We spent a lot of time in class discussing Return on Assets (ROA) and in particular the DuPont method. This is of course a key measure used externally to compare companies and their relative performance and internally to measure management on their effective use of assets.

However it is not a perfect measure. Different companies have different strategies. Lets use the Jewelry business as a first example. First consider Tiffany. They are very exclusive and expensive and I would guess that on average they have a higher quality of diamonds than say Kay. On the other hand, Kay while having a range of diamonds, does sell some high quality as well and ultimately lets face it, at some point a diamond is, well just a diamond. At least I think?

But they have very different strategies. Tiffany sells at a very high profit margin, but is willing to have much lower volumes and turnover of their assets which for a Jeweler is pretty much inventory. Where as Kay, moves inventory fast. There are in many more and less exclusive locations, have more sales and discounting, so they would have a lower profit margin, but turn their inventory over much faster. Nevertheless, both companies have the opportunity to have a good return on their assets, but with different strategies and the DuPont method would call that out very quickly.

Another situation that can happen is that two similar companies, with similar output and similar net income all else being equal, could have very different strategies. One company may rely on automation, read that as robotics and accordingly have a very high asset base. The other may rely on a labor intensive model that uses people but not nearly as many assets.

You are the analyst and are asked to compare the two enterprises and have ROA high on your list of analytics. Because you now know you need to dig deep into Financial Reporting to get the whole story, you realize this difference in strategy and realize that the labor intensive company is going to simply by nature have a higher ROA, since the assets in the denominator are lower and from there it is just the math.

So now what to do. Can you think of alternative ways to compare the two companies.