ROA and RNOA

Chapter 6 shows how the traditional measure of operational profitability, Return on Assets (ROA) is in error. First, ROA includes debt assets in the total assets in its denominator, but these are part of financing activities not operating activities, as chapter 5 explained. Second, ROA omits operating liabilities is the denominator. That is corrected by substituting net operating assets for total assets in the denominator, as in the Return on Net Operating Assets (RNOA) profitability measure. The correction is important for valuation because using ROA in the calculation of residual income mismeasures the value added in operations.

On average, ROA over the past 50 years is about 6.8% for U.S. firms. That on the face of it looks odd: With the average required return deemed to be about 10%, that means firms were typically earning less than their hurdle rate with this measure; the residual income from operations is negative. Indeed, the average ROA is not much higher than the average risk-free rate of 6.4% over these years. Investment in risky operations would seem to require a higher risk premium over the risk-free rate. In contrast, the average RNOA is about 11.2%.

Chapter 6 compared ROA and RNOA in fiscal 2022 for Microsoft. Here is the comparison for 2023 and 2024 with the difference explained by the amount of debt assets in total assets and the amount of operating liabilities (OL):