Why E*TRADE Financial Corporation’s (NASDAQ:ETFC) ROE Of 9.44% Does Not Tell The Whole Story

E*TRADE Financial Corporation’s (NASDAQ:ETFC) most recent return on equity was a substandard 9.44% relative to its industry performance of 13.60% over the past year. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into ETFC’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of ETFC’s returns. View our latest analysis for E*TRADE Financial

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 $0.09 in earnings from this. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Investment Banking and Brokerage sector by choosing the highest returning stock. However, this can be deceiving as each company has varying costs of equity and debt levels, which could exaggeratedly push up ROE at the same time as accumulating high interest expense.

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 E*TRADE Financial, which is 9.55%. Given a discrepancy of -0.0011% between return and cost, this indicated that E*TRADE Financial may be paying more for its capital than what it’s generating 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:

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

NasdaqGS:ETFC Last Perf Jan 25th 18
NasdaqGS:ETFC Last Perf Jan 25th 18

The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue E*TRADE Financial 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. We can assess whether E*TRADE Financial is fuelling ROE by excessively raising debt. Ideally, E*TRADE Financial should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The most recent ratio is 44.90%, which is sensible and indicates E*TRADE Financial has not taken on too much leverage. Thus, we can conclude its below-average ROE may be a result of low debt, and E*TRADE Financial still has room to increase leverage and grow future returns.

NasdaqGS:ETFC Historical Debt Jan 25th 18
NasdaqGS:ETFC Historical Debt Jan 25th 18

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. E*TRADE Financial exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of E*TRADE Financial’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.

For E*TRADE Financial, there are three essential factors you should look at: