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Return on Assets is one of the most treasured tools in the fundamental investor's arsenal. It accurately shows how effective a company is at creating profits from its existing assets. Many investors give plenty of weight to ROA in their analysis of companies but don't actually calculate it themselves or think about what it represents. ROA is really designed to show how profitable a company is compared to what its operational assets, those assets that really create the profit, are worth. Recently, I was discussing Apple (AAPL) with a friend of mine and he mentioned that Apple had a 71% return on operational assets. I wasn't exactly sure what he meant at first, but when it became clear to me what he had done, I felt confident that I had a tool I could use to find hidden value even in an overvalued market like the one we're in now.

To find return on operational assets, we will change the calculation a little bit so that the denominator more accurately represents only those assets which are at work, generating a profit. To do this, we simply subtract cash and investments from total assets and then divide net income by this new figure.

I've done some screening and come up with 6 companies that show promise through their return on operational assets. Most investors probably haven't recognized how profitable these companies are because they don't account for cash and investments in their fundamental calculations, they just look at the ratio displayed on the company's quote page of their screener. Here's the companies:

Company

Net Income (TTM)

Total Assets

Cash and Short Term Investments

Long Term Investments

Operational Assets

Return on Operational Assets

Apple

$41.750

$196.088

$39.820

$97.292

$58.976

70.79%

MasterCard (MA)

$2.758

$12.462

$5.003

$0.000

$7.459

36.98%

Bridgepoint Education (BPI)

$134.830

$747.190

$324.560

$146.890

$275.740

48.90%

Changeyou.com Limited (CYOU)

$293.600

$1,114.510

$418.360

$0.850

$695.300

42.23%

Cray Inc. (CRAY)

$178.240

$534.730

$258.950

$20.090

$255.690

69.71%

NetEase.com, Inc. (NTES)

$3,637.450

$19,277.960

$15,762.970

$490.000

$3,024.990

120.25%

I know this method isn't always accurate. There are companies out there earning large portions of their profits from their investments. Berkshire Hathaway (BRK.A , BRK.B) is the first company that comes to mind. Warren Buffett and the other investment managers at Berkshire invest a large portion of the company's assets and because they invest in equities for the most part, they make a high return and a good chunk of earnings from their investments. If we used my method on a company like Berkshire the results would be far too optimistic.

What I want to stress though, is that the method can be manipulated. The concept is that when you calculate ROA, you should only include assets that are in the company's operations in your calculation. For a company like Berkshire that is mostly involved in insurance, investments are an integral part of the company's operations. That's why we wouldn't subtract investments from assets for an insurance company. We would still subtract cash though. Once you understand the concept of what we're trying to do with this calculation, you'll know when to include cash and investments and when not to. I suggest screening for companies with high ROA, low debt, and lots of cash. Also limit your search to non-financial stocks as they probably will depend on investments in their operations. You'll be surprised the value you can find in profitable companies with strong balance sheets if you use this method. Let's take a look at the companies presented in the table.

Apple

(click to enlarge)

We all know about Apple and I am really enthusiastic about this company. What's really attractive about Apple for me is the cheap price compared to future growth. Analysts predict Apple to grow earnings by 19% in the next 5 years but the stock's net P/E (P/E after subtracting cash and investments from market cap and adding debt) is only 7. Normally, if you want to invest in growth you have to pay for it. For example, Amazon (AMZN) is a company expected to grow earnings by 40% annually in the next 5 years but the market price reflects this growth as it trades at a forward P/E of 75.

With Apple, you're getting a company that has proven it can grow, with 60% annual growth in the past 5 years, for a no-growth price, cheaper than mature companies like Wal-Mart (WMT) and Johnson & Johnson (JNJ). The price has dropped off over 35% since its high in September due to a weak earnings report, but what most investors are forgetting is that the report included one less week than the year ago quarter and that Apple would have earned significantly more if it hadn't been for a shortage in supply of Macs. The company competes with the likes of Google (GOOG), Microsoft (MSFT), and Samsung, but has competitive advantages in its brand, loyal consumer base, and app and software ecosystems. The company has also shown that it can be quite profitable even with a small percentage of market share because of how vertically integrated it is. There's also no shortage of innovation. Expect an iWatch, cheaper iPhone, iTV, and game monetization of the Apple TV through the issuing of SDKs to independent app developers, all in the next year.

Mastercard

(click to enlarge)

Another well-known company, Mastercard makes its money in credit cards and various other transaction processing services. The company has, like Apple achieved fast growth in the past 5 years at 22% annually, but the stock price reflects that growth and future growth. The company trades at a P/E of 24 and sells at nearly 10 times book value. This is important to consider because although the company achieves high returns on operational assets at 37%, the market price is much higher than these operational assets. Insider transactions aren't very promising either; the MasterCard Foundation has sold about 500,000 shares since July. The company competes against the likes of Visa (V) and American Express (AXP), which is worrisome to me as Warren Buffett owns almost $10 billion worth of American Express through his company, Berkshire Hathaway (BRK.A , BRK.B). Owning American Express, to me is a bet against Mastercard, and if that's what Buffett is doing then that is very scary to me as an investor looking into Mastercard.

