This article is intended for those of you who are at the beginning of your investing journey and want to begin learning the link between company’s fundamentals and stock market performance.
Pareto Bank ASA (OB:PARB) outperformed the diversified banks industry on the basis of its ROE – producing a higher 14.10% relative to the peer average of 9.57% over the past 12 months. But what is more interesting is whether PARB can sustain this above-average ratio. 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 ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Pareto Bank’s profit relative to its shareholders’ equity. An ROE of 14.10% implies NOK0.14 returned on every NOK1 invested, so the higher the return, the better. 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 Pareto Bank’s equity capital deployed. Its cost of equity is 8.40%. This means Pareto Bank returns enough to cover its own cost of equity, with a buffer of 5.70%. This sustainable practice implies that the company pays less 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. Asset turnover reveals how much revenue can be generated from Pareto Bank’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can assess whether Pareto Bank is fuelling ROE by excessively raising debt. Ideally, Pareto Bank 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 220.36%, which is relatively high, indicating Pareto Bank’s above-average ROE is generated by its high leverage and its ability to grow profit hinges on a sizeable debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Pareto Bank 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Pareto Bank, I’ve compiled three relevant 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.
- Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for Pareto Bank’s future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Pareto Bank? 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 pass 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 email@example.com.