Return on Assets and Profit Margins

Capital intensity of a business versus Pricing Power

I’ve talked a lot about competitive advantages before, and I’ve explained before how consistently high pre-tax profit margins are the best indicator of whether a company has such an advantage or not.

Not many people agree with me though, many point to return on assets, or return on invested capital as “the primary indicator for the existence of a competitive advantage” instead. Indeed return on assets is used as a key input to the investment strategy known as Magic Formula Investing.

Now, I’m not necessarily against return on assets as a useful metric, but it’s not really an indicator of a businesses competitive advantage, and indeed in some businesses it may be the other way around!

Let’s talk about that…

Return On Assets

What is Return On Assets?

The term return on assets (ROA) refers to a financial ratio that indicates how profitable a company is in relation to its total assets. Corporate management, analysts, and investors can use ROA to determine how efficiently a company uses its assets to generate a profit.

That’s a fairly simple definition, and there’s even a simpler way to calculate it!

All you have to do is divide your companies net income with the total amount of assets on the balance sheet:

There’s also other similar ratios that can be used, such as return on equity, or return on invested capital.

Each of these is calculated differently, and they each tell you different things about the business they belong to. They are particularly useful if you use them together, and compare the results to one another.

For example, a business with low returns on assets, and high returns on equity is highly leveraged with debt. They’re juicing up their returns with borrowed capital, and are subsequently a less stable business for it.

On the other hand a company with low returns on assets, but high returns on invested capital might be carrying on its balance sheet too much cash, and that might be a sign that they might be getting ready to pay a dividend, or conduct some share buybacks.

The key thing to understand here is that these ratios don’t exist in a vacuum, and they do tell you something about the business.

However, what they don’t tell you is whether a business has a durable competitive advantage.

This may seem odd, but it’s true!

The fact of the matter is that return on assets is a lot more useful to determine how much capital is required to expand the business, rather than whether that business has some sort of advantage over its competitors.

This is a good thing! It means you’re getting good returns based on how much you reinvest into the business!

But it doesn’t say anything about whether the business has some advantage! Indeed, in some businesses, the high amounts of capital requirements means that high returns on capital are very difficult, even when the business is essentially unassailable by competitors.

And case in we have a business we reviewed before, Air Products and Chemicals.

This is a business with fairly low Returns on Assets, of around 8%, but it’s the fact that those assets cost so much that allows them to have profit margins in the 20% range.

On the other hand if we compare it with a company like Texas Roadhouse, a business with similar return on assets, we can see that this restaurant chain has significantly lower profit margins.

That’s because despite having good returns on assets, the business simply doesn’t have much of a competitive advantage. And the reason we know this is because if the company did, they would have the pricing power, or control over their supply chain, to keep those profit margins high!

Now, some of this is often attributed to industry trends… the old “Of course they have lower margins, Restaurants/retailers/etc… always have low margins”.

But this is not a good argument against using margins to measure competitive advantages.

In fact, if anything it’s an argument against using return on assets! Because While pricing power, or cost control, are applicable to every industry and every business, returns on asset are not!

Some businesses simply need a lot of capital expenditures to produce any cash at all, even if the cash is reliable and profitable for a long time! ADP is the perfect example, since they need a lot of capex for new customers, but then that huge amount of capex becomes its moat against competitors!

Comparing with Peers

A lot of people say that you really need to compare these metrics with the companies peers, and ignore comparisons with other businesses outside of the specific industry.

The problem I have with this argument is that you're investing in businesses in general, not a specific industry.

You don't have to invest in supermarkets if the underlying economics of the industry are bad.

Low margin businesses are inherently vulnerable to disruption, they have no moat, no way to protect themselves against competition, and any significant disruption or even normal fluctuations in the business cycle can easily turn your company from profitable to unprofitable.

Tiny margins means you're competing primarily on price, and not just that, but it means you don't have the pricing power needed to do so in an effective manner.

The fact that all of its competitors have low margins, doesn't say anything about the quality of the business, it just says something about the quality of the industry its in.

I gave the example of supermarkets, because that's a perfect example of a terrible industry to own.

It's highly competitive, requires gigantic capital investments to not only operate but to grow, and the profits your business produces, even for the best companies in that industry, are tiny and easily disrupt-able.

On the other hand high margin businesses don't have to worry about that.

They are not competing on price, hence clients will be more open to accept price increases.

They have the pricing power over not just their competitors, but over their suppliers as well, giving them the flexibility to quickly adjust the business if need be. The high margins also form a buffer against significant disruption to the business, since even a large increase in costs won't leave the company in the red and will merely eat into the margins. Such increases can also be passed on to clients more easily.

I like to put companies in one of 3 “buckets” based on their pre-tax profit margins:

• <10% - Bad businesses in highly competitive industries

• 10% to 20% - Average businesses, neither good nor bad

• >20% - Good businesses with a clear competitive advantage

10% isn't an exact number, but it's a decent rule of thumb for a threshold for a bad business, just like 20% is not an exact number but just a rule of thumb for a good business.

For example, Aflac is a great business, but it’s margins are only around 18%! Don’t be afraid to deviate slightly for something undervalued, but keep it in mind! And of course, demand a higher margin of safety for it!

At the end of the day, why would I care what the average for the industry is?

If a company can barely make money, I don't want to invest in it, no matter whether its peers are in the same situation.

In summary

Return on assets is a good way to tell whether a company can reinvest in itself in an effective manner, but it tells you little as to whether it’s got a durable competitive advantage.

In order to find that durable competitive advantage, there is really no alternative to consistently elevated profit margins, preferably above 20%.

Do you have any other key indicator that you look at when deciding whther to invest? Let me know in the comments below!