State Bank of India (NSEI:SBIN) delivered a less impressive 0.11% ROE over the past year, compared to the 7.81% return generated by its industry. 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 SBIN’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of SBIN’s returns. See our latest analysis for State Bank of India
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. An ROE of 0.11% implies ₹0 returned on every ₹1 invested, so the higher the return, the better. 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 State Bank of India 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. State Bank of India’s cost of equity is 14.01%. This means State Bank of India’s returns actually do not cover its own cost of equity, with a discrepancy of -13.89%. This isn’t sustainable as it implies, very simply, that the company 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 State Bank of India 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. We can assess whether State Bank of India is fuelling ROE by excessively raising debt. Ideally, State Bank of India should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. Currently the ratio stands at 116.16%, which is relatively balanced. This means State Bank of India has not taken on excessive leverage, and its current ROE is driven by its ability to grow its profit without a significant debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. State Bank of India’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of State Bank of India’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.
For State Bank of India, there are three key 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. Valuation: What is State Bank of India 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 State Bank of India is currently mispriced by the market.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of State Bank of India? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!