Grong Sparebank (OB:GRONG-ME) performed in line with its regional banks industry on the basis of its ROE – producing a return of8.27% relative to the peer average of 9.57% over the past 12 months. But what is more interesting is whether GRONG-ME can sustain or improve on this level of return. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of GRONG-ME’s returns. Check out our latest analysis for Grongrebank
What you must know about ROE
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 NOK1 in the form of equity, it will generate NOK0.08 in earnings from this. Investors seeking to maximise their return in the Regional 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 Grongrebank 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. Grongrebank’s cost of equity is 8.40%. Given a discrepancy of -0.13% between return and cost, this indicated that Grongrebank may be paying more for its capital than what it’s generating 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 shows how much revenue Grongrebank can generate with its current asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show 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 Grongrebank’s debt-to-equity ratio to examine sustainability of its returns. The ratio currently stands at a high 160.67%, meaning Grongrebank may have taken on a disproportionate level of debt which is driving its return. The company’s ability to produce profit growth may hinge on its big debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Grongrebank exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Grongrebank’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 Grongrebank, there are three pertinent aspects you should look at:
- 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 Grongrebank 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 Grongrebank is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Grongrebank? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!