As an investor, you want to find a profitable home for your savings. So, what’s the best way to assess a company’s profitability?
Although a ‘gut feeling’ about companies probably plays a part in decisions for many amateur investors, it’s essential to have more objective measures to help you compare companies with one another. You may feel drawn to a particular company for personal or political reasons, but, even so, should know the likely profit from your investment, so that you can either go in or stay out with your eyes open.
Some tools for comparing companies’ profitability are in common use. The three main ones are known as ROE (return on equity), ROA (return on assets) and ROIC (return on investment capital).
‘Return on equity’ refers to a calculation that compares the company’s ‘net annual income after tax’ with its ‘equity’, or the total value of its assets less the value of its debts. That means that long-term borrowings are disregarded. The ROE measure makes it look as though the whole profit has been generated by the equity, ignoring the part played by borrowed money in financing the company. So the company may look more profitable than it really is if it has been highly ‘leveraged’, in other words, if it has borrowed heavily against its assets.
The ‘return on assets’ metric counts borrowed money in the calculation, but has the drawback that it doesn’t differentiate between assets like land or machinery, which are used to generate profits, and assets like stock-in-trade, which will not be held long-term. A company may be holding a high amount of stock-in-trade for valid reasons, such as to take advantage of fluctuations in wholesale prices, but the ROA calculation may make it look relatively unprofitable. Nonetheless, ROA is a helpful way of comparing different companies operating in the same sector.
The concept behind ‘return on investment capital’ arguably has fewer drawbacks than the other two measures. It defines ‘investment capital’ as ‘operating net working capital plus operating fixed assets’. Operating fixed assets are only those assets that are used to generate income in the long term, like land or equipment. Therefore, it leaves out of the calculation the value of short-term assets like stock-in-trade or excess cash. It includes the figure for long-term liabilities. Therefore, money that has been borrowed for use in the business is factored in.
The ROIC measure can be used to compare businesses that have differing amounts of long-term debts, and also across different industries and sectors.
Unfortunately, the ROIC isn’t something that appears ready-made in a company’s ‘official’ accounts. It’s necessary to work the figure out from the available raw data. That’s not necessarily an easy task for the layman to be confident about. It isn’t rocket science though, and if an amateur investor wants to understand his or her investment choices, then it’s worth getting to grips with the concept. It’s also important that private investors understand the terms that are used by professional advisers so that they don’t fall victim to mystification.