Education: Growth & Income Investing

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Figuring the Return on Assets

If you were privileged enough to read my article covering return on equity, you are familiar with one of the drawbacks of the calculation—its inability to account for company debt. Well, have no fear, ROA is here.

ROA, an acronym for return on assets, helps investors gauge how well a company uses its financing from borrowing and bonds. ROA serves as a nice complement to ROE. Let’s learn why.

Return on Assets Defined

Similar to return on equity, return on assets is another important profitability metric that investors can utilize. ROA tells an investor how much profit a company generated for each $1 in assets, and is calculated as follows:

ROA = Net Income/Total Assets

Net income is simply a company’s profits or bottom line. Total assets include both current and long-term assets. Current assets can include cash, accounts receivables (money which is owed to a company by its customers), inventory, etc. These are generally assets that can be converted to cash within one year. Long-term assets are assets that are expected to be in use for more than one year—property, equipment, etc.

Net income can be found on a company’s income statement, while total assets reside on its balance sheet.

Getting Our Hands Dirty

Let's calculate ROA for The Boeing Company for 2006. To get the necessary data, go to www.zacks.com and enter Boeing’s ticker (BA) into the cell in the upper left hand corner and hit the Go button. Under Quotes and Research, click on Financials and then Income Statement. Scroll down to the bottom where you will find the company’s net income for 2006—$2.22 billion.

Next, click on the Balance Sheet link (next to the Income Statement link). Scroll down towards the bottom of the statement and locate the figure next to Total Assets—$51.79 billion.

Going back to our formula above, take the $2.22 billion in net income and divide that figure by the $51.79 billion in total assets. This produces a return on assets of 0.04, or 4%. This figure tells us that in 2006 Boeing earned a 4% profit on the resources it owned or four cents for each $1 in assets. Is this good or bad? Let’s dig a little deeper.

Comparison Shopping

Is a 4% return on assets good for The Boeing Company? As you have most likely heard us mention time and time again, no ratio should ever be used as a stand-alone measure to pinpoint potential purchases—and this includes ROA.

One would need to determine what the ROA of the industry is in which Boeing participates—the aerospace/defense industry. If the industry average is below that of Boeing’s, we can infer that the company’s management team is doing a better job than its competitors. This would be welcome news to investors.

It would also be a good idea to track the progress of Boeing’s ROA. Good management will strive to extract greater profit from every dollar of assets at its disposal, leading to an increasing ROA. Investors should calculate this measure over the past few years to determine whether or not management has been successful in doing so. A falling ROA can be a sign of trouble.

Following the same steps outlined earlier in calculating Boeing’s ROA for 2006, you can also run the calculation on an annual basis back to 2002 on zacks.com. Comparing its 5-year average to the industry can also prove beneficial.

Avoid the Pitfalls

ROA can’t always be trusted—sort of like…well…I will let you fill in that blank.

One thing to keep in mind is that the number used for total assets in the ROA equation pertains specifically to fixed assets. Fixed assets are long-term tangible pieces of property owned by a company and used in the production of its income. A good example would be a building or a piece of equipment.

What is left out of the equation are intangible assets—assets that are not physical in nature. Examples include patents, trademarks, copyrights, brand recognition, etc. Boeing, in our earlier example, will most likely have more assets on its balance sheet than say a software maker. Constructing an airplane requires big, expensive machinery or equipment to generate a profit. Putting together a software program is quite the contrary. One can also consider a company like The Walt Disney Company. The Disney name is extremely valuable but it is not reflected in the company’s balance sheet in terms of an asset.

Another thing to keep in mind is the net income figure used in the numerator of the ROA equation. I don’t think I need to tell you that some companies have a tendency to “massage” that figure. I will leave it at that…

ROA, Earnings, and Zacks Rank, Oh My!

The higher the ROA number, the better it is perceived. But what is considered high enough? Since return on assets can vary greatly from company to company, the importance of comparing a company’s ROA with that of the industry was mentioned earlier. It also helps to compare the company’s measure against its previous ROA numbers. When you throw two more ingredients into the mix—earnings estimate revisions and the Zacks rank—you definitely have something cooking.

When you find a stock that has a ROA that is greater than the industry average, and one that has been steadily increasing, the next step would be to see in what direction analysts are revising their earnings estimates for the company. When a flurry of analysts is submitting positive revisions to their earnings estimates, this is a good sign. The company is moving in the right direction and analysts have come to this realization. This should lead to an attractive Zacks Rank (Learn more about the Zacks Rank). A steady stream of positive earnings estimate revisions is most likely fueled by strong management and an excellent product line. Companies of this nature are most likely great candidates for long-term ownership and fit right into the hands of growth and income investors.