Efficiency Ratio

The Return on Assets (ROA) percentage shows how profitable a company's assets are in generating evenue.

ROA can be computed as:

ROA = Net Income / Total Assets = (Net Income / Sales) * (Sales / Assets )

This number tells you "what the company can do with what it's got", i.e. how many dollars of earnings they derive from each dollar of assets they control. It's a useful number for comparing competing companies in the same industry. The number will vary widely across different industries. Return on assets gives an indication of the capital intensity of the company, which will depend on the industry; companies that require large initial investments will generally have lower return on assets.

Return on Equity (ROE, Return on average common equity, return on net worth) measures the rate of return on the ownership interest of the common stock owners. ROE is viewed as one of the most important financial ratios. It measures a firm's efficiency at generating profits from every dollar of net assets, and shows how well a company uses investment dollars to generate earnings growth. ROE is equal to a fiscal year net income(after preferred stock dividends but before common stock dividends) divided by total equity (excluding preferred shares), expressed as a percentage.

ROE = Net Income / Average stockholder's equity

But not all high-ROE companies make good investments. Some industries have high ROE because they require no assets, such as consulting firms. Other industries require large infrastructure builds before they generate a penny of profit, such as oil refiners. You cannot conclude that consulting firms are better investments than refiners just because of their ROE. Generally, capital-intensive businesses have high barriers to entry, which limit competition. But high-ROE firms with small asset bases have lower barriers to entry. Thus, such firms face more business risk because competitors can replicate their success without having to obtain much outside funding. As with many financial ratios, ROE is best used to compare companies in the same industry.

High ROE yields no immediate benefit. Since stock prices are most strongly determined by earnings per share (EPS), you will be paying twice as much (in Price/Book terms) for a 20% ROE company as for a 10% ROE company. The benefit comes from the earnings reinvested in the company at a high ROE rate, which in turn gives the company a high growth rate. ROE is irrelevant if the earnings are not reinvested.

As measures of pure efficiency, these ratios aren't particularly accurate. Because earnings can be manipulated. It's also true that the asset values expressed on balance sheets are not entirely reflective of what a company is really worth. General Eletric or an investment bank like Goldman Sachs rely on thousands of intellectual assets that walk out the front door every day.

But ROE and ROA are still effective tools for comparing stocks. Since all U.S. companies are required to follow the same accounting rules, these ratios do put companies in like industries on a level playing field. They also allow you to see which industries are inherently more profitable than others.