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IF58: Efficiency and Financial Ratios Formulas: ROA, ROE, & ROC

 

financial ratio formulas

Welcome to Investing for Beginners podcast, this is episode 58. Tonight Andrew and I are going to talk about financial ratios and we’re going to talk about some ones that we have not discussed before so this will be fun.

We’re going to take a shot at talking about return on assets, return on equity, and return on invested capital as well as maybe a few other tidbits so Andrew why don’t you go ahead and take our first shot at return on assets.

Andrew: okay yeah I could do that. Return on assets so basically the three of these ratios a good way to think about them is they’re kind of like efficiency ratios. They are ways to evaluate whether a business is good at creating cash with what they have.

We’ve talked about some ratios in the past we talked about valuations episode 11 really good for that so we should I think we also talked about the cash flow statement I know we did that we might have done the income statement so we’re trying to piecemeal these lessons here and there.

These efficiency ratios are good to keep in your back pocket for doing the kind of stuff that some of these value investors like to do I know Buffett likes to use efficiency ratios like I think he uses ROE, Joel Greenblatt uses ROIC so these are some good ones to know and to understand obviously some of these accounting metrics are a little bit hard to conceptualize if you aren’t familiar with financial statements.

I would recommend maybe that’s a little bit over your head to try to learn some of the basics first try to tackle a financial statement and then maybe go back to an episode like this and then you can really comprehend return on assets. so that’s simple like it sounds so when you hear all of these return they’re basically talking about like what a company is able to create as far as profits go so the simplest way to use this equation as to say return is net income and then you divide it by assets which is total assets.

Pretty self-explanatory I would say you think about the type of businesses that are going to be scoring better on both return on assets and return on equity one that comes to mind would be like a Facebook right where they don’t need as many assets pretty much any financial website or why did I say financial that at least my brains on somewhat of the right general topic.

But any website any business that isn’t very capital intensive doesn’t need huge expensive factories in order to run they’re generally going to score really well on ROA or ROE and so I think ROE is also self-explanatory Dave do you want to talk about that one and talk about anything I missed about our way.

Dave: yeah the ROA what I like about it is it’s obviously it’s very simple to calculate and as Andrew was saying it is an efficiency ratio and I think that the thing that I like about return on assets is it gives you it gives you an idea of how effectively the company is converting its money into income.

And obviously the higher the number the better it is and so as Andrew and I like to talk about a lot assets are really was drive a business earning more money and when you think about return on assets the best way to think about it when you’re using it as a way to value a company is to look at the financial ratio as a comparison to like companies.

So for example you wouldn’t take a railroad and look at the return on assets and compare that to a bank or you wouldn’t take the railroad and compare it to Facebook because there are two different types of businesses. Where it’s going to be most effective is when you’re going to use it in in a relationship to other like to like businesses.

Let’s say  the fang stocks which was  all the rage so if you take Facebook and maybe Google or alphabet and compare those return on assets those it’s going to be more even comparison than it would be if you took Facebook and compared to Wells Fargo for example those would not be the similar type of assets.

And when you also think about those types of assets you also have to look at the business that it’s in so a return on assets for a company that has less assets it’s going to be a much I guess lower number is the best way of putting it. Because Facebook is what you would consider kind of an asset light company because their assets are really more based on their technology and they don’t have hard physical stuff.

When you think about a railroad or you think about Walmart  they got stuff they got buildings and they got distribution centers and they got equipment and they have all the product they can have and all those things are physical things and that’s that’s what I think of when I think of assets and this is not a diss on Facebook in comparison they just don’t have that kind of stuff they don’t have lots of things sitting around it’s more about the people that are working in their brain power is what generates the assets for their company.

And so when you’re looking at return on assets to me you have to always use it in comparison to another company trying to compare it to because it’s going to give you a much better feel for whether the return on assets for this particular company is good or not and also you also want to look at the type of industry that it’s in.

