Carolina Financial Corporation (NASDAQ:CARO) outperformed the Regional Banks industry on the basis of its ROE – producing a higher 12.16% relative to the peer average of 8.87% over the past 12 months. While the impressive ratio tells us that CARO has made significant profits from little equity capital, ROE doesn’t tell us if CARO has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether CARO’s ROE is actually sustainable. View our latest analysis for Carolina 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. It essentially shows how much CARO can generate in earnings given the amount of equity it has raised. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of CARO’s equity capital deployed. Its cost of equity is 9.86%. Given a positive discrepancy of 2.30% between return and cost, this indicates that CARO pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue CARO can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable CARO’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine CARO’s debt-to-equity level. The debt-to-equity ratio currently stands at a sensible 80.82%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
What this means for you:
Are you a shareholder? CARO’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.
Are you a potential investor? If you are considering investing in CARO, basing your decision on ROE alone is certainly not sufficient. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Carolina Financial to help you make a more informed investment decision.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.