Now it is time for investors to do their homework. How do you find the right stocks? How do you find the best stocks? What is the magic number? First of all; you must know what makes a stock good and other stocks bad. So, what is the magic numbers?
Finding great stocks is not so difficult as you think. Unfortunately, the magic numbers doesn`t exist. But it is some metrics you have to look for that is more important than others. I often start to look at a company’s ROA (return on assets).
ROA (return on assets)
This is the leading measure of a company`s effectiveness. It tells you how effective the management are using the assets. ROA tells you what earnings were generated from invested capital (assets). It is best to compare a company`s ROA with the previous ROA numbers, or you can compare it with a similar company.
Definition of Return On Assets – ROA
An indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company’s annual earnings by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as “return on investment”.
The formula for return on assets is:
ROA = Net Income/Total Assets
Note: Some investors add interest expense back into net income when performing this calculation because they’d like to use operating returns before cost of borrowing.
Both debt and equity is the company`s assets and they are used to fund the operations of the company. The higher the ROA number is, the better it is. In this case, it tells you that the company are earning more money on less investments and that is a sign of an effective company.
Company A has a net income of $2 million. Total assets is $5 million. ROA is 40% (2/5 = 40%).
Company B has a net income of $2 million. But the assets is twice as much as Company A, which is $10 million. ROA is 20% (2/10 = 20%).
Who is the best? Company A have a higher ROA than Company B, which means Company A is better than Company B. It is because Company A is better to convert its investments into profit.
This is why investors sometimes want to change a company’s leader, because they are not satisfied with their earnings. The leader and a company`s management are doing a very important job. Not only for their company and their employees, but also for the investors and not at least the society. It`s all about makes big money with small investments. That`s it.
Also remember that ROA is often referred to as ROI, and we add the interest expense to ignore the costs associated with funding those assets. So, ranking company’s by size is meaningless. It`s interesting to know the size of a company, but ranking companies by size of their assets is completely meaningless. It`s better to look at ROA and how a company is better than another to squeeze profit from its assets, regardless of size.
ROA is far away from being the ideal investment tool. The return numerator of net income can be suspect. Assets as we know, is also numbers that is valued in the balance sheet.
You can`t always compare companies with ROA, because the assets is not what it seems to be. You can`t see people, ideas, trademark, brands or patents in the assets. A grocery have more assets than an online techno company. The techno company`s assets will be understated, and it`s ROA may get a questionable boost. Two of the worlds biggest company`s is Apple and Exxon Mobile. You can`t compare them. Two different comany`s in two different industries with two different assets. Appel`s ROA is 19,3, while Exxon Mobil`s ROA is 10.
All in all; ROA makes it easier for investors to recognize good stocks and minimizing the risk of doing a bad investment with bad stocks.
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