Return On Assets (ROA)
Return On Assets (ROA) is the ratio of how profitable a company is, relative to its total assets, and measures how efficient management is at using its assets to generate earnings.
ROA - Return On Assets
Return On Assets (ROA) is the ratio of how profitable a company is, relative to its total assets, and measures how efficient management is at using its assets to generate earnings. The ROA helps management and investors alike to identify how well the company's investment in assets is translated into profits. Sometimes Return On Assets is referred to as Return On Total Assets.
Return On Assets Formula
Return on Assets is calculated by dividing a company's annual earnings by its total assets, with ROA being displayed as a percentage. There are two formula for calculating Return On Assets: the first is:
The total assets may be calculated by using the total assets at the end of the period, or the average total assets may be used, by averaging the total assets at the start and end of the period. Both methods are acceptable.
The second formula expresses Return On Assets in terms of profit margin and total asset turnover:
Note that analysts prefer to eliminate cost of borrowing from the Return On Assets by adding back the interest expense into net income.
There are three versions of Return On Assets commonly use.
- Trailing ROA: the net income generated over the last 4 company quarters (12 months) period divided by the average total assets from the same period
- Quarterly ROA: the net income generated over the last quarter divided by the average total assets from the same period. The quarterly figure is usually converted to an annual percentage.
- Annual ROA: the net income generated from the last company fiscal year divided by the average total assets from the same period
Interpretation of ROA
Return On Assets is a key profitability ratio which measures the amount of profit made by a company per dollar of its assets. Unlike other profitability ratios, such as return on equity (ROE), ROA measurements include all of a company's assets – including those which arise from liabilities to creditors as well as those which arise from contributions by investors.
Return On Assets gives an indication of the capital intensity of the company, which will vary from industry to industry. Capital-intensive industries (such as railroads and thermal power plant) will yield a low ROA, since they must possess such valuable assets to do business. Shoestring operations (such as software companies and personal services firms) will have a high Return On Assets as their required assets are minimal. The number will vary widely across different industries. This is why, when using ROA as a comparative measure, it is best to compare it against a company's previous ROA figures or that of a similar company.
Good quantitative factors exhibit relationships with stock returns that not only have a fundamental and/or theoretical basis for stock returns but are also stable and persistent over time. In the case of Return On Assets, the fundamental formula (Net income/Total
Assets) doesn't make sense. The numerator is net income, i.e. what is available to common shareholders after interest payments have been made to bondholders. Net income is available to one class of capital providers. Whereas the denominator is assets, and is funded with both equity and debt.
The single factor analysis provided below shows that Return On Assets does not perform as well as other metrics, such as Return On Investment.
Single factor tests using the ROA only showed promise with a long investment horizon (1 year) using Trailing ROA and a SmallCap stock universe. The investment horizon is referred to as "rebalance period" by Quantitative Analysts. The rebalance period is the time a stock is held prior to refreshing the portfolio holdings.
The Quantitative Analyst assesses individual stock factors by:
- separating the stocks into quintiles (or deciles) based on the value of the factor
- calculating the performance of each quintile based on rebalance period and total back-test period
- analyzing the spread of performance between Quintile 1 to Quintile 5
Ideally the performance spread should be "monotonic", meaning that Quintile 1 outperforms Quintile 2, Quintile 2 outperforms Quintile 3, and so forth.
Using the process described above, the stocks from the Russell2000 Index (SmallCap stock universe) were evaluated over the 10 year back-test period 2005-2014 with a 3 month rebalance period and yearly rebalance period, using the Trailing Return On Investment.
In Quantitative Analysis, single factor back-tests are not executed to generate real-life performance figures or to outdo a benchmark. At this stage the Technical Analyst is simply trying to identify whether the stock factor contains useful predictive value.
As can be seen from the above, the yearly rebalance chart shows monotonic behavior but not a uniform spread. None of the other rebalance periods or rebalance periods exhibited monotonic spread. Thus the Return On Assets stock factor is not a great quantitative metric and should be used with caution.
There are many other considerations involved in the construction of a portfolio that will change the performance numbers.