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How to Analyse Stocks Using Return on Assets (ROA)

Author Deepika Khude | Posted May 20, 2021

Return on Assets (ROA) is a type of profitability ratio that measures the returns generated by a company on its assets. It shows how profitable a company is relative to its assets. For example: The ROA of Reliance Industries is 5.14%. This means that the company generates Rs 5.14 for every Rs 100 in assets.

But why should investors care about return on assets? Let me explain.

What happens when you buy shares of a company? You become a proportionate owner of the company, correct?

What does this mean?

This means you become a proportionate owner of a company’s assets too. A company is nothing but a bunch of assets generating revenue.

When assets are used efficiently, higher revenue is generated. High revenue means more money for investors. This can be in the form of both capital appreciation and dividends. This is why ROA is crucial for investors.

It is also equally important for a company’s management. It helps investors gauge management’s efficiency in managing its assets. After all, one of the main goals of management is to generate higher return on assets. A successful business is one where the management is able to generate maximum profit from limited resources (assets).

Hence ROA is important for both investors and management. However, it is often ignored as investors only focus on return on equity (ROE). This is a flawed approach.

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In this article, we will learn how to use ROA in stock selection and also discuss the following:

1. What is Return on Assets?
2. Return on Assets Example
3. How to Calculate Return on Assets?
4. What is the Ideal Return on Assets Ratio?
5. How to Use ROA in Stock Selection?
6. List of 10 Stocks with Best Return on Assets in India for 2021.
7. FAQs on Return on Assets (ROA)

What is Return on Assets (ROA)?

Return on Assets is also known as total return on assets. As the name suggests, it helps investors understand the return a company generates on its assets. Higher the return on assets ratio, the more efficient a company’s management is in generating value for its investors.

A company has two types of assets:

  • Tangible Assets
  • Intangible Assets

Land, vehicle, machinery, cash, employees etc are tangible assets. Patents, trademarks, intellectual property etc are intangible assets.

There is an inverse relationship between types of asset and ROA.

  • High Tangible Assets = Low ROA
  • High Intangible Assets = High ROA

Capital intensive companies always have lower return on assets. This is because they have high tangible assets. So, they need more revenue to cover cost of assets. Example: Steel, Power, Refining etc.

Banks and Information & Technology (IT) companies always have higher ROA as they have more intangible assets. But only a high or low ROA does not decide whether a stock is an attractive investment opportunity.

For example: The ROA of Vedanta Ltd is 6.10%. This is above the minimum ideal ROA of 5%. However, its ROE is -11.32%. This means that assets made money but investors didn’t! This is one of the reasons why Vedanta Ltd is a 0.5 star rated stock. It is recommended to avoid such companies.

Return on Assets (ROA) Example

We have all had tea from the roadside chaiwala.

Do you recall seeing a cloth used to strain the tea?

Return on Assets_Example

This cloth contains tea leaves and ginger. These are assets for a chaiwala.

What does he do with these strained ingredients? Does he throw it away after one use?

Absolutely Not!

The same tea leaves and ginger is used to make another batch of tea. What is the chaiwala doing? He is maximising his return on assets.

Let’s say he makes 20 cups of tea with 100 grams of tea leaves and 20 grams of ginger. His total profit is Rs 100.

By reusing the same ginger and tea leaves, he manages to make another 20 cups of tea. So, he ends up making a profit of Rs 200 with the same quantity of assets (ginger and tea leaves).

Let us now understand how ROA helps in stock selection with the below example.

There are two companies in the same sector.

  • ABC Ltd.’s net profit is Rs 10,000.
  • XYZ Ltd.’s net profit is Rs 20,000.

Which one will you choose?

Of course, you will choose XYZ Ltd. It generates more profit.

But ABC Ltd.’s total assets are worth Rs 1 Lakh. Whereas XYZ Ltd.’s total assets are Rs 2.5 Lakhs.

Now which company will you choose?

To make a decision, you will have to calculate return on assets.

ROA is calculated by dividing a company’s net profit by its total assets.

  • ABC Ltd.’s ROA = (Rs 10,000 / Rs 1,00,000) = 10%
  • XYZ Ltd.’s ROA = (Rs 20,000 / Rs 2,50,000) = 8%

So, while XYZ Ltd is more profitable, ABC Ltd is more efficient. In the long run, you should invest in efficient businesses.

How to Calculate Return on Assets (ROA)?

There are three formulas to calculate return on assets:

  • Return on Assets Formula = Earnings Before Interest and Tax (EBIT)/ Total Assets
  • Return on Assets Formula = Profit after tax (PAT) + Interest *(1-Tax rate) / Total Assets
  • Return on Assets Formula = Net Profit / Total Assets.

Net profit is the amount left after paying interest, depreciation and tax. It is easily available in a company’s profit and loss (P&L) statement.