Bridgepoint Education

(click to enlarge)

With market cap just under $600M, this is a much smaller company than those mentioned thus far. Bridgepoint is another company I am very optimistic about and already discussed in a few of my other articles. It is a different kind of value than Apple in that here, there is much more reward than Apple, but also plenty more risk. Apple is 50% undervalued in my opinion, but with BPI, you could make 3 to 5 times your money in just a few months if the company maintains accreditation. Bridgepoint is a for-profit education company. It operates Ashford University and the University of the Rockies and has over 80,000 students, mostly online. For-profit education is certainly a risky industry.

The federal government has cracked down on for-profits recently and many companies are struggling to maintain accreditation, but some companies like Bridgepoint are priced for bankruptcy, an unlikely event considering the company's cash hoard. BPI's net P/E is .80 after accounting for all that cash and investments, meaning it sells for less than the profit it has generated in the past year. Companies this cheap don't come around very often. If you have some tolerance for risk, this company looks really attractive.

Changeyou.com Limited

(click to enlarge)

Changeyou is a Chinese technology company but in my opinion it's really more of a services company. The company makes massive multiplayer online games (MMOs) and also has a game review website. The games are free to play but users can choose to pay for supplemental in-game items and quests that give them an advantage over other users and make the game more fun. The company also generates revenues from advertising on its website, which it boasts is the most popular game review site in China. The company has 175 million accounts but only 3.2 million active paying accounts. As a young college student at a large university, I take many classes with international students from China. I've asked several of them about the company and they all say its games' popularity are in decline. The company reminds me of Facebook (FB) in that it has plenty of users, but is having trouble maintaining social 'coolness' and monetizing its services. The potential is there though. This company is always showing up on my screens because of its growth in the past 5 years and outstanding fundamentals.

As you can see, it's an Apple-like grower, with 64% eps growth per annum in the past 5 years. I like that ownership has a 7% stake in the company and literally every fundamental is outstanding. I've never been able to pull the trigger though because I am bothered by what my colleagues said about the games and have a natural fear of Chinese companies. I've read about Chinese accounting fraud and how even big investors like John Paulson have gotten burned. I also fear the Chinese government; there is potential for regulation at any time on all Chinese companies. This one is worth considering though if you already have investments in China and know more about the risk involved. It is after all a larger company and, from what I understand, the smaller companies are the real culprits of fraud.

Cray Inc.

(click to enlarge)

Cray Inc. is a technology company that creates high performance, high memory computers called 'supercomputers.' I first heard about this company in Blumenthal's Steve Jobs: The Man Who Thought Different. This is a company that's been around and has been doing the same thing since it was first created. Supercomputing is sort of a niche market; there are a few competitors like IBM (IBM) and Fujitsu, but the industry is relatively uncompetitive. Cray was operating at a loss 5 years ago but turned a profit in early 2011 and earnings have jumped higher since. The volatile results worry me, but I like the uncompetitive environment.

The company's fundamentals are all outstanding right now but I think a lot of that is due to the exceptionally good results this year. Normalized earnings, if they can even be identified, are lower than what the company's earnings are at now. Stock price has already appreciated 200% this year, so I'd say we missed the ride on this one. I hate buying companies at 52 week highs. I know the highs and lows shouldn't matter in the long term, but in the short term stock price is more likely to depreciate after a 52 week high than keep going up. This is a company to watch, but don't buy in now.

Netease.com, Inc.

(click to enlarge)

This is another Chinese gaming company with good fundamentals that's always showing up on my screener. Netease offers its own MMOs to users as well as offering licensed games like Activision Blizzard's (ATVI) World of Warcraft (the most popular MMO in the world) and Starcraft II. Netease is really impressive to me because of its steady, rapid earnings growth, ridiculously high return on operational assets (this is the kind of profitability you can find hidden in companies when you calculate this way), and clear competitive advantage. World of Warcraft and Starcraft II are ultra-popular and this company has the exclusive rights to offer these games in China. My Chinese friends have told me that these games have been popular in China for a while and show no signs of letting up.

The games keep users interested and monetized by offering expansion packs roughly every year. Users also must subscribe and pay monthly to play these games but are willing to do so because of their superiority and unmatched active playing communities. Again, I fear the company because it is based in China but this is an even bigger company at a $7B market cap and I'd like to hope the chances of fraud are much smaller. If you're interested in this company I definitely suggest researching it intensively and making sure the numbers all add up and the reports are explicit and candid.

Of these companies, I have a lot of confidence that at least one will be a big winner. I have all of my money in Apple and really like most of the others. These are all companies that return on operational assets helped me find and I think it can be a helpful tool for other investors too. These descriptions are meant to introduce you to the companies, but ultimately it is up to you to do your research and put your money in what you believe in. Hope it helps.

Source: 6 Companies More Profitable Than You Think And A New Way To Think Of ROA