Q. How do you calculate return on assets, and what does it tell you?
A. You've probably heard the term "capital-intensive" and you probably have an idea of what it means. A steel company is capital-intensive, requiring a lot of costly equipment to generate its earnings. Software companies typically have a much lighter business model. Once the software has been developed, it's simply a matter of copying it onto disks, packaging it, and marketing it. Lighter, less capital-intensive companies tend to be more attractive investments on many counts.
You can measure a company's asset-heaviness by calculating its return on assets (ROA). There are a few steps involved in this, but they aren't too tough. (Got your pencil ready?) You'll find all the numbers you need on a company's recent balance sheet and income statement. We'll use Wal-Mart's (NYSE: WMT) fiscal 2001 results as an example.
Return on assets is determined by multiplying net profit margin by asset turnover. To get net profit margin, look near the bottom of the income statement for net income and divide that by net sales (also called revenues) from the top of the statement. Dividing Wal-Mart's net income of $6.3 billion by its revenues of $193.3 billion (yowza!), we get a net profit margin of 0.0326, or 3.26%.
Asset turnover is calculated by dividing total revenues by the average of total assets for the period. (Total assets are listed on the balance sheet.) Since the revenues we're using cover all of fiscal 2001, we'll add the total assets from this earnings report to those from a year ago, and we'll divide by two. Dividing Wal-Mart's revenue by its average total assets of $74.2 billion yields an asset turnover of 2.61. In other words, Wal-Mart generates more than $2.50 in sales from each dollar of assets. Not bad.
Now that we have a net profit margin of 0.0326 and an asset turnover of 2.61, we multiply them to get a return on assets of 9%. This shows that Wal-Mart creates 9 cents of earnings from each dollar of assets. By comparison, Target's (NYSE: TGT) ROA for 2001 is 7%.
These are just some of the measures to examine when studying a business. They tell you a lot about how much value the company is creating for shareholders.
Note: There is an easier way to calculate ROA. You can simply divide net income for a period by the average total assets for the period. The reason for making it more complicated, as I did above, is to get even more information out of the calculation. Remember that ROA can be broken down into two telling parts: net profit margin (net income divided by revenues) and asset turnover (revenues divided by average total assets). You'll learn more about a company by determining both parts and multiplying them together to arrive at ROA.
This offers insights into two different business levers. At a glance, you can see whether a firm's ROA of 20% is determined by a profit margin of 5% and an asset turnover of 4, or a profit margin of 10% and an asset turnover of 2. By knowing what's typical for the industry, you can quickly see why a company is succeeding, which components might be improved, and the effect any improvement will have on earnings.
To learn more about this and other measures that will help you evaluate the worthiness of possible investments, check out our Choosing Stocks With the Motley Fool online seminar -- there's even a money-back guarantee!
This question and answer is adapted from The Motley Fool Money Guide: Answers to Your Questions About Saving, Spending and Investing. For answers to this and 499 other common money questions, check it out -- it's a handy resource.
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