A useful ratio for investors to learn is known as return on assets (ROA). This formula is great for measuring the performance of management and generally is used to compare different companies in the same industry and how the company uses its assets.
In our continuing series on profitability ratios (ROE and ROIC), we are going to dive into the return on assets ratio. Similar to the return on equity, it is a fairly easy ratio to calculate, and it gives great insight into management’s use of its assets.
Warren Buffett loves to invest in banks and insurance companies, that is certainly where one of his circle of competences lie. One of the best ratios for determining the financial strength of a bank, for example, is the use of return on assets.
Each industry is going to have a differing return on assets and is best used when comparing companies within similar industries. Comparing Walmart’s return on assets to Apple would not be a beneficial comparison, nor would comparing Walmart to Wells Fargo.
You have probably heard the term “capital-intensive” and are familiar with what it means. A car manufacturer like Ford is capital intensive, requiring lots of expensive equipment to generate its earnings.
Software companies typically have a much lighter model. They create the software, print it to CDs, package it, and ship or release it online. Lighter, less-capital-intensive companies tend to be much more attractive investments, but using comparisons is still best.
In today’s post, we will explore:
- What is Return on Assets (ROA)
- How to calculate Return on Assets
- Pros and cons of Return on Assets
- Industry return on assets for comparisons
What is Return on Assets (ROA)?
Return on assets, otherwise known as ROA, is the ratio that shows how effective a company utilizes its assets to generate a profit. Using the ROA, we can see how the income that a company makes relates to everything creating that income, and how effective it is using those assets.
The ratio helps us see how much profit compares to the assets, think of a ROA of 9% as nine cents for each dollar of assets, the higher, the better. The ratio will vary from industry and can be used to compare companies in similar industries.
The assets of the return on assets refer to all items in the asset section of the balance sheet. Items such as cash, cash equivalents, marketable securities, property, inventories, accounts receivables, are all considered assets.
Return on assets also takes into account debt that the company carries, unlike the return on equity ratio.
Comparing profits to incomes is useful, but the return on assets cuts to the bone of what every company strives for; comparing net income to the assets required to produce that income and effective it is doing that very thing.
Higher return on assets means more asset efficiency; in this case, bigger is better.
How Do We Calculate Return on Assets
The formula for return on assets is simple to use and easy to find the data. The formula is:
Return on Assets (ROA) = Net income / ( Average total assets for a period )
We will find the net income on the income statement and the total assets we will find in the balance sheet. We will use the average of total assets for a period, either annuals or you can use quarters if you prefer. I like to use annuals to be consistent.
Let’s take a look at some companies’ financials and get an idea of how the return on assets works for several different industries.
The first company I would like to look at is Microsoft. We will use the 10-k dated June 30, 2019, for our example.
I am taking a look first at the income statement. Before I forget, all the numbers listed will be in millions.
We see from the above picture that the income for Microsoft for the period ending June 2019 is $39,240.
Next, we will look at the balance sheet from the same 10-k.
We can see from the balance sheet above that the total assets for 2019 and 2018 were:
- 2019 $286,556
- 2018 $258,848
Now that we have gathered all of our numbers, let’s find the return on assets for Microsoft.
Return on assets = $39,240 / ( ($286,556 + $258,848/2)
Return on assets = $39,240 / $272,702
Return on assets = 14.38%
Pretty easy, huh?
The ratio tells us that Microsoft can create 14.38 cents for every dollar of assets it has. We will discuss later how this stacks up to companies in Microsoft’s sector and how this ranks.
Remember that we are looking for a higher number, regardless of the sector.
Let’s try another one.
How about Walmart? They are a huge retailer, and it would be interesting to see how their return on assets work.
We will use the latest 10-k for Walmart, which is dated January 31, 2019.
The income statement will be first to find the net income for Walmart.
The net income for the year ending 2019 for Walmart is $6,670.
Next, we will look up the total assets for the same annual report.
Walmart’s total assets for the periods ending 2018 and 2019:
- 2019 $219,295
- 2018 $204,522
Now that we have our numbers let’s plug them into our formula to find the return on assets for Walmart.
Return on Assets = $6,670 / (($219,295 + $204,522) / )
Return on Assets = $6,670 / $211,909
Return on Assets = 3.15%
After calculating our ratio, we can see that Walmart was able to generate 3.15 cents for every dollar of assets it has. The return on assets is much lower for Walmart than Microsoft, is this a fair comparison?
Not really because the nature of the assets for Walmart is different than Microsoft and is not an apple to apple comparison. Think about the nature of their businesses, Walmart is a retailer with huge inventories, and huge accounts payables, where Microsoft is a software company and is much asset lighter in that once they create a program or system they can sell it costs much less to continue to sell that product.
Walmart has to buy more shoes to sell more shoes, where Microsoft has already created their cloud product Azure and can keep selling it without having to spend more money to create it, they, of course, have to spend money to continue to tweak it, but that is peanuts compared to creating the said product.
Ok, let’s try another. I would like to look at AT&T to see how effective they are in creating income from their assets. We will use their latest 10-k, which is dated December 31, 2019.
We can see from the above picture that AT&T’s net income for 2019 was $14,975.
Next, let’s look at their balance sheet to find their total assets.
We can see from the above balance sheet that AT&T’s total assets are:
- 2019 $551,669
- 2018 $531,864
Ok, let’s find the return on assets for AT&T.
Return on Assets = $14,975 / (( $551,669 + $531,864)/2)
Return on Assets = $14,975 / $541,767
Return on Assets = 2.76%
We can see that AT&T had a lower return on assets than Walmart and Microsoft. Does this mean that AT&T is worse than the others in creating profit from their assets? Not necessarily, but we will explore this more fully in a bit.
