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2 Simple Ratios To Spot Very Profitable Companies

2 Simple Ratios To Spot Very Profitable Companies

When I started investing, I found it quite challenging to analyse which company was better than the other. I knew that profitability was very important in this analysis, but how do you measure profitability? Well, this article will give you a great starting point, as we will discuss 2 simple ratios that you can use to measure a company’s level of profitability.

These 2 ratios are the Return on Assets (ROA) and Return on Equity (ROE)

Return On Assets (ROA)

The return on assets is a profitability ratio that indicates how much profit is earned for every dollar of assets that the company owns. In other words, it measures how effective a company uses their assets to produce a profit.

Assets are everything that the company owns, such as cash, equipment, property, patents, factories, inventory etc. Assets are stated on the balance sheet

How To Calculate Return On Assets

Return on Assets = Net Income / Average Total Assets

9 out of 10 times you don’t have to calculate ROA yourself, as you can find it on sites like Morningstar.com, Yahoo Finance or Google Finance.

If the ROA is 20% for example, 20 cents of profit is earned with the ‘use’ of $1 of assets.

Example : Return on Assets of Intel Corp.

intel-instruments-1

What Does Return On Assets Tell You

All else being equal, the higher the Return on Assets, the better. A higher ROA indicates that a company is more effective at using its assets in order to produce a profit. So essentially, you want to look for a company that has one of the highest ROA compared to competitors, as this indicates a higher level of profitability. Another thing you want to look for is the trend of a company’s ROA over the last 5 – 10 years. Is it improving, declining or does it stay fairly stable?

Example : Return on Assets of Intel Corp. and Texas Instruments

 

intel-instruments-2

We can clearly see that Texas Instruments has a much higher ROA than Intel Corp. Another important thing is that Texas Instruments has a clearly improving ROA year over year, while Intel’s ROA is falling year over year. On the basis of the ROA, Texas Instruments would be the better pick.

Advantage

The advantage of the ROA is that is a very easy and fast way to scan the profitability level of a company compared to competitors. When you look at a company’s ROA of the last 5 – 10 years, you can quickly see if their level of profitability is improving and whether is outperforms competition.

Drawbacks

Unfortunately, the ROA has some drawbacks. First of all, it is not effective to use the ROA when comparing companies from different industries. This is because some industries typically have a lot more assets than other industries. Where oil companies need a lot of assets in the form of equipment (oil rigs, drills etc.), a software company needs a lot less. Therefore, the ROA will generally be much higher in the software industry compared to asset-intensive industries such as the oil industry.

Another drawback is that the net income can be a misleading number. This is because net income can give a wrong impression about the actual result of a company in a given year. When a company sells equipment or a part of its business for example, this sale contributes to a higher net income, while it doesn’t take into account that this money isn’t earned with normal business operations and may destroy future profitability. Therefore, take a look at the income statement to see if this was the case or not.

Despite these two drawbacks, the ROA still forms a good starting point to analyse a company’s profitability level.

Return on Equity (ROE)

The return on equity is a similar ratio compared to the return on assets, with a slightly different perspective. The return on equity (ROE) is a ratio that measures how much profit is earned compared to every dollar of shareholders equity.

Shareholder’s Equity, which is also called book value, is the difference between total assets and total liabilities. It is essentially the amount of money left over for shareholders when all assets are sold and all liabilities are repaid. Shareholder’s Equity is stated on the balance sheet.

How To Calculate Return On Equity

Return on Equity = Net Income / Shareholders’ Equity.

If the ROE is 15% for example, 15 cents of profit is earned with the ‘use’ of $1 of shareholder equity.

Example : Return on Equity of Intel Corp.

Intel Corp.

intel-instruments-3

What Does Return On Equity Tell You

All else being equal, the higher the ROE, the better. A higher ROE indicates that a company is more effective at using shareholder’s money in order to produce a profit. So essentially, you want to look for a company that has one of the highest ROE compared to competitors, as this indicates a higher level of profitability. Another thing you want to look for is the trend of a company’s ROE over the last 5 – 10 years. Is it improving, declining or does it stay fairly stable? A rising ROE suggests that a company is increasing its ability to generate profit without needing as much capital.

Example : Return on Equity of Intel Corp. and Texas Instruments

 

intel-instruments-4

Here we see again that Texas Instruments would be the better pick. This is because they have a much higher ROE than Intel Corp. Another important thing is that Texas Instruments has a clearly improving ROE year over year, while Intel’s ROE is falling year over year.

Advantage

The ROE is, just like the ROA, a very easy and fast way to scan the profitability level of a company. In just a couple of minutes you see whether profitability is improving and whether it is better than most competitors.

Drawbacks

Unfortunately, ROE also has some drawbacks. The first drawback is that the Return on Equity isn’t useful when comparing companies from different sectors, just like the Return on Assets. What is a high Return on Equity for one industry can be a low Return on Equity for another.

The second drawback is that the ROE can be misleading if you do not look deeper into the balance sheet of a company. This is because the ROE can be manipulated if a company is borrowing a lot of money. Therefore, you need to take a look at the balance sheet to see how financially leveraged a company is.

All in All..

The Return on Assets and Return on Equity are a very easy and fast way to analyse a company’s profitability level. Both ratios have some drawbacks that you need to take into account, but they still offer a great place to start your analysis. When both ratios are higher than that of competitors and are improving over the last 5 – 10 years, this is usually a strong sign on which you can build your further analysis.

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