I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.
With an ROE of 9.99%, Fidelity Southern Corporation (NASDAQ:LION) returned in-line to its own industry which delivered 8.45% over the past year. But what is more interesting is whether LION can sustain this level of return. 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
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 $0.10 in earnings from this. 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 Fidelity Southern 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
Returns are usually compared to costs to measure the efficiency of capital. Fidelity Southern’s cost of equity is 9.79%. Since Fidelity Southern’s return covers its cost in excess of 0.20%, its use of equity capital is efficient and likely to be sustainable. Simply put, Fidelity Southern pays less for its capital than what it generates 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
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 Fidelity Southern can make from its asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at Fidelity Southern’s debt-to-equity ratio to examine sustainability of its returns. The ratio currently stands at a balanced 112.01%, meaning Fidelity Southern has not taken on excessively disproportionate debt to drive its returns. The company is able to produce profit growth without a substantial debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Fidelity Southern exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Fidelity Southern, I’ve compiled three relevant 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.
- Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for Fidelity Southern’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 Fidelity Southern? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!