Northern Trust Corporation (NASDAQ:NTRS) delivered an ROE of 11.23% over the past 12 months, which is relatively in-line with its industry average of 12.81% during the same period. But what is more interesting is whether NTRS can sustain or improve on this level of return. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of NTRS’s returns. Check out our latest analysis for Northern Trust
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Northern Trust’s profit against the level of its shareholders’ equity. An ROE of 11.23% implies $0.11 returned on every $1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Asset Management and Custody 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 Northern Trust 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 measured against cost of equity in order to determine the efficiency of Northern Trust’s equity capital deployed. Its cost of equity is 11.79%. Since Northern Trust’s return does not cover its cost, with a difference of -0.56%, this means its current use of equity is not efficient and not sustainable. Very simply, Northern Trust pays more for its capital than what it generates 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:
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 Northern Trust 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 Northern Trust’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 Northern Trust’s debt-to-equity ratio. The most recent ratio is 131.30%, which is relatively proportionate and indicates Northern Trust has not taken on extreme leverage. Thus, we can conclude its current ROE is generated from its capacity to increase profit without a massive debt burden.
ROE – More than just a profitability ratio
ROE is called the mother of all ratios for a reason. It helps gauge a company’s efficiency by looking at both its income statement and balance sheet. Northern Trust’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Northern Trust, I’ve compiled three pertinent factors you should further examine:
1. 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.
2. Valuation: What is Northern Trust 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 Northern Trust is currently mispriced by the market.
3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Northern Trust? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!