I am writing today to help inform people who are new to 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 7.49%, Bank of Commerce Holdings (NASDAQ:BOCH) returned in-line to its own industry which delivered 8.83% over the past year. But what is more interesting is whether BOCH 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 BOCH’s returns.
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Bank of Commerce Holdings’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.075 in earnings from this. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Regional Banks sector by choosing 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 Bank of Commerce Holdings 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 Bank of Commerce Holdings, which is 9.82%. This means Bank of Commerce Holdings’s returns actually do not cover its own cost of equity, with a discrepancy of -2.33%. This isn’t sustainable as it implies, very simply, that the company pays more 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 reveals how much revenue can be generated from Bank of Commerce Holdings’s 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 determine if Bank of Commerce Holdings’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at Bank of Commerce Holdings’s debt-to-equity ratio. Currently the ratio stands at 65.72%, which is reasonable. This means Bank of Commerce Holdings has not taken on too much leverage, and its current ROE is driven by its ability to grow its profit without a huge 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. Bank of Commerce Holdings’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. 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 Bank of Commerce Holdings, there are three essential 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 Bank of Commerce Holdings 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 Bank of Commerce Holdings is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Bank of Commerce Holdings? 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.