Total assets are available in a company’s balance sheet and include tangible assets only. Intangible assets are excluded while calculating ROA.

Let us now calculate return on assets for Larsen & Toubro Ltd (L&T) for March 2020. Net profit for the year was Rs 9,549 crores.

Return on Assets_L&T Balance Sheet

Total Assets on 31st March 2020 were worth Rs 3,06,687 crores.

Return on Assets_L&T P&L Statement

ROA = Net Profit / Total Assets

= Rs 9,549 / Rs 3,06,687

= 3.11%

The ROA of L&T is 3.11%. This is below our minimum ideal ROA of 5%. This is one of the reasons why L&T is a 0.5 star rated stock.

In comparison, the ROA of Tata Consultancy Ltd (TCS) is 34.9%.

So, can we conclude that TCS is a better company because it has higher ROA?

No.

L&T is a construction company with very high tangible assets. Whereas TCS is a software company with low tangible assets. Comparing ROA of different sectors is quite pointless. ROA should always be used in comparing companies in the same industry.

What is the Ideal ROA Ratio?

Ideal Return on Assets is above 5%. Companies with ROA of less than 5% are not asset-efficient and should be avoided. A ROA of more than 20% signals attractive investment opportunities.

However, different sectors have different ideal return on assets ratios. Asset heavy businesses like cement, steel, power, refining etc have lower ROA. The ROA of service sector is very high. For example:  IT companies and banks.

Industry ROA comparison is wrong as some companies require massive assets to generate revenue. For example: Car manufacturers or Oil refining companies. They will naturally have lower ROA compared to banks.

Let us evaluate the return on assets of banking and commercial vehicles sector.

How to Evaluate Companies Using Return on Assets

The below table shows the ROA, ROE and ROCE of commercial vehicle stocks as on March 2020.  

Commercial Vehicles Sector Stocks ROCE ROE ROA  Market Cap

 

(in Crores)

Tata Motors Ltd -0.37% -19.70% -4.75% 1,07,364
Ashok Leyland Ltd 8.85% 4.25% 1.55% 33,538
Escorts Ltd 19.10% 14.60% 15.30% 15,676
BEML Ltd 2.31% 2.88% 1.85% 4,894
Garden Reach Shipbuilders & Engineers Ltd 22.40% 16.20% 15.10% 1,959
VST Tillers Tractors Ltd 6.29% 4.18% 3.89% 1,566
SML ISUZU Ltd -3.88% -5.32% -3.18% 660
Titagarh Wagons Ltd 1.81% -4.63% -2.19% 554
Gujarat Apollo Industries Ltd 3.55% 5.38% 5.27% 271
Skyline Millars Ltd 3.92% 3.92% 3.69% 31
Brady & Morris Engineering Company Ltd 11.10% 7.91% 6.47% 18
Laxmipati Engineering Works Ltd 12.00% 14.50% 7.02% 14
Cranex Ltd 6.83% 9.64% 2.53% 6
         
Average 7.22% 4.14% 4.04%  

The average return on assets of commercial vehicle sector is 4.04%. Even though Tata Motors Ltd has the largest market capitalisation, its return on assets ratio is – 4.75%. This is extremely poor and is a red flag for investors regarding the efficiency of its assets.

Escorts Ltd.’s return on assets is roughly four times the sector average. While impressive, you need to check its price to earnings and book value to ensure the stock is not overvalued.

Let us also evaluate return on assets of Public Sector Banks as on March 2020

Public Sector Banks Market Capitalisation ROCE ROA ROE
State Bank of India 3,19,724 4.99% 0.45% 6.79%
Punjab National Bank 37,982 4.69% 0.05% 0.73%
Bank of Baroda 36,484 5.06% 0.10% 1.47%
Indian Overseas Bank 26,053 1.53% -3.49% -52.50%
Canara Bank 23,762 4.95% -0.28% -5.04%
Bank of India 22,168 3.59% -0.49% -7.03%
Union Bank of India 22,136 4.23% -0.61% -10.30%
Bank of Maharashtra 15,974 4.98% 0.05% 5.24%
Indian Bank 12,751 5.25% 0.30% 4.05%
UCO Bank 11,208 2.82% -1.08% -14.80%
Central Bank of India 9,636 4.47% -0.37% -6.17%
Punjab & Sind Bank 7,660 4.23% -0.97% -17.60%
Average    4.23% -0.58% -7.93%

As you can see… The average return on assets of public sector banks is -0.58%. This means they are making a loss on their assets. You should avoid such companies.

On the other hand, the average return on assets ratio of top five private sector banks is 1.57%. Much higher than -0.58%.

