When you're appraising investments, return on equity and return on assets can both help you. ROE measures a company's net after-tax income divided by shareholder equity. ROA measures the same income divided by assets. You can use the ratios to measure the performance of companies of different sizes and get a sense of how well they're performing compared to each other.
Shareholder equity is the value of company assets, less the company's debts. A company that earns $10 million and has $2 million in equity, for example, has a five-to-one ROE. This works best if the companies you compare have similar levels of debt financing because debt reduces equity. Suppose, say, the company earning $10 million takes on another million in debt. That leaves $1 million in equity, so the ROE is ten-to-one. As it's taken on more debt, though, it may be a poorer investment.
Because it uses assets rather than equity, ROA provides a more reliable metric. Company borrowing affects the equity and the ROE but it doesn't alter the assets. What can lead you astray is using ROA to compare businesses in different fields. A manufacturer typically has more physical assets than an ad agency or software firm, for instance. With more assets, the manufacturer's ROA is smaller, but that doesn't demonstrate than it's run less well than low-asset businesses.
Significance of ROE
The Morningstar investment firm says that if a company has a 15 percent ROE or better it probably has a "moat" -- an advantage that allows a company to stay consistently ahead of its competition. Forbes, however, notes that ROE often has no real significance because it's so easy to distort. A company that buys back lots of shares, for example, reduces equity -- which increases ROE. This may make it look as if it's out-earning the competition even if it's floundering.
Importance of ROA
ROA tells you how well the companies you're looking at manage their assets to make money. An ROA of 10 percent, according to Morningstar, is another sign the company has a competitive moat. It's not as easy to distort ROA as it is ROE, but many investors are less interested in ROA. What's important to them is not how efficiently the company uses its money, but how good a return it gives the shareholders.