A reader contacted me recently asking about the difference between return on assets (RoA) and return on equity (RoE) as her broker offers both and they’re different values, with RoA being higher than RoE. She also wanted to know which was better to use when looking at a company.
Typically, one uses RoE, but first let’s delve into what each one is before we decide which, if any, is better to use.
Return on assets
RoA is also sometimes called return on investments (RoI). To work it out, first we need to determine the assets of a company – this is easy as they can be found on the balance sheet. All assets will be listed along with the total value for them.
Assets include things such as cash (easy to value), property and equipment (harder to value) and intangible things such as brand value, which are almost impossible to value.
There will also be goodwill included in the asset value. This is created when a company is bought for a higher value than its net asset value (NAV), with the difference being goodwill and added to the balance sheet as an asset.
When using the asset value, I would definitely strip out any goodwill from the equation – sure, it was paid for but it doesn’t really belong on a balance sheet, in my mind.
So once we’ve determined the value of the tangible assets, we find the profit for the previous year and we divide that by the asset value. We then get an RoA as a percentage – in other words, the percentage of profit the assets generate. For example, assets of R1m and profits of R200 000 would result in a RoA of 20%.
This number on its own is not of much use; you’ll have to compare it to previous years’ RoAs and that of industry peers to determine how good it is. Also have a look at the trend – is the percentage increasing or decreasing? It is also worth looking at the value of the assets – is it increasing or decreasing? At what speed? A sudden revaluation of a property, for example, could push the asset value higher and hence RoA lower.
Return on equity
This also takes into account the liabilities a company has, as equity is assets less liabilities. For the most part, these liabilities would be debt.
So equity will always be a lower number than just straight assets and another phrase for equity is NAV. This NAV is the breakup value of the company – if all debts were to be paid and all assets were to be sold, NAV is the resulting pile of cash left over. Tangible NAV (TNAV) excludes non-tangible assets like goodwill and, again, this is my preferred number.
Once we have the equity value, we use the same formula as above for RoA to get to the RoE and again we’d compare it against previous years for the company and against peers in the industry.
Be very careful of comparing across industries as they have different asset requirements. For example, a trucking firm will have a lot of assets in the form of expensive trucks boosting assets overall and reducing RoA, whereas an IT company may likely have a much lower asset base, making for a much higher RoA.
Personally, I prefer RoE as it takes debt into account, and we cannot ignore debt. An RoA could be high and increasing, but if debt is out of control and/or increasing even faster, then your RoA doesn’t mean much as the company could run into trouble servicing its debts.
At the end of the day both can be used and there is no reason why not, but if you’re only going to use one make it the RoE.
This article originally appeared in the 1 September edition of finweek. Buy and download the magazine here.