Understanding Return on Equity and Return on Assets
The amount of money the management team of a company is able to generate with the existing resources is what you should look at when you decide on the investment in a particular company. This is commonly referred to as management efficiency. Two ratios that are usually used in order to measure it are return on equity (ROE) and return on assets (ROA).
Since a company has limited resources and it should put them in the most efficient use, ROE and ROA aim to measure the earnings that the company manages to generate through such efficient use of resources.
In order to calculate return on equity you should divide the company's income by its common equity or book value. Since the company employs a specific amount of equity capital this ratio gives you return that it generates from this capital. ROE is expressed in percentage.
Return on assets is calculated by dividing income by the total assets the company has. This ratio presents a measurement of the money the company generates from the employment of all of its assets it has on the books, such as inventories, production facilities and etc.
No matter that ROE and ROA give a general view on the management efficiency, you should have in mind that they are not of a perfect accuracy. This is so, since earnings can be used in a manipulative way by the company's management in order to achieve results it targets. Many high-tech companies have intangible assets that are not included in its books. This means that the book values of such companies can be significantly lower than their true values because of the failure to include intangible assets.
Nevertheless, ROE and ROA should not be overlooked when you start to compare different target stocks. The same accounting rules and regulations companies should follow leads to the same representation of these ratios. Aside from the many benefits they have one more can be added, namely the general profitability picture it gives regarding a particular industry.
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