22 January 2014

ROE vs ROA

ROE (Return on Equities)

The formula of ROE can be described as Net Profit distributable to Shareholders divided by Total Shareholders Fund. My favorite breakdown of ROE formula is shown as below:

ROE =  Net Profit Margin x Asset Turnover x Equity Multiplier

In summary, ROE is a measurement of management on generating profit based on current shareholders fund. Some of the enterprises could boost up their performance via certain examples:

1. Increase Sales - By having more A&P activities and more distribution channels, the products could be reached to end clients in faster and broader ways. However, the net profit margin could be lowered down as operating expenses is increased.

2. Increase Operating Efficiency - By managing fixed costs (such as CAPEX) and variable costs (e.g. working capital & overhead costs etc), the total assets can be managed in optimal way. You may compare the Asset Turnover Ratio, Cash Conversion Cycle days with peers to find out how efficient the company can work at. I personally prefer those companies with good capital management, which means that they could have better bargaining power with clients / suppliers and it could reduce the risk of bad debts / inventory write off.

3. Achieve optimal corporate finance structure - In modern finance theory, a company could improve the ROE by obtaining optimal debt / equity ratio. Such practice is very common in REIT / Business REIT management as normally those companies would apply about 30% Debt / Equity ratio. A good corporate finance practice could increase ROE as well as reduce the default risk after accessing free cash flow.

ROA (Return on Assets)

ROA in general means Net Profit attributable to Shareholders divided by Total Assets.

The main difference of ROE & ROA is that ROA is ROE without Equity Multiplier. Some investors would like to compare ROA among peers while some prefer to compare ROE among peers. To me, I am ok with both measurement, and slightly adjust it with comparing ROE and debt ratio among peers. This would provide me a clearer picture of how a company perform against the peers.

In personal, I would prefer a company with ROA 10% and above and ROE 15% and above. While ROE/ROA may not be a good indicator for future earning growth, it definitely shows how a company could generate profits from the current assets / equities. Some companies may dilute EPS by issuing private placements or right issues for future earning growth. It will be resulted in lower EPS in near term but probably higher EPS in future (we have to do more homework to determine the impact of private placement / right issues). For example, Ezion try to get as much as oil & gas projects as it could by issuing both debt & equities placement. In this case, it can grow as fast as it could, but it also bring to another issue: how do Ezion reduce the working capital requirement later after the growth reaches its peak later.

Nonetheless, I think ROE & ROA is just part of the business assessment. We should look at business prospective such as the financial strength, relationship with suppliers & customers and competition against other ecosystem etc.

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