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Current time:0:00Total duration:10:17

Video transcript

in the last video I talked about how there's multiple ways to define return on asset this is given in some textbooks and on some 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 the taxes or there they're still taking in 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's these two other ones which one was operating profit divided by asset which is what I gave in the first video really just as kind of a simplifying assumption and really to give you the intuition in my mind of what ROA really is about of what are you how good is a company at operating its assets and actually getting a return from them and then a slightly more general definition would be EBIT divided by assets and we talked about the fact that II bid is just net income plus interest plus taxes or another way to think about it its operating profit plus non operating profits so any other type of profit that the company might have gotten from from from some assets that it owns that actually aren't essential to actually managing the business but then I in the last part of the video I talked about you know 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 and I think the best way to talk about it is with an example so let's say I have two companies two companies ok company now let me I want to do thicker lines so okay so I have one company here say they have the same amount of assets so that's one company and then this is the other company right here that I'm trying to draw the left-hand side of the balance sheet so these are the assets assets now let's say that this guy right let and let's say they're the same amount so let's say they have ten million dollars of assets ten million dollars and let's say that company that this guy let's say that this these are the actual roas is the way I calculated them so this is your a bit divided by divided by total assets right so if a bit is ten percent of this that that means that this guy is spitting out ten percent which would be 1 million dollars of EBIT right and in a world where there are no non operating profit this is you could view as operating profit remember Eve it is just earnings before interest in taxes right let's go back to that income statement that we started off with EBIT is earnings before interest in taxes so if you add back interest in taxes you put 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 a bit for most functional purposes unless you're talking about like a financial most firms that aren't doing anything too fancy on their non operating side of their balance sheet even an operating profit are pretty close to each other but anyway in this case this guy is generating 1 million dollars of e bit and let's say that this company Company B Mart labeled eases Company A this is Company B Company B it's generating 15% of its getting a 15% EBIT return on its assets so it's generating 1.5 million and EBIT per year so just when I look at the left hand sides of the balance sheet I haven't drawn the right hand sides 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 say that this guy well let's give a situation where you know this this guy has very little debt right this guy has very little debt let's say he has no debt and he has all equity so so the right hand side of his balance sheet looks like this let's say he has no liabilities of significance so liabilities liabilities right here oh sorry he has no liabilities of significance so this is all equity all equity so when you when you want to figure out this guy's pre-tax income you take a bit - - actually let me move the window down a little bit you take a bit - interest right 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 could call it which no one else forever does is a bit which you wouldn'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 $1,000,000 right and then if you go even further and you say you know what this guy for some reason he just he had a bunch of tax credits this year or he was able to 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 right so his earnings his earnings or his net income is also $1,000,000 right fair enough so this guy has a 10% EBIT return on his assets but he's earning but his earnings or his net income is also this $1,000,000 now let's say this guy over here he has a little bit more dead 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 let's say he has five million dollars of debt but the amount isn't what's necessarily the most important thing so he has five million dollars of debt or liabilities liabilities could be other things as well it could be you know he owes pension liabilities or who knows what else so he has five million dollars of debt but the important thing is he has interest right so every year let's say he has to pay five hundred thousand in interest five hundred thousand in interest he's paying ten percent interest on the on his debt ten percent of five million is five hundred thousand so his pre-tax so if you took let's do the bottom part of his balance sheet balance sheet it is a bit his earnings before interest in taxes is 1.5 million but then if you want to subtract out interest interest you'd subtract out minus 0.5 million five hundred thousand dollars and so his pre-tax pre-tax is going to be 1 million dollars right and now this guy also you know so essentially the equity holders before paying tax this is equity here he has 5 million of equity this guy had 10 million right here and let this is pre-tax then he has to pay the 30% like we did in the previous example just say 30% of on taxes so his net income his net income will be $700,000 right because he has a million dollar pre-tax he has to pay 300,000 in taxes so he has a 700,000 net income now let's look at how what we would get in terms of an AR away if we did it using this definition that some textbooks will give you for the first guy his net earnings are $1,000,000 and his assets were 10 million so bited this definition up here company a has a 10% ROA by that definition over here this guy made seven hundred thousand dollars of net income off of ten million dollars so he is going to be making an ROA of what seven hundred thousand divided by ten is seven percent so now if you just look superficially 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 return EBIT return on his assets he was only getting 10 percent this guy was getting 15 percent Company A was just better at one it didn't have any debt and it was also better it may be this year avoiding paying taxes so when you talk about ROA so you know there are other ratios that start factoring it is how good is a company it you know at financing its assets and how good is a company is that you at paying taxes efficiently which is just another way of evading as many taxes as possible but 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 that when you do the net income version you're factoring things in like interest in 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 in assets this 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 said oh no you know Sal said its operating profit divided by asset or Eve it divided by asset it's good to know these so that you don't that these aren't unfamiliar terms to you what I'm telling you is that this definition or this definition is more of a real intuitive sense of what a company is doing with this assets while these are kind of textbook definitions this one attempts to add back interest it adds back interest so that it definitely it wouldn't just the interest part between this company in this company it 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 attack savings from interest because that'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 so I'll focus back on that on the next video see you soon