Can shareholders only care about Return on Equity and NOT Return on Assets? (Hint: NO!)
As a shareholder you might be tempted to care only your part of the investments, i.e. return on equity. This post explains why that doesn't work.
Just now we discussed what is making money. In the short term, making money means having positive economic profit. In the long term, it means creating value for shareholders.
The amount of value created for shareholders is determined by the difference between the return of invested capital and cost of capital. If we want to make improvements in our company, we should, on the one hand, increase return on invested capital, and on the other hand, think of ways to lower cost of capital. Normally cost of capital is related to the industry and the capital structure, so we won't put too much energy on this topic. Instead, let's examine return on investment, or ROI.
Although return on invested capital is a more accurate indicator to return on investment, it actually has the same economic meaning as return on total asset. To simplify the issue, we will still use return on total asset for the following discussions.
You may remember that return on total asset is determined by two factors, effectiveness and efficiency. Effectiveness is represented by net profit ratio. Efficiency is represented by total asset turnover. And Return on Total Asset is the product of effectiveness and efficiency, or net profit ratio and total asset turnover.
Whether a company chooses to prioritize effectiveness or efficiency is a matter of strategic choice. There are two types of strategic choices: one prioritizes effectiveness over efficiency, called differentiation strategy, and the other vice versa, called cost leadership strategy. A company would normally make a strategic choice voluntarily by taking into considerations of the trade-offs. Of course, once a strategy is chosen, there is also the matter of strategy implementations.
Some investors may argue that they should only care about return on equity (ROE) and not return on total assets (ROA), for the reason that shareholders should only care about their part of the returns on capital. Why should they care about the return on capital for creditors?
To solve this issue we will need to understand the relations between ROA and ROE.
ROE is net profit divided by shareholders' equitites.
Let’s assume that I don’t know the value of shareholders’ equities, but I do know that of total asset. Obviously I cannot get ROE, but I can get ROA. If I want to get ROE, I have to multiply ROA by another ratio, called total asset divided by shareholders' equities. In this way, the two total assets will be crossed out, leaving us with net profit divided by shareholders’ equities.
Here we see this new multiplier, total asset divided by shareholders' equities, for the first time. However, even if it is new, it's actually closely related to another term we've already come across before, called debt asset ratio.
Recalled that debt asset ratio is calculated by dividing debt by total asset. In addition, one of the most fundamental equations in accounting is that total assets alway equal to the total of liabilities and shareholders' equities. Combining both, we will get to the following equation:
Now. let's assume that the total asset of a company remains the same but its liabilities have increased. We know that the debt asset ratio will increase. Once we subtract debt asset ratio from 1 and then invert the result, we will find an increased value for total assets divided by shareholders' equities. That’s why we said this number is closely related to the debt asset ratio; they move in the same directions, i.e. they are positively related. The higher the debt asset ratio, the higher the indicator. Because it describes the number of times total asset is over shareholders’ equities, it is often referred to as equity multiplier.
Now we know ROE equals to ROA times equity multiplier. If I were a shareholder who wants to increase the ROI of shareholders, I have two ways to achieve my goal. One way is to increase ROA, and another way is to raise the debt level of the company in order to increase equity multiplier. As a matter of fact, raising the debt level seems much easier than raising the ROA. As long as I keep borrowing more money, my ROE will increase. That sounds easy.
However, a prerequisite of this claim is that when raising the equity multiplier, our ROA must stay the same so the product will also increase as a result. Let's see if that could actually happen.
If I borrow money and just put it in the bank, what's going to happen to my net profit? Obviously, because the interest rate of deposit is always lower than that of loans, my net profit will decrease. And because borrowing doesn't affect my shareholders’ equities, the ROE of my company will decrease as a result.
However, no companies should only borrow money to put it in the bank. Money must be put into work, i.e. investment. But does investment always make money? Not necessarily. It may cause losses, or maybe even more losses than depositing it in the bank.
What does this mean? It means although seemingly there are two ways to increase returns on investment of shareholders; one is to raise ROA, and the other is to increase equity multiplier. The two ways are actually leading to the same result.Even if I decide to borrow more money, I still need to solve the second problem, which is to use borrowed money to make more money.
From this perspective, we see that the fundamental factor that determines return on investment for shareholders is not how high your debt asset ratio is, but how much the return on investment is for the company as a whole, aka. ROA. For a good company, the most important thing is to create value, which is equivalent to increasing ROA. This is also important to shareholders since the fundamental factor determining the return on investment of shareholders is still the return on investment for the company as a whole, or the ROA.
For all the terms and formulas we've covered regarding how to evaluate the quality of a company, visit this link.
