To explain suppose we learn that this company has 500

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To explain, suppose we learn that this company has $500 million in assets. We now assess the $10 million profit as low because relative to the size of its asset investment, the company earned a paltry 2% return, computed as $10 million divided by $500 million. A 2% return on assets is what a much lower-risk investment in government-backed bond might yield. The important point is that a company's profitability must be assessed with respect to the size of its investment. One common metric is the return on assets (ROA)-defined as net income for that period divided by the average assets for that period. Components of Return on Assets We can separate return on assets into two components: profitability and productivity. Profitability relates profit to sales. This ratio is called the profit margin (PM), and it reflects the net income (profit after tax) earned on each sales dollar. Management wants to earn as much profit as pos- sible from sales. Productivity relates sales to assets. This component, called asset turnover (AT), reflects sales generated by each dollar of assets. Management wants to maximize asset productivity, that is, to achieve the highest possible sales level for a given level of assets (or to achieve a given level of sales with the smallest level of assets). Exhibit 1.8 depicts the disaggregation of return on assets into these two components. Profit- ability (PM) and productivity (AT) are multiplied to yield the return on assets (ROA). Average assets are commonly defined as (beginning-year assets + ending-year assets)/2. - - -~ - --- EXHIBIT 1.8 Return on Assets Disaggregation Return on assets x x Profitability and Productivity There are an infinite number of combinations of profit margin and asset turnover that yield the same return on assets. To illustrate, Exhibit 1.9 graphs actual combinations of these two com-
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Module 1 I Framework for Analysis and Valuation 1-22 ponents for companies that we highlight in this book (each is identified by their ticker symbol). Retailers, like Costco (COST), Best Buy (BBY) and TJX Companies (TJX) are characterized by relatively low profit margins and a high turnover of their assets. The business models for other companies such as the pharmaceuticals [Johnson & Johnson UNJ) and Pfizer (PFE)] require a larger investment in assets. These companies must earn a higher profit margin to yield an accept- able ROA. We might be surprised to see technology companies such as Apple in the group with high asset investments. Technology companies typically maintain a high level of cash and short- term investments on their balance sheets, which allows them to respond quickly to opportunities. The solid line represents those profitability and productivity combinations that yield about a 10% return on assets. I EXl-ilBIT 1.9 Profitability and Productivity across Industries 4.0 3.5 3.0 •..
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