Andhra Bank (NSEI:ANDHRABANK) delivered a less impressive 1.84% ROE over the past year, compared to the 8.57% return generated by its industry. Though ANDHRABANK’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on ANDHRABANK’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of ANDHRABANK’s returns. Check out our latest analysis for Andhra Bank
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests ₹1 in the form of equity, it will generate ₹0.02 in earnings from this. Investors seeking to maximise their return in the Diversified Banks industry may want to choose 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 Andhra 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
ROE is measured against cost of equity in order to determine the efficiency of Andhra Bank’s equity capital deployed. Its cost of equity is 14.21%. Since Andhra Bank’s return does not cover its cost, with a difference of -12.37%, this means its current use of equity is not efficient and not sustainable. Very simply, Andhra Bank pays more for its capital than what it generates in return. ROE can be split up into three useful 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. The other component, asset turnover, illustrates how much revenue Andhra Bank can make from its 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. ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at Andhra Bank’s debt-to-equity ratio to examine sustainability of its returns. The ratio currently stands at a sensible 77.58%, meaning Andhra Bank has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Andhra Bank’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.
For Andhra Bank, I’ve put together three important aspects you should look at:
- 1. 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.
- 2. Future Earnings: How does Andhra Bank’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Andhra 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!