Investors often look for the magic number or metric that will identify a great stock out of the universe of all stocks.
This magic number doesn’t exist.
However, when you are considering stocks to buy, there are certain metrics and numbers that are more important than others.
They can’t be used as the sole qualifier to determine great stocks, but you can use them to eliminate poor performers.
You must always look at the big picture when considering a stock and that means considering a number of metrics.
Return on Assets is one of the handful of really important metrics every investor should know.
Return on Assets (ROA) tells you how efficiently (or inefficiently) a company turns assets into net income. It is a way to tell at a glance how profitable a company is.
Consider that companies take capital from investors and turn it into profits, which are in turn returned to the investor in one form or another.
ROA measures how efficiently the company does this.
Obviously, the more efficient a company is in converting assets (capital) into profits, the more attractive it will be to investors.
That’s about as simple as it comes: companies that make more money for the owners are worth more than companies that don’t make as much money.
ROA is made up of two components: net margin and asset turnover. When used together, these two metrics tell an important story.
First, a quick review. Net margin is found by dividing net income by sales. Net margin reveals what percentage of each dollar in sales and company retains.
Companies that wring lots of profit out of each dollar of sales have a big advantage, but it is not the final answer.
The other component is asset turnover, which gives you an idea of how well a company does in producing sales from its assets. You find asset turnover by dividing sales by assets.
Once you have net margin and asset turnover, multiply them together to determine ROA. You now have an idea of how well a company can convert assets into profits. Companies with high ROA compared to their peers are more efficient at using assets to generate profits.
You can calculate ROA for yourself or you can use one of the Web sites that has done all the math for you. One site that offers ROA is Morningstar.com.
Even if you don’t do the calculations yourself, it is important to know how the numbers are generated.
ROA shows how companies have two choices in improving efficiency.
Companies can raise prices and create high margins or rapidly move assets through the company. Either way (or both) improves ROA.
It is important to compare companies in the same industries. Some industries traditionally have higher margins or asset turnover than other industries do.
ROA is an important measure to use and understand, but its flaw is that the metric does not consider the effect of borrowed capital.
The next column will look at Return on Equity, which does consider the importance of borrowed money (leverage).