An ROA/ROE related interview question
I saw this question elsewhere and found it interesting. I'd like to discuss with you guys what's the best way to answer it.
It's said to be a question from a 2nd round interview for a mega fund.
The question is "Assume the industry, product, EBITDA and growth of company A and B are the same. A has a higher ROA but lower ROE, and B has a lower ROA and higher ROE. Which company do you think is better?"
My thinking is:
The company with a higher ROE is generally a better target for investors, which is B.
If dive deeper into the ROE formula, from the Dupont analysis, ROE = ROA * (1+ Debt/Equity).
For B, it has higher ROE but lower ROA, meaning it has a higher debt-to-equity ratio. We need to further analysis the leverage situation of B. If B has a way too high leverage ratio, B might be risky to invest in.
For A, it has lower ROE but higher ROA, meaning its debt-to-equity ratio is lower than B, which implies improvement potentials in capital structure. In an LBO context, this might be where PE firms can add value. Additionally, A's higher ROA means better operation profitability (net margin) or operating efficiency (asset turnover) or both.
Any comments and thoughts are welcome!
I agree with your answer. I actually have heard of this question. Could you PM where you saw online?
I can't PM you :(
Maybe you can PM me?
Sounds like your thinking is right. However, in a buyout context, the sponsor would recapitalize the business to an ideal capital structure so we don't really care about levered returns going in as much (hence why ROIC is a great metric to use). So in this case A would be the better buyout.
So you're saying... in a LBO context, since the sponsor will optimize the capital structure anyway, ROA matters more (better ROA, better business operation). I think it makes sense! Thx :)
And what if this is a minority deal? In a minority deal, I think the sponsor will focus more on ROE than ROIC, which might apply to my original thoughts better.
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