Return on Assets (ROA): Meaning, Calculations, and Excel Examples
The Return on Assets in corporate finance equals a company’s Net Income in a period, such as 1 year, divided by its average Shareholders’ Equity over that same period. Return on Assets measures how efficiently a company uses its Total Assets to generate after-tax profits.
Return on Assets (ROA) Definition: The Return on Assets in corporate finance equals a company’s Net Income in a period, such as 1 year, divided by its average Shareholders’ Equity over that same period.
Return on Assets measures how efficiently a company uses its Total Assets to generate after-tax profits.
In other words, if two companies each have $500 million in Total Assets, including items such as factories and inventory, which one generates higher profits on those assets?
Companies that do this more efficiently have higher ROAs and should, therefore, be valued more highly.
Many online sources give examples of ROA for “standard” companies, such as retail and manufacturing companies, but in real life, ROA is primarily a metric for financial institutions, such as commercial banks and insurance firms.
That’s because these firms make money directly from the Total Assets on their Balance Sheet, while the link is less direct in most other industries.
Return on Assets (ROA): Example Calculation and Benchmarking for Retailers
To demonstrate the ROA calculation, let’s look at two U.S.-based retailers: Target and Costco, both of which have revenue over $100 billion (with Costco over $200 billion).
Here’s the ROA calculation for each one over several years:
Costco’s ROA increased slightly over this period, going from 7-8% to 9-10%, while Target’s ROA recently declined, falling from the ~7-10% range to ~5%.
Based on these results, we expect Costco to trade at higher valuation multiples.
Sure enough, at the time of this analysis, Costco traded at higher multiples than Target:
The Return on Assets (ROA) is not the sole explanation; it’s one of many factors.
However, if you find a company that does not trade at higher multiples despite higher ROA and growth metrics, it might be a sign the company is currently undervalued.
Return on Assets (ROA) for Commercial Banks and Why It Matters
This example above is a bit contrived because ROA is not that important for most companies in industries like consumer retail.
Many other factors, such as their employees’ performance, relationships with suppliers, and sales & marketing efforts, also affect their Net Income.
Asset efficiency plays a role, but it’s less of a direct link than some people claim.
Return on Assets is far more significant in the financial sector (i.e., Financial Institutions Groups (FIG) at banks) because many of these companies generate revenue and profits directly based on their Balance Sheets.
For example, the major drivers for commercial banks are Loans and Deposits.
A bank lends money to customers who need to borrow, and on the other side of its Balance Sheet (Liabilities & Equity), it creates Deposits to match these Loans.
But a bank can’t do this indefinitely; it must also maintain a certain amount of regulatory capital in case too many of its Loans default, resulting in unexpected losses.
Bank regulatory capital is, basically, Common Shareholders’ Equity with some adjustments (see our detailed tutorial on bank regulatory capital here).
Since a bank’s Loans represent over 50% of its Total Assets, and since it earns money directly from the Interest Income on these Loans:
-Loans and Total Assets are the key drivers in all bank models.
-Return on Assets (ROA) is critical because a bank using its Total Assets more efficiently will generate higher Net Income.
-And the more Net Income the bank generates, the more “regulatory capital” (Shareholders’ Equity) it will need to support its Loan Growth.
Return on Assets (ROA) for Commercial Banks: Benchmarking
Here’s a specific example of the ROA calculation and the bank-specific valuation multiples (P / E and P / BV) for two large, money-center banks (JP Morgan and Citi):
JP Morgan’s ROA is almost twice as high as Citi’s (1.0% vs. 0.6%), and it has been higher for many years.
Its margins and growth prospects are also better, so it is no surprise that it trades at higher valuation multiples.
The most important multiples for banks are Price to Earnings (P / E) and Price to Book Value (P / BV), and JPM has higher numbers in both.
Again, ROA is not the only factor.
You also look at metrics such as the Return on Equity (ROE), Loan Growth, the Net Interest Margin (NIM), and more.
However, if all these metrics, including ROA, are higher for one bank, this bank “should” be valued more highly in the market (assuming it’s similar in terms of size and geography to all the other banks in your set of comparable companies).
If it’s not valued more highly than similar banks with lower ROA and ROE figures, you may have found an undervalued bank.
Return on Assets (ROA) in Real-Life Financial Models
Instead, it’s more of an “informational metric” that you can use to answer questions such as:
-Do your assumptions translate into higher efficiency for the company you are modeling?
-Does that higher efficiency also correlate with higher valuation multiples?
-What revenue growth and margins are required for a company to achieve an ROA of X%?
Even in commercial bank valuations and dividend discount models, ROA is used to cross-check your work rather than a direct input.
If you understand that, you’ll be ahead of the game with Return on Assets in all contexts.