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 start learning about core concepts of fundamental analysis on practical examples from today’s market.
With an ROE of 6.71%, Allegiance Bancshares Inc (NASDAQ:ABTX) returned in-line to its own industry which delivered 8.83% over the past year. But what is more interesting is whether ABTX 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 ABTX’s returns.
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. For example, if the company invests $1 in the form of equity, it will generate $0.067 in earnings from this. Investors seeking to maximise their return in the Regional Banks industry may want to choose 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 Allegiance Bancshares, which is 9.81%. Since Allegiance Bancshares’s return does not cover its cost, with a difference of -3.10%, this means its current use of equity is not efficient and not sustainable. Very simply, Allegiance Bancshares pays more 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Allegiance Bancshares can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can assess whether Allegiance Bancshares is fuelling ROE by excessively raising debt. Ideally, Allegiance Bancshares 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 101.39%, which is relatively proportionate and indicates Allegiance Bancshares has not taken on extreme leverage. Thus, we can conclude its current ROE is generated from its capacity to increase profit without a massive debt burden.
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Allegiance Bancshares exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Allegiance Bancshares, I’ve compiled three essential 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 Allegiance Bancshares 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 Allegiance Bancshares is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Allegiance Bancshares? 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 email@example.com.