IFB58: Efficiency and Financial Ratios Formulas: ROA, ROE, & ROC

 

Welcome to Investing for Beginners podcast, this is episode 58. Tonight Andrew and I are going to talk about financial ratios and we’re going to talk about some ones that we have not discussed before so this will be fun.
We’re going to take a shot at talking about return on assets, return on equity, and return on invested capital as well as maybe a few other tidbits so Andrew why don’t you go ahead and take our first shot at return on assets.
Andrew: okay yeah I could do that. Return on assets so basically the three of these ratios a good way to think about them is they’re kind of like efficiency ratios. They are ways to evaluate whether a business is good at creating cash with what they have.
We’ve talked about some ratios in the past we talked about valuations episode 11 really good for that so we should I think we also talked about the cash flow statement I know we did that we might have done the income statement so we’re trying to piecemeal these lessons here and there.
These efficiency ratios are good to keep in your back pocket for doing the kind of stuff that some of these value investors like to do I know Buffett likes to use efficiency ratios like I think he uses ROE, Joel Greenblatt uses ROIC so these are some good ones to know and to understand obviously some of these accounting metrics are a little bit hard to conceptualize if you aren’t familiar with financial statements.
I would recommend maybe that’s a little bit over your head to try to learn some of the basics first try to tackle a financial statement and then maybe go back to an episode like this and then you can really comprehend return on assets. so that’s simple like it sounds so when you hear all of these return they’re basically talking about like what a company is able to create as far as profits go so the simplest way to use this equation as to say return is net income and then you divide it by assets which is total assets.
Pretty self-explanatory I would say you think about the type of businesses that are going to be scoring better on both return on assets and return on equity one that comes to mind would be like a Facebook right where they don’t need as many assets pretty much any financial website or why did I say financial that at least my brains on somewhat of the right general topic.
But any website any business that isn’t very capital intensive doesn’t need huge expensive factories in order to run they’re generally going to score really well on ROA or ROE and so I think ROE is also self-explanatory Dave do you want to talk about that one and talk about anything I missed about our way.
Dave: yeah the ROA what I like about it is it’s obviously it’s very simple to calculate and as Andrew was saying it is an efficiency ratio and I think that the thing that I like about return on assets is it gives you it gives you an idea of how effectively the company is converting its money into income.
And obviously the higher the number the better it is and so as Andrew and I like to talk about a lot assets are really was drive a business earning more money and when you think about return on assets the best way to think about it when you’re using it as a way to value a company is to look at the financial ratio as a comparison to like companies.
So for example you wouldn’t take a railroad and look at the return on assets and compare that to a bank or you wouldn’t take the railroad and compare it to Facebook because there are two different types of businesses. Where it’s going to be most effective is when you’re going to use it in in a relationship to other like to like businesses.
Let’s say  the fang stocks which was  all the rage so if you take Facebook and maybe Google or alphabet and compare those return on assets those it’s going to be more e...