If you’re looking at banks then you’re going to want to compare to other banks so you’re going to compare JPMorgan to Wells Fargo to Bank of America to  whoever US bank whatever bank that you’re comparing or to that that will give you a really good idea of whether return on assets is a good number for Wells Fargo whereas the same would apply if you’re looking in the technology sector so you’re looking at Microsoft and Facebook and Amazon is other types of companies that you can think of that would give you a better number with return on assets.

It’s a super easy formula to calculate and it takes just a few seconds to figure out the biggest issue with it is just understanding what it is that you’re comparing to when you’re looking at efficiency ratios you always want to think about how that’s comparing things to things okay so I think I’ve beaten that into the deaths so Andrew did you want anything else.

Andrew: yeah my question I guess when you have companies with goodwill and stuff right because goodwill is a way to measure basically what the company’s assets is that’s not like all physical thing like you said.

An example of goodwill would be this example gets used all the time but whatever Hershey’s Buffett likes the type of businesses that have brand names like Hershey’s or Coca-Cola because not only are their factories valuable but the fact that people love these brands is so valuable so sometimes you can’t put a dollar amount on exactly how much people love a certain brand.

So accountants will try to do that with metric on the balance sheet that they call goodwill they also refer to as intangible assets sometimes those terms are interchangeable but it’s basically talking about similar things.

My question for you is  how would will affect our ROA or ROE because they’re essentially looking at very similar things and what kind of problems could arise from a goodwill calculation being wrong and being too aggressive or being too conservative on how valuable company’s brand or their patents or any of those things really are.

Dave: well you gotta take it I guess business by business really because goodwill is it’s really kind of a what’s the word uh there’s a there’s a term I heard Buffett used for it it’s kind of a catch-all for wherever accountants want to throw things that they’re not really sure what they want to do with.

And it can be misleading and they can use it to hide a lot of gobbledygook in there that really is not an asset and I know that when I have done when I look at owner earnings for example goodwill is excluded from that Buffett doesn’t consider it a valid asset and he’s the one that kind of came up with us owner earnings topic and this is for a whole another discussion.

But I guess where I’m going with that is I always think of goodwill as it I really have to dive into what’s really in that number because like you said it can some companies will delineate on the statement what the items are in goodwill and other ones will not they’ll just if there’s goodwill and there’s two point two billion dollars of it what is that so then you have to go to the footnote.

So you have to try to dig through and find out what it is and it can really lead you down a really big rabbit hole and I know when you’re calculating just return on assets the goodwill is not something that’s generally discussed because of that very fact that it can be it can be misleading and it can it can also be intangible such that it’s something that doesn’t really and one say it doesn’t affect the business.

But it could be something that is not really it’s really hard to put a value on does that make sense?

Andrew: yeah totally so you think it would be fair to say that a business that’s maybe less asset you I think you say asset like asset heavy so how business that’s more asset light doesn’t need as much capital doesn’t as many assets. and if it’s also additionally kind of have a higher proportion of goodwill comprising their assets that maybe ROA would not be a good efficiency ratio to use oh yeah particular company.

Dave: yeah that’s kind of that’s kind of how I would think of it yeah.

Andrew: well I mean I thought we should present that to ya don’t do are we

Dave: yes so return on equity return on equity again a very simple ratio to calculate and it is our friend net income divided by shareholder equity and return on equity is a great way for a company to illustrate how much money it’s making on its equity. So for every dollar of equity you have how many dollars can you make your income and again the higher the ratio the better it is and excuse me again it really comes back to looking at using return on equity as a comparison to other like businesses you wouldn’t want to compare the return on equity of Berkshire Hathaway to Facebook.

There’s just there’s it’s not the same they’re not the same businesses so you’re going to want to use that to help you’re going to want to have the return on equity match the type of business that you’re comparing it to. And it’s super easy to calculate and it’s something that I do whenever I look at any type of company.

Andrew: so I guess the difference between an ROA and ROE in this case would because really going to shareholders equity rather than total assets. So the problem with total assets is that  if a company has a bunch of total liabilities to go along with it think like Lehman Brothers had plenty total assets but plenty of total liabilities to go along with it.

