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Company Valuation Methods - Management Effectiveness Ratios

Before you purchase a stock, you should make an evaluation of it using many different criteria. One of them concerns the management of the company and its way of using the company's resources.

The performance of the company depends on its management team. By measuring its effectiveness you will be able to make reasonable comparison between the company and its peers from the same industry or sector. Additionally, you will be able to make judgments on its performance relative to the market as a whole.

If the management effectiveness results are low, you should consider it as a signal to rethink your investment decision.

Many times investors want to invest in stocks of companies coming from different industries. So, they need comparison tools to facilitate their investment decisions. By using these tools, you can make reliable comparisons. You don't need to make the calculations on your own since many online resources provide them.

Management Effectiveness Ratios

  1. Return on Assets (ROA)

    This ratio gives you an idea on the company's management effectiveness in utilizing its assets to make a profit for its shareholders. The formula for calculating it is:

    ROA = Net Income / Total Assets

    You can use this formula to make comparisons over time. It will show you how well the company progresses in terms of effective resource utilization.

    The best case is to receive a high result for the ROA ratio. This means the company's management is effective in its resource utilization. In addition to this, if the ROA ratio is continually high over the time, then this signifies that the management of the company practices discipline regarding the effective use of assets to make a profit.

    Every industry has its ROA average. Companies with poor management teams fall below this average level, so you should make sure that you avoid investing in such companies.

  2. Return on Investment (ROI)

    Using the ROI ratio you will be able to determine the company's contribution as well as its effective use of leverage or debt in order to expand the activities of the company. It is calculated by the following formula:

    ROI = Net Profits / (Long-Term Debt + Long-Term Liabilities + Equity)

    In order to extend the planned programs in a more fast and efficient way, many companies prefer to combine their equity with the debt they have taken from outside sources.

    The efficient use of borrowed by the company money can make a big difference regarding the value of a project. Thus, the profits from the successful project can be applied for the coverage of the debt.

  3. Return on Equity (ROE)

    ROE measures the amount of money that the company has managed to generate for its shareholders.

    The formula we use to calculate ROE is:

    ROE = Net Income / Shareholders Equity

    As you can see from the formula, the debt of the company is not included in the calculations. This in one way or another distorts the estimations and represents a drawback of ROE.

    Return on Equity ratio has its advantages, but nevertheless lacks many of the benefits of the Return on Assets ratio.

In order to make a clear view of the company's management effectiveness use both the return on investment and the return on assets ratios. On the other hand, don't overlook the return on equity, which also represents a tool for measuring the company's effectiveness. No matter which ratios you apply, never forget to add other criteria in your stock decision making in order to make more reasonable choices.

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