With an ROE of 8.81%, Surnadal Sparebank AS (OB:SUSB-ME) returned in-line to its own industry which delivered 9.57% over the past year. But what is more interesting is whether SUSB-ME can sustain or improve on this level of return. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of SUSB-ME’s returns. View our latest analysis for Surnadalrebank
Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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. However, this can be misleading as each firm has different costs of equity and debt levels i.e. the more debt Surnadalrebank 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
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 Surnadalrebank, which is 8.40%. While Surnadalrebank’s peers may have higher ROE, it may also incur higher cost of equity. An undesirable and unsustainable practice would be if returns exceeded cost. However, this is not the case for Surnadalrebank which is encouraging. 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 shows how much revenue Surnadalrebank can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can assess whether Surnadalrebank is fuelling ROE by excessively raising debt. Ideally, Surnadalrebank should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The ratio currently stands is significantly high, above 2.5 times, meaning Surnadalrebank has taken on a disproportionately large level of debt which is driving its return. The company’s ability to produce profit growth hinges on its large debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Even though Surnadalrebank returned below the industry average, its ROE comes in excess of its cost of equity. Its appropriate level of leverage means investors can be more confident in the sustainability of Surnadalrebank’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Surnadalrebank, I’ve put together three important factors 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.
- Valuation: What is Surnadalrebank 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 Surnadalrebank is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Surnadalrebank? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!