You’re maybe potentially getting yourself into a stock that seems like it has a great return on what that’s bringing in but it’s fueling that return with a bunch of debt right yep or a bunch of expenses whatever comes up as liabilities that’s going to make shareholders equity lower. That’s where return on equity can come in and then you can say okay now we’re kind of killing two birds with one stone because we’re looking at profitability as it relates to assets.

But the less that we have the higher the equity is going to be and so you can look at the business and say wow they’re really able to make that many that much money that much profit that much earnings out of such a such a small equity amount and they’re doing it taking on less debt and that becomes even more impressive than a company with either lower ROE or like a high ROA but low ROE.

I think those can kind of be useful in that way I personally don’t use either and I’ll kind of describe why but just from a surface level I would say I’d probably prefer to use ROA and not really use ROA it just seems like ROE just makes more sense in my head and it can already covers what ROA would cover but then also gives you that liability consideration to go along with it.

Dave: yes I would agree with that the big reason why I use them is because I invest in banks and you do not and return on assets and return on equity are two ratios that are very helpful in comparing how your bank is doing compared to other banks in in the industry.

When you’re looking at JPMorgan and you want to go hey is this  besides doing other valuation metrics you can also look at these two ratios and they can help you determine whether they’re really doing a good job compared to their peers or their sucking compared to their peers. And so it could be helpful in that regard and that’s what I use them for.

If I’m looking and investing in I don’t know Berkshire Hathaway no I wouldn’t use it but if I am looking at  any sort of financial and just institution whether it’s a bank a financial an investment bank or an insurance company I would definitely use them because they are helpful in comparing like industries.

Andrew: how that if you’re looking at several years is it maybe it goes without saying that if you find a company with increasing ROE  every year that’s going to be more favorable to one that’s maybe decreasing but might be higher at the time or does that exact like against basis by basis situation.

Dave: no it’s you definitely you want to look at it for example I was just doing some research on JP Morgan just recently and I was noticing that their return on equity had been increasing over the last two or three years and I started looking at a quarter by quarter just to kind of delve more into it to understand what it was I was looking at I was comparing it to Wells Fargo who has been going through lots and lots of legal hits  just every time you turn around its body blow body blue and so they dug their own hole so they’re there they’re reaping what they sown.

But when you look at the return on equity comparing JP Morgan whose stock prices shot up compared to Wells Fargo’s you can also see the difference in the return on equity and return on assets that they’ve done a much better job.

Andrew: would you consider these metrics like kind of growth component rather than value?

Dave: yes.

Andrew: cool these easy questions easy answers yeah we should also probably cover return on capital so how would you describe that.

Dave: how would I describe return on capital?

Andrew: and this is this is a tricky one because go ahead if anybody out there questions  the this ratio just tried to google and see that you get like five different answers so that’s why I asked generally how would you answer this question.

Dave: um well let me look at Investopedia.

Andrew: I’ll tell you how I would define it okay how it the way I look at it is it’s just return on equity adding debt to the equation so when i mentioned before you have ROA and ROE and return on equity is basically taking liabilities into account right so then when you look at return on capital it’s doing the same kind of thing but now instead of just looking at making sure we can see their liabilities we’re also making sure we consider debt.

Are these liabilities comprised of a lot of debt or are they like quote unquote good liabilities where they’re more they’re more like expenses that you need to run the business rather than debt where you need to make that payments and there’s interests attached to it.

I hope that makes sense from an audio medium basically when you when you look at the difference between total assets and shareholders equity which is a difference between return on assets and return on equity. We’re looking at total assets and then when you – when you take out total liabilities from total assets that’s how you get a shareholders equity.

When you want to look at return on capital when they’re talking about capital they’re talking about basically it’s what the equity what’s freed up from the equity. So basically the logic behind the equation is that sure you might have these assets but in the worst case let’s say all your debt needed to be paid today.

Well you’re going to have to sell off some of those assets in order to make that debt square so that’s where that and then what you have left after making those debts clean then that would be your capital. That’s why they say return on capital so to go from return on equity to return on capital we’re taking the same return on equity equation and we’re just adding liabilities to the shareholders equity.

