Why ROE and ROA are The Most Important Financial Ratio
If I had to rate a company’s fundamentals and only had two financial ratios of choice to decide, it would be the ROE / Return on Equity and ROA / Return on Assets.
Return on equity is a measure of how effectively a company utilizes important money.
We divide the net income by the average shareholder’s equity / total assets to calculate ROE / ROA.
ROE = Average Shareholders’ Equity / Annual Net Income
This ratio tells you so much about a business’ fundamentals.
Overall performance of the business
ROE measures how well a company uses shareholders’ money to generate profits, which ultimately matters. It’s like the interest rate of a bond. It would also be an excellent option to compare the ROE of a business with its competitors in the same industry/sector.
Asset turnover and profit margin
Analyzing further, we can also break down ROE with the DuPont Analysis, which decomposes ROE into three variables: asset turnover, profit margin, and financial leverage.
A company with a high ROE would either have high revenues, high-profit margins, or a mix of both. Usually, it would be a mix of both, as having a profit margin or revenue too low would not result in a good ROE ratio. Not all cases are like this, though. Walmart, for example, has low margins but has an enormous revenue to compensate for it.
Financial Leverage
By comparing the ROA and ROE ratios, you can also see how much leverage a company uses. If the ROE is much lower than the ROA, the company relies heavily on liabilities to finance its operations. Remember that different industries have different leveraging levels (A construction company typically has higher debt than a consumer goods company).
Growth
Companies with a high ROA require less money/capital to increase their profits. For example, imagine two companies, A and B. Both companies earn $10 million, but A has $100 million in assets, while B only has $50 million. This means A has a ROA of 10% while B has a ROE of 20%. They can maintain the same ROA over time, so their future earnings and growth are here.
Companies with a high ROA require less money/capital to increase their profits. To increase earnings from $10 million to $20 million, B only needs to grow assets by $50 million, but A needs $100 million.
Warren Buffet on ROE
ROE is one of the ratios that Buffet utilizes a lot. He uses it in his calculations for sustainable growth and ROE to measure how well the management is performing. He often uses ROE to decide on remunerations for the management team. Berkshire’s investment also mainly comprises higher ROE stocks: $AAPL, $KO, $TSMC, etc.
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