This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Bank of America Corporation (NYSE:BAC) delivered an ROE of 7.44% over the past 12 months, which is relatively in-line with its industry average of 8.45% during the same period. But what is more interesting is whether BAC can sustain or improve on this level of return. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of BAC’s returns. Let me show you what I mean by this. View out our latest analysis for Bank of America
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Bank of America’s profit relative to its shareholders’ equity. An ROE of 7.44% implies $0.074 returned on every $1 invested, so the higher the return, the better. If investors diversify their portfolio by industry, they may want to maximise their return in the Diversified Banks sector by investing in 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 measured against cost of equity in order to determine the efficiency of Bank of America’s equity capital deployed. Its cost of equity is 9.81%. This means Bank of America’s returns actually do not cover its own cost of equity, with a discrepancy of -2.37%. 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 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. The other component, asset turnover, illustrates how much revenue Bank of America can make from its 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 America’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 America’s debt-to-equity ratio. The ratio currently stands at a high 188.86%, meaning Bank of America may have taken on a disproportionate level of debt which is driving its return. The company’s ability to produce profit growth may hinge on its big debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Bank of America’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Also, with debt capital in excess of equity, ROE may already be inflated by the use of debt funding, raising questions over the possibility of further decline in the company’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For Bank of America, I’ve put together three essential factors you should look at:
- 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 America 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 America is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Bank of America? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!