## Tuesday, December 1, 2009

### Components of RNOA: Margin and Turnover

Previously, I touched on the importance of Return on Net Operating Assets (RNOA), specifically with respect to my view that it's foolish to examine a firm's ROE without an idea as to the relative contributions of operating and nonoperating returns. I'd like to examine RNOA a bit further, and place some emphasis on it's dual components of margin and turnover. Just to refresh, the original formula for Operating Return is:

RNOA = Net Operating Profit After Taxes / Average Net Operating Assets

In order to illustrate the margin and turnover components, I'll create a new, equivalent equation:

RNOA = (Net Operating Profit Margin / Sales)  X (Sales / Net Operating Asset Turnover)

Therefore:

RNOA = Net Operating Profit Margin (NOPM)  X  Net Operating Asset Turnover (NOAT)

Truthfully, I don't blame you if this still doesn't make a whole lot of sense. So, let's look at this using some real numbers from the largest employer in the world/retail titan..WalMart (WMT).

Above I've included every part of an equation necessary to understand RNOA's components of NOPM and NOAT. Keep in mind that WalMart's RNOA was originally calculated using NOPAT/RNOA, or \$15,637/\$109,987 to yield 14.22%. To calculate Net Operating Profit Margin (NOPM) I took NOPAT of \$15,637 and divided it by 2009 revenue of \$401,244. The resulting 3.9% seems rather feeble for such a monster like WalMart; it means that for every dollar of sales revenue, WalMart is only earning 3.9 cents of after tax operating profit. Remember though that the margin is somewhat useless in the absence of turnover figures. To calculate Net Operating Asset Turnover (NOAT), I took 2009 revenue of \$401,244 (millions by the way, crazy right) and divided it by Average Net Operating Assets of \$109,987. The resulting NOAT is 3.65. Now multiply 3.9 (NOPM) by 3.65 (NOAT); the result should look familiar - 14.2%. Walmart's figures highlight an important concerning the relationship between margins and asset turnover. A high margin firm won't necessarily earn healthy returns for shareholders; it all depends on the turnover they are able to achieve given that level of margin.

I included WalMart's 20.63% ROE just to illustrate that the company is earning a very healthy operating return component of 69% (14.22RNOA / 20.63ROE). Interestingly, the company doesn't highlight this ratio in its financial presentations. Rather, they use a modified return on investment (ROI) formula that takes operating income as its starting point, and adds back in some non-cash adjustments for depreciation and amortization to arrive at the numerator. In the denominator, WalMart creates an average operating assets figure, similar to NOA except that operating liabilities are not netted out of the equation. Although investors should keep an eye on these metrics that are recommended by management, don't forget that they are non-GAAP and are probably suggested for a reason.

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