PNB Housing Finance Limited’s (NSEI:PNBHOUSING) most recent return on equity was a substandard 12.97% relative to its industry performance of 18.63% over the past year. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into PNBHOUSING’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of PNBHOUSING’s returns. See our latest analysis for PNB Housing Finance
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. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Thrifts and Mortgage Finance sector by choosing 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 PNB Housing Finance 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 PNB Housing Finance’s equity capital deployed. Its cost of equity is 13.40%. Since PNB Housing Finance’s return does not cover its cost, with a difference of -0.43%, this means its current use of equity is not efficient and not sustainable. Very simply, PNB Housing Finance pays more for its capital than what it generates in return. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue PNB Housing Finance 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 PNB Housing Finance’s debt-to-equity ratio to examine sustainability of its returns. Currently the ratio stands at more than 2.5 times, which is very high. This is not a good sign given PNB Housing Finance’s below-average ROE is already being driven by its significant debt levels and its ability to grow profit hinges on a significant debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. PNB Housing Finance’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 PNB Housing Finance, I’ve compiled three important aspects you should further examine:
- 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 PNB Housing Finance 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 PNB Housing Finance is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of PNB Housing Finance? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!