This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
Central Pacific Financial Corp (NYSE:CPF) delivered an ROE of 9.28% over the past 12 months, which is an impressive feat relative to its industry average of 8.83% during the same period. Superficially, this looks great since we know that CPF has generated big profits with little equity capital; however, ROE doesn’t tell us how much CPF has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of CPF’s ROE.
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Central Pacific Financial’s profit relative to its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.093 in earnings from this. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Central Pacific Financial’s equity capital deployed. Its cost of equity is 9.82%. Since Central Pacific Financial’s return does not cover its cost, with a difference of -0.54%, this means its current use of equity is not efficient and not sustainable. Very simply, Central Pacific Financial 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 Central Pacific 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. Since ROE can be inflated by excessive debt, we need to examine Central Pacific Financial’s debt-to-equity level. At 37.41%, