Picking stocks in the stock market is like picking items in a supermarket.
Among various items, shoppers will see whether they get the best deals based on factors like brands, unit prices, and coupons.
So how do investors know if they get a good deal or not in the stock market?
In financial analysis, we can use two metrics to measure a company's fundamentals: return on assets (ROA) and return on equity (ROE).
ROA is a profitability ratio calculated by dividing net income by a company's total assets. It measures how efficiently a company uses its assets to generate profits.
In general, the higher the ROA ratio, the better, as it indicates that a company is making more profits from its assets. On the contrary, a low ROA means a company's management is not using its assets effectively.
For example, there are two coffee shops, both of which have total assets of $100,000.
Coffee Shop A has a net income of $20,000 in a given period, and Coffee Shop B's net income is $30,000. After calculation, their ROA is 20% and 30%, respectively. Coffee Shop B has a higher ROA, indicating that more profits are generated from every dollar it owns.
However, some companies' assets may be acquired by using borrowed funds from banks.
After debts are deducted from assets, the leftover belongs to the company's shareholders, that is, the shareholders' equity. Therefore, if you are a company shareholder, you may consider another profitability indicator, ROE.
ROE is calculated by dividing a company's net income by its shareholders' equity. It measures how efficiently a company uses investors' money to generate profits.
Back to the previous example.
Suppose Coffee Shop A's 100,000 total assets include 50,000 shareholders' equity and 50,000 liabilities. Its ROE equals 20,000 divided by 50,000, which is 40%. Assuming that Coffee Shop B has no liabilities, then its shareholders' equity equals its total assets, which is 100,000. As a result, the ROE of Coffee Shop B is 30%.
Coffee Shop A has a higher ROE, meaning it is doing a better job at generating profits with shareholders' money.
As investors, we prefer companies to have higher ROE because it indicates that we're getting a good return on our money.
But remember that sometimes an extremely high ROE may not be good.
A company can raise its ROE by increasing net income and reducing shareholders' equity. Suppose a higher ROE is driven by an increasing net income. It is a good sign that the company is making more money. However, investors should be careful if the company's net income increases due to one-time events, which is unsustainable.
A company may also boost its ROE by reducing its shareholders' equity. The common way is to borrow money to buy back shares of its stock, which will result in a decrease in the shareholders' equity. In this case, the company's ROE will increase even if its net income remains unchanged.
So, what counts as a good ROE?
As with most other financial metrics, it will depend on the company's industry. Some industries tend to have higher ROEs than others.
Therefore, when evaluating a company's ROE, it's essential to compare it to the industry average. If a company's ROE is higher than the industry average, the company is more competitive than other companies in the same industry.
Investors can also compare a company's most recent ROE to its historical level. A sustainable increasing ROE over time indicates a company is good at generating shareholder value. In contrast, a declining ROE should raise a red flag for the investors.
In general, ROA and ROE are two financial metrics that measure a company's fundamentals.
Both metrics help investors know how well a company uses its resources to generate profits.
This marks the end of the video. See you next time.