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Monday, June 21, 1999

FOOL ON THE HILL
An Investment Opinion
by Paul Larson

Ask the average investor how Return on Assets (ROA) is calculated and he or she will probably give you the following equation:

```           Net Income
ROA  =   -------------
Total Assets
```

While the above equation is absolutely correct, there is another way of arriving at ROA that is very insightful to both investors and managers. It involves using two seemingly dissimilar efficiency metrics that often get overlooked. The alternative route to ROA is the following:

Return on Assets = Asset Turnover X Net Margins

Break the two halves of the above equation down mathematically a bit further and we see why this works. Asset turnover is defined as trailing sales divided by total assets, and net margin is defined as net income divided by sales. The "sales" cancel each other out from the two fractions and we are left with our original equation of ROA equaling income divided by assets.
```ROA     =       Sales                Net Income
----------      X    -------------
Total Assets              Sales
```

What's the point here? Stick with me, this is more than just a boring math exercise. The point is that many investors seem to have it ingrained in their heads that "low margin businesses are bad." The common thought is that the higher margins a company can achieve, the better. However, looking at margins in solitude without looking at how efficiently a company uses its assets is practically useless.

The above equations should tell you that a low-margin business turning its assets over very frequently can be just as successful as a high margin business that lumbers with its assets. It's a bimodal equation, and having a company efficiently using its assets is equally as important as achieving high margins. Having high margins doesn't do you much good if you can't get sufficient sales volume. Likewise, having high revenue doesn't mean a whole lot if the profit margin is not there.

Plotting both asset turnover and net margin on a simple four-quadrant chart, the desirability and efficiency in regard to ROA might look something like this:
```
Asset Turnover
High             Low
M
A  High  Best            Good
R      (Dell)         (Microsoft)
G
I  Low  Good              Poor
N    (Wal-Mart)     (Bethlehem Steel)

```

In picking out high-profile companies that fit the above model, Dell (Nasdaq: DELL) was the best "best" I could come up with. Dell has net margins of 8.0% (versus about 5.4% for the rest of the market) and asset turnover of 3.3 times (versus 0.5 times for the average public company). The company is in the "best" category, but more accurately plotted it would probably be somewhere in the middle between Microsoft and Wal-Mart.

Microsoft (Nasdaq: MSFT) has margins to die for, 40.3% net, but it only managed to turn its assets over 0.6 times in the last twelve months. Back before Microsoft had more cash than what it knew what to do with, it was well into the "Best" category of ROA heaven. This was obviously a boon to the company's shareholders and among the factors that made Bill Gates as insanely wealthy as he is. For reference sake, Microsoft now has \$21.5 billion in cash on the asset side of its balance sheet. This means roughly 65% of the company's assets are tied up in cash, which is a major drag on the company's ROA and why it has shifted right on the above chart. (Yo, Bill! Think about buying some more shares back!)

And then there's Wal-Mart (NYSE: WMT) sitting there in the lower left quadrant of the above chart. The company has margins of a mere 3.3% but turned its assets over 2.9 times in the last year. Best Buy (NYSE: BBY) has also gotten on the efficiency bandwagon and turned its assets 4.4 times even while margins were a comparatively thin 2.4%. Just like there is more than one way to skin a cat, it should hopefully be apparent that there is more than one way companies can get a return on their investment.

In other words, it's not really prudent to dismiss companies with low margins without first seeing how they use their assets, too. This is especially relevant for those interested in the emerging e-commerce explosion. Many companies operating solely on the Internet may be operating with relatively low gross and net margins, yet they are not hobbled with billions worth of assets tied up in bricks, mortar, and inventory. Amazon (Nasdaq: AMZN) instantly comes to mind as do numerous other e-commerce companies as examples of firms that are taking the low-margin, high-turnover approach to, hopefully, eventual profitability. (For more on this thought, check this out.)

Thinking about ROA in this different way may also help explain why eBay (Nasdaq: EBAY) has been bid to nosebleed levels. EBay already has extremely high margins for such a young company, 84.9% gross and 17.4% net in the most recent quarter. Plus, the company has an extreme amount of leverage at its disposal to increase its top line, technical embarrassments aside. Without adding a dime to its nonexistent inventory and investing minimal amounts in its physical operations, the company has the ability to exponentially grow sales. Over the past year eBay has managed to grow its sales at triple the rate that its property, plant, and equipment has grown. Smell those asset turns kicking into turbo?

Rewind ten years and try to think about a company that had the types of massive operating leverage eBay and many other "new era" companies enjoy today. Can't think of one? Me neither. (Except for maybe Microsoft, maybe.)

It's also worth noting that one can substitute "invested capital" in the above figures and equations to calculate a more meaningful and important ratio than ROA, Return on Invested Capital (ROIC). While an extremely important number for companies and investors alike, figuring out exactly how much "invested capital" a company has is not so cut and dried. Some assets, such as goodwill, are obviously accounting relics and not invested capital, but exactly how to back out other numbers such as "excess cash" is not so clear. Get ten analysts in a room, ask them to calculate a given company's invested capital, and you are likely to get ten different answers with none of them being incorrect.

Regardless, the above equations work equally well when thinking about ROA and ROIC, even if ROIC varies a bit from one person's analysis to the other. The point of this whole exercise in math is to help both investors and business managers think better about what strategies different businesses may use to generate shareholder value.

If there's one take-home message in this whole column it is the following: Margins are important, but to get the true efficiency of a company margins must be taken in the context of how often a company can turn its capital. It's not one metric or the other that matters, but both.

Related Articles:
-- How to Value Stocks (Fool's School)

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