Return On Investment: The Great Equalizer
Return On Investment: The Great Equalizer
Return On Investment: The Great Equalizer
When faced with an investment decision it is hard to compare a large cap company with a small cap company. The comparison of small cap to large cap can be compared to the Davids and Goliaths of the business world with return on investment being the equalizer.
Return on investment is a simple ratio:
Return on investment (ROI) = Net Income / Average total assets.
This ratio is a way of placing all companies on a level playing field in terms of how profitable they are. It shows how efficiently a company has been with turning their assets into a profit.
The balance sheet and income statement for a company contain many valuable pieces of information for determining a company's profitability. For use within the return on investment ratio, the net income can be taken directly from the income statement. Total assets can be found on the balance sheet; however, the total assets figure that is listed on the balance sheet cannot be used to accurately calculate ROI. This is because when a balance sheet is composed it will show the total assets at that day and time, while net income has been reported for the entire period. Both of these values must be for the same period of time. In order to calculate for this difference in net income and total assets, average total assets is the value that is used. Average total assets are an average of the current year's total assets and last year's total assets, turning the ROI calculation into:
Return on investment = Net Income / ((total assets previous year + total assets current year)/2))
To see the practical use of this formula we can take a look at Company A and Company B. Company A is a large cap company with market capitalization of around $200 billion. Company B is a small cap company with a market capitalization around $30 million. Market capitalization is the total value of all outstanding shares; this is determined by multiplying the current price per share and the number of outstanding shares.
Company A reported net income in the amount of $10 billion for 2010, compared to Company B that reported $6,000. The total assets for 2010 and 2009 respectively for Company A are $160 billion and $150 billion, and for Company B are $24,000 and $26,000. When placed into the ROI equation these should look like this:
Company A:
Return on investment = $10 billion / ([($160 billion + $150 billion) / 2]
Return on investment = $10 billion / $165 billion
Return on investment = 6%
Company B:
Return on investment = $6,000 / [($24,000 + $26,000) / 2]
Return on investment = $6,000 / $25,000
Return on investment = 24%
When initially comparing the two companies it is obvious that $10 billion dollars of income is more than $6,000 of income. However, Company A is only seeing returns of 6% for assets they invest in, while Company B is seeing a 24% return. While this is a simple example, it shows how more isn't always better and how efficiency is the key. All else being similar for each company, Company B is the more efficient company and is more effectively using their assets to return a profit.
The net income of a company can be misleading, especially when comparing a large company with a small company. In the example above Company A is representing large cap companies such a Walmart and GE. Company B is representing small, relatively unknown companies. While Company A has made $10 billion dollars for the year it took them $165 billion to do so. For comparison, Company A would need to cut their total assets down to $50 billion and still have income of around $165 billion in order to have a rate on investment close to that of Company B.
When a company has a low return on investment percentage, they are like a machine not running on all cylinders, they are inefficient. They are not making the most efficient use of the assets they are investing in. And while it is easy when comparing two potential investments to automatically invest in the company that is making $50 billion. Bad investments can be avoided by digging a little deeper, and using the return on investment calculation to find which company is more efficiently using their assets.
Short Term Vs Long Term Investment SIPP Approved Investment With Fixed Returns of 39% Owning an Investment Property in New Zealand Industry Experts in Agreement, Istanbul is a Hot Property Investment Investment Terms Vary PPC Campaigns - Obtaining The Most From Your Investment Good Investment Last Edinburgh Letting Company for Best Property Investment Results Foreign property investment A lot goes into a fridge to make it such a big investment Investment property for sale - Choosing the right location for your investment property Investment property for sale - The Benefits of Caribbean Investment Property Investment property for sale - Investment Property for sale Find Land Investment