ROA discussion 1

One of the viewers pointed out not incorrectly that one definition of return on asset-- so this whole video's going to be on return on asset-- that one definition of return on asset, and if you look it up on some of the finance sites or even some finance textbooks, they'll tell you it's net income over total assets. Which is different from what I told you. And other sources, namely Wikipedia, will tell you that it is actually-- so this is one definition of return on asset. Another definition is net income. I'll just abbreviate that as NI. Net income plus interest. So they're adding back your interest. And then they're subtracting out the tax savings due to interest. And we could a whole video on the tax savings from interest. And when it makes more sense to raise money with debt versus equity, because of the cost of interest. But that also increases your chance of bankruptcy, the more debt you take on. We could do a series of videos on that. But tax savings from interest. Divided by assets. This is a definition that Wikipedia gives you. And then the very first definition I gave you was operating profit over assets. And then I'll add one more definition to this video, just because I think it's worth talking about. And I think this is kind of a general theme in finance, is that there's all these formulas for things. And people memorize them. But in the process, you lose a lot of the intuition. And it's also important to realize that there are multiple ways of defining the exact same terms. So people can confidently say the ROA is this. And you know what? It's never a bad question to ask them what they mean by ROA. And I think you'll also be surprised by how many people won't be able to tell you what they mean by ROA. But then the last one, if I have time to go over, we'll call it EBIT. I know that look like a very strange word. EBIT divided by assets. But just so you know what EBIT is, EBIT is just Earnings Before Interest and Taxes. So this is just the same thing as net income plus interest plus taxes. So it's kind of a pre-tax ROA divided by assets. So these are all different things. And you might already say, wait if I took net income-- let's actually talk about this for a second. Let's compare EBIT to operating profit. You might immediately say, if I took net income-- so let's remember EBIT is just an acronym for Earnings Before Interest and Taxes. So let's see. If our earnings are $350,000. And we were to add back the taxes and the interest. So we add back the taxes, which gets us to pre-tax. And we add back the interest, at least in this example, we get to an operating profit number. So you might say, why is there a different term EBIT instead of, why don't people just always use operating profit? And the reason why there's a different term is, sometimes you can have the non-operating profit. So let's say that out of this $10 million of assets-- and I didn't go there in the first example because I didn't really want to complicate the issue, but I'll complicate the issue a little bit now. Let's say out of this $10 million of assets, let's say that $9 million are operating assets. They're the enterprise. They're the things that are needed to generate the operating profit. And then you had another $1 million of assets of this $10 million. That the company really doesn't need to operate. They just have it around. Maybe they're speculating on oil prices. Or they're just hedging something. Or they just have a super flush bank account. So these assets might be generating non-operating income. So you could have a line here for interest income or investment income. Let me put that. Investment income. And then the company might have made some money there. It might make $10,000 on investment income. And of course that'll drop to this line. This'll then become $510,000. The taxes will be $153,000. And the net income is $357,000. Because we have a 30% tax rate. And that make sense, right? I added an extra $10,000 of income here. And then at the end of the day, you're going to tax at 30%, so this should be $7,000 more of earnings. So that makes sense. $357,000. But this is the difference between operating income and EBIT. EBIT in this case would be the operating profit plus this investment income. So EBIT, in the case that I just added some investment income, would be $1,010,000, while operating profit would be $1 million. I didn't want to go there in the first video, and that's why I just said operating profit divided by assets. But if you really consider all of the assets, and if you assume that there are some assets there that are non-operating. They're not really used to make widgets, or to sell widgets or market widgets, or help the CEO in any way do his or her job. Then whatever this generates is actually non-operating income. And so EBIT factors that in. So EBIT, I kind of view that it goes backwards. It starts with net income. And then it adds back the taxes and interest. While operating profit, you start at the top line and you go down. But in general if you take EBIT and you take out the non-operating income, you get back to operating profits. So that's what EBIT is right here. And so you can already imagine that both EBIT and the way I defined it initially, operating profit divided by assets. They're ways of saying, before you consider taxes, what are your assets doing for you? So once again, if this is a balance sheet, this is the assets, here are your liabilities. Debt could be one of them. But in general it could be a bunch of other things. You might owe other vendors money or whatever. Then you have your equity. It's important whenever you talk about any of these ratios. What context? Are you trying to pass the CFA exam, or are you trying to impress your MBA professor? Or are you trying to get an intuition for helping to become a better investor? And if you are an investor, you're probably going to want to do the last of the three. And there, ROA, the Return on Assets is telling you, how good is this company at getting a return out of this thing right here? I don't care how they paid for it, whether they had debt. I don't want to think about, are they good at getting low interest? I don't want to think about, is their CFO good at getting a better interest rate than another CFO? Or are they better at evading taxes than another company? All I care is the assets that they have, how good are they at putting those assets to work? And what type of a return can they get? So if I calculate it using you EBIT divided by assets, or operating profit divided by assets, if I use either of these as my metric for ROA and Company A has a 10% ROA and Company B has a 15% ROA, then I say, you know what? I don't care whether B's guy is better at getting a low interest rate. Or getting some type of tax handout from the government. Or doing something fancy with where he keeps his subsidiaries. I just want to know which management is better at getting a return out of these assets. And these metrics will tell you that. Because it tells you either how much operating profit is being generated from here, or it could tell you how much EBIT. In this case, an EBIT might be a little bit more informative. Because some of income might be generated from non-operating assets. So maybe the company holds some stock, or it holds some gold or something. Or it holds some forward contracts to hedge its exposure to oil or foreign currency or something. So in general if you want to know what I think is the best ROA, I would say it's EBIT over assets, which is very close to operating profit over assets. And now you say, well Sal, why are these other things here? And why don't you like them as much? Well, net income over assets, I think the reason why that definition exists is because: one, net income does factor into these things that frankly I didn't want to think as much about. But when you talk about return, what you get off the asset, you still are going to pay taxes on them. And if you do have some financing, you will be paying some interest on that. So that's why this comes out. Where they actually just take the bottom line. When people talk about top line and bottom line, now you know where those words come from. Top line is revenue. It's the top line of the income statement. And your bottom line, that's the bottom line of the income statement. That's where the word comes from. So that one definition takes this and they divide by the total assets. But the reason why I don't like that is this definition does not separate out that one company might be better at evading taxes or paying taxes. And another company might be better at somehow getting better financing from the bank. And that's not what matters. I care about the assets. I care just about the left-hand side of the balance sheet. While this is taking into consideration some of the factors on that side of the balance sheet. For example, let's say you have two identical companies. This could be an interesting example. You have one company-- Actually I just realized I'm out of time. I'll continue the example in the next video, and I'll explain a little bit about the tax savings from carrying debt or interest. See you in the next video.