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.
SpareBank 1 Nord-Norge (OB:NONG) performed in-line with its regional banks industry on the basis of its ROE – producing a return of12.43% relative to the peer average of 9.57% over the past 12 months. However, whether this ROE is actually impressive depends on if it can be maintained. 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
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 12.43% implies NOK0.12 returned on every NOK1 invested, so the higher the return, the better. If investors diversify their portfolio by industry, they may want to maximise their return in the Regional Banks sector by investing in the highest returning stock. But this can be misleading as each company has different costs of equity and also varying debt levels, which could artificially push up ROE whilst accumulating high interest expense.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for SpareBank 1 Nord-Norge, which is 8.40%. Since SpareBank 1 Nord-Norge’s return covers its cost in excess of 4.04%, its use of equity capital is efficient and likely to be sustainable. Simply put, SpareBank 1 Nord-Norge pays less 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue SpareBank 1 Nord-Norge can generate with its current 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 SpareBank 1 Nord-Norge is fuelling ROE by excessively raising debt. Ideally, SpareBank 1 Nord-Norge should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The most recent ratio is 217.77%, which is relatively high, indicating SpareBank 1 Nord-Norge’s above-average ROE is generated by its high leverage and its ability to grow profit hinges on a sizeable debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. SpareBank 1 Nord-Norge exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. With debt capital in excess of equity, ROE may be inflated by the use of debt funding, raising questions over the sustainability of the company’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For SpareBank 1 Nord-Norge, I’ve put together three key 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 SpareBank 1 Nord-Norge 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 SpareBank 1 Nord-Norge is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of SpareBank 1 Nord-Norge? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!