I am writing today to help inform people who are new to the stock market and looking to gauge the potential return on investment in HomeTown Bankshares Corporation (NASDAQ:HMTA).
With an ROE of 5.81%, HomeTown Bankshares Corporation (NASDAQ:HMTA) returned in-line to its own industry which delivered 8.45% over the past year. But what is more interesting is whether HMTA 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 HMTA’s returns. Check out our latest analysis for HomeTown Bankshares
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs HomeTown Bankshares’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.058 in earnings from this. Investors seeking to maximise their return in the Regional Banks industry may want to choose 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 HomeTown Bankshares 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 HomeTown Bankshares, which is 9.95%. Given a discrepancy of -4.15% between return and cost, this indicated that HomeTown Bankshares may be paying more for its capital than what it’s generating in return. ROE can be split up into three useful 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 HomeTown Bankshares’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 HomeTown Bankshares’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 HomeTown Bankshares’s debt-to-equity ratio. The ratio currently stands at a sensible 40.01%, meaning HomeTown Bankshares has not taken on excessive debt to drive its returns. The company is able to produce profit growth 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. HomeTown Bankshares 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. Although ROE can be a useful metric, it is only a small part of diligent research.
For HomeTown Bankshares, I’ve put together three important 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.
- Future Earnings: How does HomeTown Bankshares’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of HomeTown Bankshares? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!