The Problem with Asset Intensive Businesses

Using the Return on Assets (ROA) Ratio

Truly great businesses have the ability to fund growth through internally generated cash. Asset intensive businesses (or “smokestack” industries, as they are commonly called), on the other hand, must continually raise funds through equity and bond issues in order to pay dividends, retire existing debt, and build new plants. These businesses may report earnings, but in many cases are not actually increasing the purchasing power of their owners. Thus, it can be said that they are not truly earning money.

This is not to say, however, that you cannot make profits by taking advantage of occasional under valuation of smokestack shares. Asset intensive businesses do, from time to time, sell at prices far below liquidation or replacement value, at which times they may make for bargain opportunities. In fact, when an asset intensive business is trading below the replacement value of its equipment and systems, management can best serve shareholders by repurchasing shares.

The most effective way to gauge the asset intensiveness of a business is to calculate the return on assets (ROA for short). The return on assets financial ratio tells an investor the return a business earned on all of the assets it has at its disposal, including borrowed money (note that if a company has no debt, the return on equity and return on assets will be the same). For instance, a company with a 15% ROA earned $0.15 for each $1 in assets.

For more information on the return on assets financial ratio, asset intensiveness, and two methods of computation, read Investing Lesson 4: Return on Assets (ROA).