Top 5 Private Sector Banks ROCE ROA ROE
HDFC Bank 6.76% 2.11% 18.00%
ICICI Bank 6.04% 1.58% 15.00%
Kotak Mahindra Bank 6.65% 2.35% 14.90%
Axis Bank 5.06% 0.82% 8.33%
IndusInd Bank 6.54% 0.98% 8.60%
Average 6.21% 1.57% 12.97%

Even the average ROE is 12.97%. This means the returns generated by the assets have been passed onto investors. Hence you must view ROE, ROCE and ROA together.

Another important thing about return on assets is that investors need to study it for at least five-years for better analysis. A stock with consistent return on assets is always a better investment than a stock with uneven ROA.

Let us study the five-Year return on assets of Adani Total Gas Ltd and Infosys Ltd.

Return on Assets_Adani Vs Infosys

A look at Adani Total Gas Ltd.’s ROA over the last  five years will show you why you shouldn’t invest in the stock. It’s return on assets rose by 43.50% between 2016-17. The very next year, it fell by 74.69%! In the next year, it again increased by 33.14%. Like a roller-coaster ride.

Whereas the return on assets of Infosys Ltd has been consistent throughout the last five years. It’s no wonder that Infosys Ltd is a 4-star rated stock!

Note: While both Adani Total Gas Ltd and Infosys Ltd belong to different sectors, the focus is on the volatility of their returns.

However, there is an exception here. The return on equity of Tesla was -50% in 2013. This was the time the company was investing heavily in machinery to build model S cars. But with rising sales and profit, this reduced to -3.9% in 2017. In 2021, Tesla’s ROA is 3.33%. So, while a negative ratio is acceptable, the 5-year trend should be moving upwards.

Like all financial ratios, even return on assets can be easily manipulated by decreasing total assets. This is done by leasing assets rather than buying them or achieving higher inventory turnover.

To combat this issue, a variation of return on asset is used – Return on Operating Asset (ROOA).

ROOA measures the efficiency of only operating assets. This is especially useful in cyclical businesses. For example: When demand is high, businesses will increase assets to achieve higher turnover. Whereas when demand falls, businesses sell extra assets to increase revenue. Hence ROOA is more accurate than return on assets.

Here is the list of the 10 best stocks in India with ROA of more than 20%

Stocks with highest ROA ROA ROE
Colgate Palmolive (India) Ltd 49.81% 53.70%
IRCTC 40.71% 44.14%
Nestle India Ltd 39.77% 105.76%
P&G Hygiene and HealthCare Ltd 39.40% 42.09%
Britannia Industries Ltd 35.49% 46.89%
Tata Consultancy Services Ltd 34.94% 39.06%
Marico Ltd 33.79% 36.95%
HDFC Asset Management Company Ltd 29.85% 30.11%
Mindtree Ltd 25.82% 29.71%
Hindustan Unilever Ltd 23.88% 29.25%

So, the next time you analyse an investment opportunity, don’t ignore return on assets ratio. A good company will have a high ROA accompanied with high ROE and ROCE.

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FAQs on Return on Assets

  1. What does ROA mean in business?

ROA is the return generated by a company on its assets. Higher the ROA, the more efficient a business is in maximising its profits from its assets.

  1. What is a good ROA?

Return on asset ratio differs across industries. But ROA of more than 5% is considered good. Whereas ROA of more than 20% is excellent for companies.

  1. Is a high ROA good?

Return on assets of more than 5% is considered to be good. But it should be accompanied with a high ROE and low Debt to Equity ratio.

  1. How do you calculate return on assets?

To calculate return on assets, you need to divide net profit by total assets. Net income is the total profit after paying taxes and other expenditure. Total assets include only tangible assets.

  1. How do you calculate average total assets?

To calculate average total returns, add total assets of both years and then divide by two.

  1. How do you increase return on assets?

You can increase return on asset by increasing your net profits. This can be done by achieving better economies of scale and reducing operating expenses. You can also lease assets instead of buying.

  1. Which is better ROA or ROE?

ROA and ROE both show a company’s profitability. But the main difference between ROE and ROA is that ROE measures returns on equity capital only. It does not include debt capital. Whereas return on assets uses both equity and debt capital.

  1. What is a good ROA for banks?

The ROA of public sector banks in India is -0.58%. Whereas the ROA of top five private sector banks is 12.97%, which is decent.

  1. What does an increasing ROA mean?

An increasing ROA means that the company is generating higher profits on its assets. This also indicates an efficient management.

  1. Can a company have negative return on assets?

Yes, many big companies have negative return on assets. For example: Tata Motors Ltd.’s return on assets is -4.75%. Vodafone Idea has one of the worst return on assets at -24.94%!

By Deepika Khude

The author is a Certified Financial Planner (CFP) with 5 years experience in Investment Advisory and Financial Planning. Her strength lies in simplifying complex financial concepts with real life stories and analogies. Her goal is to make common retail investors financially smart and independent.

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