Bank of America Corporation (NYSE:BAC) performed in line with its diversified banks industry on the basis of its ROE – producing a return of7.44% relative to the peer average of 8.39% over the past 12 months. 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. Check out our latest analysis for Bank of America
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Bank of America’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Diversified 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 America 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. Bank of America’s cost of equity is 9.92%. This means Bank of America’s returns actually do not cover its own cost of equity, with a discrepancy of -2.48%. 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. Asset turnover reveals how much revenue can be generated from Bank of America’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. 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 181.34%, 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.
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 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. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Bank of America’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Bank of America, I’ve compiled three relevant 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!