Investors are no doubt familiar with the concept of “yield” in relation to their own share portfolios. However, they often find some other technical concepts, such as “return on equity” (ROE) and “return on assets” (ROA) slightly confusing. Both are measures of the efficiency of a company.
The return on assets (ROA) is the ratio obtained by dividing a company’s earnings before interest and tax (EBIT) by the gross tangible assets, expressed as a percentage. The calculations are best done using weighted average assets figures for the year.
A less commonly encountered variation of this theme is the return on capital employed (ROCE). Instead of using gross tangible assets in the denominator it uses gross tangible assets less current liabilities.
The return on equity (ROE) is the ratio obtained by dividing a company’s profit (net of preference dividends, if any) by the shareholders’ funds (net of preference capital and intangible assets, if any), expressed as a percentage. The calculations are best done using weighted average shareholders’ funds for the year.
The profit after tax is often used for this exercise, but using profit before tax gives more meaningful year-by-year comparisons if the rate of company tax changes.
The consistency in the numerator and denominator in all these ratios should be noted. If the former is “earnings before/after the deduction of interest” then the latter has to be “assets before/after the deduction of liabilities”.
If the ROA is less than the company’s weighted average cost of capital (WACC) then, unless this is rectified, continued trading will just destroy shareholder value. If the ROA is less than the risk-free Commonwealth bond interest rate then the investors would be better off if they put the company into voluntary liquidation and reinvested the proceeds elsewhere.
These ratios can also be used for comparing different companies with each other and for comparing a single company’s results from year to year. However, as important as these ratios can be in helping to identify companies which investors should avoid, they are less useful in picking bargains. This is because the ratios are independent of market price. A very efficient company might also constitute a very expensive investment, as when its price earnings ratio is unduly high.
Instinctively many people may feel uncomfortable when a listed company has huge liabilities in relation to its assets – especially if it is geared to the maximum extent possible. Yet in such a case the shareholders’ equity against the total assets will be small and thus an impressive-sounding ROE can result.
Of course, the result will be truly impressive only if the company performs well, but there is nothing wrong with that. By definition this particular yardstick takes into account a company’s profits from all sources.
To illustrate: If a company borrows money at, say, 9 per cent and then earns 16 per cent on the funds used in its business then those extra 7 percentage points are just as much a legitimate part of its total profits as when it deals in goods which cost it, say, $1000 to manufacture but which it then sells for $1500.
However, the instincts of those worried by the arithmetic are also correct. A heavily geared company is more risky than a lightly geared company, other things being equal. If the earnings rate on the borrowed funds which it is using are ever less than the interest rate which it is paying then it will go backwards. If its assets fall in value while its liabilities do not then it could even become insolvent.
While the return on equity figure is important, a prospective shareholder should never invest on the basis of just a single yardstick without taking other factors into consideration.
Some investors may wish to avoid companies entirely if they regard the level of their borrowings in relation to their assets as too high. Alternatively, they may be willing to accept the additional risk if they feel that the potential benefits in relation to the share price are sufficient to compensate them for this extra hazard.
The return on equity (ROE) is a measure of the efficiency of a company. It can be used by security analysts to complement the use of other yardsticks. The ROE is defined as the ratio obtained by dividing a company’s profit (net of preference dividends, if any) by the shareholders’ funds (net of preference capital and intangible assets, if any), expressed as a percentage.
The shareholders’ funds are often referred to as the equity in a company. By definition, the equity equals the company’s net assets, that is, its gross assets less its liabilities.
Another measure of efficiency is the return on assets (ROA). It is defined as the ratio obtained by dividing a company’s earnings before interest and tax (EBIT) by the gross tangible assets, expressed as a percentage.
These ratios are very much affected by the level of gearing. The figures in Table 1 show how to calculate the ratios and they also demonstrate the effect of changes in the gearing ratio (liabilities as a proportion of equity).
To aid understanding, these hypothetical figures show a deliberately simplified picture, to the extent that the liabilities are all treated as interest-bearing, which, of course, is not the case in practice.
Case A shows one set of assumptions. Case B shows the effect of a slightly higher earnings rate and Case C shows the effect of a slightly lower interest rate.
It will be noticed that at low gearing ratios the ROE is lower than the ROA. At high gearing ratios the reverse applies.
Table 2 shows the ratios for five very different companies selected at random, as derived from their latest annual reports. End-of-year figures have been used, although theoretically weighted average assets figures for the year would have been better.
The figures shown for Coles (CGJ) are probably not typical, because of the company’s disposal of the Myer stores during the year.
Two practical points for those wanting to do their own calculations: For companies with minority interests the calculations need to use the equity including these interests, not the lower equity of the shareholders in the listed parent company. The interest paid figure can usually be found in the notes to the accounts.