Again we’re generally still looking at net income on the top and then on the bottom you’re considering what the equity that the business has is plus how much do they owe as far as that goes so taking those liabilities a step further. And that’s really going to tell you I think maybe you’re getting a little too detailed in the sense because I can see it being useful where you have similar businesses but ones may be better at keeping the business lean not over compensating for management right.

Because if businesses have returned similar return on equity then that means their liability number is going to be generally the same mostly but then if the return on capital is way different well then maybe one business loaded up on the bunch of debt. but was able to cut corners and other aspects to kind of make it balance it out but then you can’t hide the fact that you have a lot of debt and return on capital.

That would be like a potential upside to using return on capital and I know if you go on Google and you search sometimes they’ll talk about instead of earnings or net income they’ll talk about subtracting dividends from it or they’ll talk about operating income and so looking at earnings in a different way and trying to figure out the operating side without looking at how a company is investing or financing.

That’s kind of like the breakdown behind it and can be useful I know like I mentioned at the top of the show Joel Greenblatt likes to use his version of return on capital and he combines that with the earnings yield which is the inverse of price to earnings ratio so that’s his way of finding kind of like a growth and value mix and that can be something useful if it’s something you’re willing to dig into and kind of commit to at least understanding okay this is what we mean by capital and if the logic behind it is sound.

You want businesses that are able to create profits and are if they’re able to do it without needing very much capital or equity or assets then the whole idea behind that is that well now you can scale much faster.

Because the more money you need to create money the slower your gross going to be but if the if the cut if the business is more lean if it’s more efficient then as it say they have a record year of profits well now you pile that in and you reinvest it now you can double triple quadruple multiply how much you can make in the next year compared to maybe a business where they might have record year profits but to create a whole new to create growth they might need to build a whole new manufacturing plant in another city.

And so they can’t build they can only build one plant whereas a company that can build five offices and 5x their income well that’s the kind of thing that like a high return on capital return on assets return on equity ratio has the potential to be able to show you as far as opportunity for growth.

I think that’s something that’s key to understand if you’re really looking at learning about these and applying them to an investment thesis.

Dave: so do you see any downsides to this?

Andrew: I mean I won’t call it a downside per se I would just say there’s kind of other ways of looking at the same thing okay so I’ll say this like you may it sounds like I know a lot about these ratios but  why don’t I use them myself personally.

I think for one return on capital return on assets return on equity I think I can fluctuate over the years and so like if and I’m not saying that anybody who uses these ratios is doing this but I would say like I think it’s easier for businesses to improve margins that that’s kind of the way that people reference it a lot when they when they talk about profits and earnings and all those things and they talk about in the business sense.

Like that’s kind of why I like to to favor making sure that I’m getting more assets with my investments with like a kind of like a more of a margin of safety approach right. because a company might have great return on equity for a year two year three years whatever that’s great um and to me that’s the same as like having a great earrnings picture.

But as a value master you have to think okay would I prefer to buy a company that has better return on equity return on assets and better growth in those in those metrics or would I prefer to get these assets at the discount and hope that they can improve return on equity return on assets. And so I think that’s kind of a consider for thinking about using these ratios just how does it relate to a value investing approach.

Return on equity and assets is something that can always be improved and it’s always going to change throughout the years you’re going to see it fluctuate it’s going to fluctuate with this the cyclical nature of an economy and an industry. a company  if the industry as a whole is having a really strong year well then they’re going to have really strong return on equity and so if you understand that that’s the reason why and again comparing it to other businesses in their industry maybe that was a poor example to bring up.

But let’s say a company had a lawsuit that just they just won favorably and so they got like a bunch of earnings to come in all in the year so their return on equity just shot up for a year compared to their competitors. well that might not be necessarily a good indication of a long term growth right and so you kind of have to think of it in that way and it’s like okay well do I want to buy businesses that are increasing return on equity but maybe like decreasing their total shareholders equity.

I like to look at growth and I like to look at there are the earnings growing and there’s the asset or the assets growing and basically what I’m saying by that is the shareholders equity growing is the book value growing. because you could have a company where the return on equity is increasing even though earnings stay constant because they are selling off assets on their shareholders equities going down.

