ROA discussion 2

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.