I am writing today to help inform people who are new to the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
Yes Bank Limited (NSE:YESBANK) outperformed the diversified banks industry on the basis of its ROE – producing a higher 16.44% relative to the peer average of 7.80% over the past 12 months. But what is more interesting is whether YESBANK can sustain this above-average ratio. This can be measured by looking at the company’s financial leverage. With more debt, YESBANK can invest even more and earn more money, thus pushing up its returns. However, ROE only measures returns against equity, not debt. This can be distorted, so let’s take a look at it further. View out our latest analysis for Yes Bank
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Yes Bank’s profit against the level of its shareholders’ equity. An ROE of 16.44% implies ₹0.16 returned on every ₹1 invested, so the higher the return, the better. If investors diversify their portfolio by industry, they may want to maximise their return in the Diversified Banks sector by investing in the highest returning stock. However, this can be misleading as each firm has different costs of equity and debt levels i.e. the more debt Yes Bank has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Yes Bank’s cost of equity is 13.66%. Given a positive discrepancy of 2.78% between return and cost, this indicates that Yes Bank pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be dissected into three distinct ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from Yes Bank’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. We can assess whether Yes Bank is fuelling ROE by excessively raising debt. Ideally, Yes Bank should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The ratio currently stands is significantly high, above 2.5 times, meaning Yes Bank has taken on a disproportionately large level of debt which is driving the high return. The company’s ability to produce profit growth hinges on its large debt burden.
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Yes Bank’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of Yes Bank’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For Yes Bank, I’ve compiled three pertinent aspects you should further research:
- Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Valuation: What is Yes Bank worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Yes Bank is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Yes Bank? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!