore, would have a different ROA. But one thing that is common across all companies is that analysts typically look for high ROA ratios: the higher the better. This is important because not only does it indicate the ability of management to generate large earnings, but it also indicative of choices made by management to generate higher earnings with relatively low investment.

But this is where we must be careful. Sometimes a high ROA ratio is not always the most sought after variable. Know that the ROA ratio is also a measure of the asset intensity of the business. It tells us how much assets are required to operate this business. Industrial manufacturing companies and railroads are examples of asset heavy businesses while something like a software company, or an internet startup, typically is not very asset heavy. So why do we have to be careful?

Simply looking for a high ROA is not satisfactory. An ROA ratio can be high because earnings are high, which is great, but remember that it also can be high because the denominator, the assets, are low. This could pose a problem. Many analysts believe the having a highly asset intensive business is not a good thing because a lot money must be funneled back into the assets to keep the business going. This is true, but what about the other side of the equation, so to speak? A low asset intensive business is dangerous because it can make it very easy for competitors to enter the industry. A low number of assets can indicate a very weak moat. An example of this is how within today’s startup industry there are so many Facebook and Groupon clones; the startup costs and assets are minimal. All that is needed to get into the game is really just a computer, some web space, and the knowledge to design your idea (note: I’m not implying that it’ll be a successful idea; only that you can create one). Don’t be fooled that just because a great product exists something else can’t triumph over it. Isn’t that actually what happened when Facebook took over the market share from MySpace?

The point is that although a high ROA ratio is a great thing, investment analysts must be weary of why it is high. If it is high because the asset number is low, this could be indicative of low barriers to entry and a weak moat. Capital is always a barrier to entry and therefore what helps make a company’s competitive advantage durable is the amount of capital that needs to be invested to enter the business. A company could have far superior economics but have a much weaker moat. Understanding the ROA ratio can help discern these things and is a key player in any value investor’s analysis arsenal.