I hope that makes sense to is that if you’re going to use return on equity to be cognizant of well where is the book value moving because the book value could be going down which is bad but that’s going to make the return on equity go up which looks good when it’s in fact not.

I mean that’s pretty much what we had today as far as a couple efficiency ratios a couple financial ratios you’ll hear if you ever dive into finance you ever dive in The Wall Street you dive into some of the stuff that they kind of used in the industry and when they talk and focus more on growth and less on value.

That’s why you’ll hear some of some of these metrics we didn’t talk about all of them obviously and there’s stuff like operating margins and lots of fun different textbook level type stuff. Obviously Dave and I like to take a value approach we like to focus on what’s the value of the business and how does it relate to what the stock market is pricing it for us at.

And so obviously profitability becomes a factor in valuation but it’s definitely not the whole picture and that’s why we talk a lot about margin of safety and price based ratios and valuations and things of that nature so keep that in mind hopefully you saw kind of the pros and the cons behind some of these and although it’s not as easy as kind of seeing it visually on the screen or practicing with a ratio yourself it does makes for some good discussion and some good kind of mind dancing that you have to do in order to understand okay this is why this is why this is useful and this is how I can apply it.

And glad Dave brought up the whole like making sure that you’re within the industry and comparing inside of there and looking over several years because that can be a useful tool.

As far as a couple of bookkeeping things at the very end before we wrap up I’m going to be in Omaha this weekend so I’m hoping this post goes live by then Dave do  yes I will okay. it’s going to be live so you’re going to hear this probably maybe you’ll be on the way to Omaha like I will be listening to this on the airplane or in your car.

But if you’re wanting to get like inside scoop on what’s going on at the meeting I want to be posting my whole weekend on Instagram put like a story together and just put little snippets or film Buffet and I’ll be meeting up with Preston and Stig from the Investors Podcast.

I’ve been on Preston’s I’ve been on their podcast once before before they got famous but uh I’ll be meeting up with them so you’ll probably see pictures from that meetup on Instagram as well so if that’s something you’re interested in seeing you can follow me at house of sloth it’s mostly a personal one but I may be putting some of my stock market stuff in there too.

That’s something to check out if you’re interested in Warren Buffett and all that good stuff one other thing I want to say before we wrap up. got a cool email from Josh he says I’m a he said he had a couple of questions with the last part he said I’m a novice and just getting into value investing and as much as I’m investing in the market I’m lockstep with your stock values as well as Dave Ahern, Corning the exception however I do love was debate slash devil advocate thoughts.

Dave, the way I interpreted it as Andrew scores one and you scored zero because you said Corning the exceptions so it means he didn’t he likes he’s lockstep with all of your stock values except for your ideas morning that’s corny and even though as negative earnings yeah so we’re talking about one of the older episodes it was episode 53 or Dave and I had a little friendly debate.

I want actually everybody listening to solve the debate for us so I’m going to set up a Twitter poll and I’m going to say  when it comes to negative earnings do you sell automatically it’s going to be one choice or does it depend on the company and so depending on how you guys vote is going to decide whether Dave was right or I’m right so follow me at value trap blog if you want to vote for the poll I’ll leave that up and we’ll see what the masses say because right now I have a 100 lead and it’s feeling really nice.

Dave: and it should it should feel nice.

Andrew: yeah I mean and it’s like with Kershaw on the mound and you guys are down by one I mean that’s it’s in the back.

Dave: I sure do yes I do although my Giants have been hanging in there so far so I’m  you give me Johnny Cueto I’ll take that bet okay well maybe we’ll see each other later on the in yeah maybe that would be nice.

All right folks well that’s going to wrap up our conversation tonight I hope you enjoyed our discussion on financial ratios and also Andrews a little tidbit about his trip to Berkshire. I’m very jealous I will be going next year I promise you that and so you guys go out and invest with the margin of safety emphasis on the safety find some great intrinsic value and have a great week.

I’ll talk to you next week