The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
ING Groep NV (AMS:INGA) delivered an ROE of 9.98% over the past 12 months, which is relatively in-line with its industry average of 9.12% during the same period. But what is more interesting is whether INGA can sustain this level of return. Sustainability can be gauged by a company’s financial leverage – the more debt it has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden. Let me show you what I mean by this.
Breaking down Return on Equity
Return on Equity (ROE) is a measure of ING Groep’s profit relative to its 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 Diversified Banks sector by choosing the highest returning stock. However, this can be deceiving as each company has varying costs of equity and debt levels, which could exaggeratedly push up ROE at the same time as accumulating high interest expense.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of ING Groep’s equity capital deployed. Its cost of equity is 13.55%. This means ING Groep’s returns actually do not cover its own cost of equity, with a discrepancy of -3.57%. 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 broken down into three different 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 ING Groep’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can assess whether ING Groep is fuelling ROE by excessively raising debt. Ideally, ING Groep 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 more than 2.5 times, which is very high. This means ING Groep’s above-average ROE is 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. ING Groep exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. Its debt level is above equity which means its above-industry ROE may be driven by debt funding which raises concerns over the sustainability of ING Groep’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For ING Groep, I’ve put together three pertinent factors 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 ING Groep 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 ING Groep is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of ING Groep? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.