ROA Discussion 2 More on the return on asset discussion.
ROA Discussion 2
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- In the last video, I talk about how there's multiple
- ways to define return on asset.
- This is given in some textbooks and maybe some
- professors would give this in a finance class: net income
- divided by assets.
- If you look on Wikipedia, they say it's net income plus
- interest minus tax savings from interest. So notice,
- they're not adding back all of the taxes.
- They're still taking taxes into consideration, but
- they're saying you're not getting any tax deduction from
- your interest. So we'll talk about that in a second.
- So this kind of still does factor in taxes.
- This one definitely does and interest as well.
- And then there are these two other ones.
- One was operating profit divided by asset, which is
- what I gave in the first video.
- It really just is kind of a simplifying assumption and
- really to give you the intuition in my mind of what
- ROA really is about, of how good is a company at operating
- its assets, at actually getting a return from them.
- And then a slightly more general definition would be
- EBIT divided by assets. and we talk about the fact that EBIT
- is just net income plus interest plus taxes, or
- another way to think about it, it's operating profit plus
- non-operating profit. so any other type of profit that the
- company might have gotten from some assets that it owns that
- actually aren't essential to actually
- managing the business.
- But then in the last part of the video, I talk about you
- have these definitions out here, but I don't like using
- them as much, and then I ran out of time, and I said I
- would cover in this video why I don't like using it as much.
- I think the best way to talk about it is with an example.
- So let's say I have two companies.
- I want to do thicker lines.
- So I have one company here.
- Say they have the same amount of assets.
- That's one company, and then this is the other company
- right here, and I'm drawing the left-hand side of their
- balance sheets.
- These are the assets.
- Now let's say that they're the same amount, so they have $10
- million of assets.
- And let's say that these are the actual ROA's as the way I
- calculated them.
- So this is your EBIT divided by total assets.
- So if EBIT is 10% of this, that means that this guy is
- spitting out 10%, which would be $1 million of EBIT.
- And in a world where there's no non-operating profit, this
- you could view as operating profit.
- Remember, EBIT is just Earnings Before
- Interest and Taxes.
- Let's go back to that income statement that
- we started off with.
- EBIT is Earnings Before Interest and Taxes.
- So if you add back interest and taxes, you essentially get
- back to operating profit unless there's a little bit of
- non-operating profit right here.
- So that's the way to think about EBIT.
- For most functional purposes, unless you're talking about
- like a financial statement, most firms that aren't doing
- anything too fancy on their non-operating side of their
- balance sheet, EBIT and operating profit are pretty
- close to each other.
- But anyway, in this case this guy's generating
- $1 million of EBIT.
- And let's say that this company, Company B-- we'll
- label these as Company A, this is Company B.
- Company B, it's getting a 15% EBIT return on its assets, so
- it's generating $1.5 million in EBIT per year.
- So just when I look at the left-hand sides of the balance
- sheet-- I haven't drawn the right-hand side yet-- I would
- say that this guy is a better manager of these assets.
- He's better at extracting value, given the amount of
- capital that has been put into this company.
- So that's why I like the definition of EBIT divided by
- assets, or operating profit divided by assets.
- Now, let's give a situation where this guy
- has very little debt.
- Let's say he has no debt and he has all equity, so the
- right-hand side of his balance sheet looks like this.
- Let's say he has no liabilities of significance.
- He has no liabilities of significance,
- so this is all equity.
- So when you want to figure out this guy's pre-tax income, you
- take EBIT minus-- actually, let me move the window down a
- little bit.
- You take EBIT minus interest to get pre-tax.
- So how much pre-tax does he have?
- Pre-tax earnings?
- Well, he has no debt, right?
- So he has no interest. So his pre-tax earnings, or you can
- call it, which no one else ever does, is EBT, which you
- don't want to say because it sounds like EBIT, but Earnings
- Before Taxes.
- No one ever says EBT.
- They always say pre-tax.
- But that would also be $1 million.
