I was alerted by some readers of The Bedokian Portfolio about certain important ratios that were missing from the book, and those are Return on Equity (ROE) and Return on Assets (ROA). Both of them are known measures of profitability. Before I explain why I had left them out, I shall explain what ROE and ROA are.
Return on Equity (ROE)
ROE is the amount of net income (total amount earned minus expenses, taxes and depreciation) returned as a percentage of shareholders equity. In other words, it is the profit generated using a given amount of shareholder equity. The formula for ROE is as follows:
Net Income / Shareholders Equity
The higher the percentage, the better the ROE is.
Return on Assets (ROA)
ROA is the amount of net income returned as a percentage of a company’s total assets. Similar to ROE as the number is expressed in percentage, the comparison is now against all of a company’s assets, which includes the shareholder equity, and the formula for ROA is:
Net Income / Total Assets
The higher the ROA, the better the ROA is.
ROE and ROA In-Depth
Let us put in another basic accounting formula, and you could clearly see the relationship of ROE and ROA:
Total Assets = Liability + Shareholders Equity
This means if there is no liability (which is uncommon), ROE equals ROA. However, if the difference between ROE and ROA is huge, better check out the liability portion in the financial statements.
So Why No ROE and ROA in The Bedokian Portfolio?
What I am going to say next may invite brickbats, but the selection criteria highlighted in The Bedokian Portfolio are sufficient for a basic Bedokian Portfolio investor. The criteria of D/E ratio and current ratio for the coverage of liability are adequate. After all, legally and accounting speaking, dividends are to be paid from profits, and if there already is a dividend yield means there is profitability.
The ratios mentioned in the book are “…the more important ones…” (The Bedokian Portfolio, p86), meaning I do not diss away the other ratios, in this case the ROE and ROA. In fact, I encourage Bedokian Portfolio investors to take a step further in using other ratios to do their analysis further.