In fundamental analysis, Return of Equity (ROE) and Return of Assets (ROA) are among the most important indicators used to evaluate the investability of targetted stock counters.
There are generally 4 components that make up the shareholders' equity:
- The shares that are sold out to the shareholders, and tradable in the market.
- The shares that are repurchased by the company and kept as treasury shares.
- Company's profit that is reinvested into the business as retained earnings.
- Additional paid-in capital pumped into the company by its shareholders.
The main different between ROE and ROA is that, ROE does not take into account the financial leverage or debt of the company, whereas ROA includes it.
As you might have aware of the basic financial equation as illustrated in the diagram below:
The company needs assets to run its business. The assets can be funded either from shareholders' equity, or from 3rd parties (non-shareholders) as liabilities, for example, in the form of financing loans.
ROA is a measurement to evaluate how effective is the company's management team in utilizing the company's assets to make profit.
ROA = Net Profit / Total Assets
ROA = Net Profit / (Shareholder Equity + Liabilities)