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# ROA discussion 2

Video transcript

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.