One item I would like you to notice, the net income for AT&T has decreased over the last three years, which corresponds to a decline in their return on assets. It is always best when using ratios to compare them over a longer period than one year, or a quarter. Small sample sizes can lead to misjudgments as the data is too small to make definitive statements.
I want to take a look at one more business, JP Morgan (JPM). Banks are a different breed, and their ROA tends to be much lower than other businesses.
We will use the latest 10-k for JP Morgan dated December 31, 2019.
We can see that JP Morgan had a net income of $36,431 for the year ending 2019.
Next, let’s look at the balance sheet for the total assets for JP Morgan.
From above we can see that JP Morgan had total assets of:
- 2019 $2,687,379
- 2019 $2,622,532
Let’s find the return on assets for JP Morgan.
Return on Assets = $36,431 / (( $2,687,379 + $2,622,532 )/2)
Return on Assets = $36,431 / $2,726,020
Return on Assets = 1.25%
As we can see, JP Morgan had a much lower return on assets than Microsoft, but within range of AT&T. Remember that banks are a special beast of their own and must treat them as a special circumstance, and you must compare them to other financials.
Ok, now that we have a handle of how to calculate a return on assets, let’s look at some pros and cons.
Pros and Cons of Return on Assets
One comparison between return on assets and return on equity is the relationship to how both ratios show that a company utilizes its resources. Return on equity only measures the equity of the company, leaving out the liabilities. The more leverage and debt a company takes on, the higher the return on equity versus the return on assets.
Advantages of a Return on Assets:
- Return on assets uses a percentage, which makes it much easier to compare across industries, also makes it easier to compare companies with different sizes of assets.
- The ratio is fairly easy to calculate; the inputs are simple and easy to find on the financial reports, the income statement, and balance sheet. Because of the ease of use, this ratio is easy to understand for non-accounting managers.
Disadvantages of using a return on assets:
- The main issue with using a return on assets is that the ratio can’t be used across industries. That’s because a company in tech and another company in oil will have different asset bases.
- Some analysts feel that the basic ROA formula is limited in its applications, being better suited for banks. Bank balance sheets better illustrate the real value of their assets and liabilities because they are carried at market value. Or, at the very least, an estimate of their market value, or historical market value, because both interest expense and interest income are already factored in. Both interest expense and interest income are terms specific to the banking industry.
- For non-financials, both debt and equity strictly separated.
There are additional formulas to calculate the return on assets for non-financial companies, but I like to keep it simple and consistent. The main strength of the ratio is the ability to quickly asses the effectiveness of the profitability of the company.
It is best used as a screener to weed out companies in an industry that you are looking for good investments. It can help you decide which is the better choice among several companies in the banking world, for example.
Industry Listing of Return on Assets
Now let’s look at some listings per industry for return on assets. Then we can compare some of the companies we did earlier to their industry averages and look at some others in their industry to see how they stack up.
Chart info provided by csimarket.com
For banks, the St. Louis Fed provides data on US bank ROAs. We can see that they have hovered around 1% since the Fed started tracking data in 1984.
Let’s look at a few comparisons using the companies that we used from above.
- AT&T 2.76%
- Verizon 6.70%
- Telecom Industry ROA average 2.89%
Based on the averages, it appears that AT&T is slightly below the industry average, where Verizon is quite a bit above the average. As I mentioned earlier, I believe that the decrease in net income has driven AT&Ts return on assets lower. The reason for a decrease would bear some investigation if we were interesting in investing in AT&T, or you could switch to looking deeper at Verizon.
Banking industry average ROA is 1.16%
- JP Morgan 1.35%
- Wells Fargo 1.02%
- US Bank 1.44%
- Bank of America 1.14%
- Ally 0.95%
Looking at the above numbers, it appears that both US Bank and JP Morgan have performed best when it comes to using their assets effectively. Wells Fargo has been on the struggle bus lately with all of their legal woes.
Retail defensive industry average ROA is 4.88%
- Walmart 3.15%
- Costco 8.22%
- Target 7.70%
- Dollar General 9.03%
- Kroger 3.78%
Interestingly, even though Walmart is by far the largest retailer, all the companies listed have performed better in regards to return on assets.
Software industry average ROA is 7.07%
- Microsoft 14.35%
- Adobe 14.94%
- Oracle 10.10%
- IBM 6.63%
- Accenture 16.74%
As we can see, almost all of the listed companies have outperformed the industry average ROA, except IBM. Microsoft has done well in regards to ROA.
For comparison’s sake, the overall return on assets for the S&P 500 as a whole is 2.87%.
Return on assets (ROA) is a simple, easy to use formula that gives us a ratio that we can use to analyze the effectiveness of any company. The ratio tells us quickly how well a company uses its assets to create more profits.
It is also best used as a screener to find companies that use their assets more effectively than their peers. It is not a great tool to find companies across different sectors like a bank versus a retailer, for example.
Return on assets is one of the main metrics I use when screening for banks, financials, brokerages, and insurance companies as it tells me who is good at using their assets to create more profits. Banks, in particular, use the funds they gather to create more profits through lending. And insurance companies create more profits from the insurance premiums they gather from customers and using those premiums to invest in fixed-income securities or growing their float.
Calculating return on assets is easy and should be included as one of your screening tools as you search for companies to buy, and it is especially useful in screening out competitors from each other. The key with screening companies is to find companies that are a hard no and moving on to others. Return on assets can help in that endeavor.
That is going to wrap up our discussion on return on assets.
As always, thank you for taking the time to read this post, and I hope you find some value that you can use on your investing journey.
If you have any questions or if I can be of any further assistance, please don’t hesitate to reach out.