- And then if you go even further, and you say, this guy
- for some reason, he had a bunch of tax credits this year
- or he had some losses last year that he was able to
- offset to use against his taxes, so this year, he also
- didn't have to pay any taxes.
- So his earnings or his net income is also $1 million.
- Fair enough.
- So this guy has a 10% EBIT return on his assets, but his
- earnings or his net income is also this $1 million.
- Now let's say this guy over here, he has a little bit more
- debt on his balance sheet.
- Let's say it's similar to the first example we did, so let
- me draw that.
- So let's say he has $5 million of debt.
- But the amount isn't necessarily the
- most important thing.
- So he has $5 million of debt or liabilities.
- Liabilities could be other things as well.
- It could be he owes pension liabilities or
- who knows what else.
- So he has $5 million of debt, but the important thing is he
- has interest. So every year, let's say he has to pay
- $500,000 in interest. He's paying 10%
- interest on his debt.
- 10% of $5 million is $500,000.
- So his pre-tax-- let's do the bottom part of his balance
- sheet-- his EBIT, his Earnings Before Interest and Taxes, is
- $1.5 million, but then if you want to subtract out interest,
- you'd subtract out minus $0.5 million, $500,000, and so his
- pre-tax is going to be $1 million.
- And now this guy also-- so essentially the equity holder
- before paying tax --this is equity here.
- He has $5 million of equity.
- This guy had $10 million right here.
- And this is pre-tax.
- He has to pay the 30% like we did in the previous example.
- He has to pay 30% on taxes.
- So his net income will be $700,000, right?
- Because he has $1 million pre-tax, he has to pay
- $300,000 in taxes, so he has a $700,000 net income.
- Now, let's look at what we would get in terms of an ROA
- if we did it using this definition that some textbooks
- will give you.
- For the first guy, his net earnings are $1 million and
- his assets were $10 million.
- So by this definition up here, Company A has a 10% ROA.
- By that definition over here, this guy made $700,000 of net
- income off of $10 million, so he is going to be making an
- ROA of what? $700,000 divided by 10 is 7%.
- So now if you just look superficially at these numbers
- as defined by this ratio right here, you'll say, oh, this
- guy, Company A, has a better return on asset.
- He's better at managing his assets.
- And you know that that's completely false.
- Company A was getting a much lower EBIT
- return on his assets.
- He was only getting 10%.
- This guy was getting 15%.
- Company A was just better at, one, it didn't have any debt,
- and it was also better at maybe this year avoiding
- paying taxes.
- So when you talk about ROA, there are other ratios that
- start factoring in how good is a company at financing its
- assets and how good is a company at paying taxes
- efficiently, which is just another way of evading as many
- taxes as possible.
- But that's a separate ratio.
- Return on asset to me says, what does a company do with
- the left-hand side of the balance sheet?
- And when you do the net income version, you're factoring
- things in like interest and taxes, and then you're
- muddying up the picture.
- You're not telling me which company is better at actually
- giving a return just on its assets, not how it actually
- pays for its assets.
- This definition that Wikipedia gives-- and it's good to be
- aware of all of them, because I don't want you to watch
- these videos and say, oh, no.
- Sal said it's operating profit divided by asset, or EBIT
- divided by asset.
- It's good to know these so that these aren't unfamiliar
- terms to you.
- What I'm telling you is that this definition is more of a
- real intuitive sense of what a company's doing with its
- assets, while these are kind of textbook definitions.
- This one attempts to add back interest. It adds back
- interest, so just the interest part between this company and
- this company won't differentiate between the two.
- But this one does take into account which company is good
- or bad at paying taxes.
- And I realize I'm out of time.
- In the next video, maybe I'll talk a little bit more in
- depth about the tax savings from interest, because it's an
- interesting concept right there.
- But I think I'm getting a little bit into the weeds now,
- because I want to kind of get back high level and give you
- an overarching view of how you can think about investments
- and price to earnings and whatever else.
- I'll focus back on that on the next video.
- See you soon.
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