Bet the Jockey, Not the Horse: What ROA Is and Why It’s Important

Stock image of jockeys

The effectiveness of a given management team can be tough to measure. If you look at it from an investor’s perspective, there are a few tried and true metrics like Net Income and P/E Ratio that can be useful for determining a company’s relative valuation, but they don’t really tell you anything about the character of the management team or how successful they are at maximizing value.

Fortunately, there is a formula for determining the impact of management on building value, and that metric is known as Return On Assets (ROA). ROA measures whether or not the management team is using the assets at their disposal to their maximum potential. A high ROA generally indicates a well-managed company with a senior team firing on all cylinders, and a low ROA is a good indication of the opposite.

In other words, profitability isn’t necessarily indicative of a Virtuoso management team, because even a broken clock is right twice a day. A far better indication of Virtuoso leadership in a company is the ratio of net profitability to average assets. Let me explain.

There are a couple formulas (formulae, if you’re fancy) used to measure ROA, but here’s the one I find most reliable:

ROA = (Net Income + Interest Expense) ÷ (Average Assets for the Period)

That particular formula corrects for the different means companies use to finance growth (debt vs. equity), and by calling for an average asset number over a given period it eliminates the bias inherent with a fixed end-of-period report.

Let’s say ABC Corp and XYZ Corp are in the same business. ABC Corp has been around longer and is recognized as the industry leader. Their total assets at year end 2013 were $1 billion and at year end 2014 they were $1.2 billion. They managed to earn $40 million over the same period, and paid $15 million in interest expense. So ABC Corp’s ROA is ($40,000,000 + $15,000,000) ÷ ($1,000,000,000 + $1,200,000,000)/2, or $55,000,000 ÷ $1,100,000,000 for an ROA of 5%.

Along comes new kid on the block XYZ Corp. Their assets at year end 2013 were only $75,000,000, but they managed to grow them to $95,000,000 by year end 2014. They earned $20 million over the same period, and did it without incurring any debt. So their ROA = $20,000,000 ÷ $85,000,000, or a 23.5% ROA. Despite the fact that they’re a much smaller company, their management team is more effective at maximizing the earning potential of the assets they do have.

To use a real world example, let’s take a look at Yahoo! (NASDAQ:YHOO). The company has made a number of aggressive moves since Marissa Mayer took over in 2012, and it appears those moves have paid off. The company’s ROA for 2014 was 16.44%, the stock is trading near its 52-week high, and it has almost doubled over the past year. Compare that to competitor AOL’s (NYSE:AOL) ROA of 3.13%, and it’s easy to understand why AOL is trading right where it was at this time last year. That’s not to say AOL is a poorly run company, or that Yahoo! Is a well run company. But there’s no arguing the fact that higher ROA has led to increased stakeholder value.

One thing to keep in mind about ROA is that it’s a fairly dynamic measure. In other words, ROA can be artificially high or low for a given company from year to year, depending upon their business activity during that time frame. That’s why it’s important to measure ROA over several years to get the most accurate picture of management effectiveness.

I predict that ROA is going to be a very popular metric over the next five years. Numerous rounds of quantitative easing — combined with the general reluctance of companies to make major capital investments since the financial crisis began — make it increasingly important to measure how effectively a company manages its stockpile of cash and other assets. It will soon become clear that the best managed companies are led by the senior teams with the highest character, and it follows that they’ll have the highest ROA.

P/E Ratios and moving averages are all about the horse. Only ROA is going to tell you whether or not the jockey is a worthwhile bet.

Authored by Dave Guilford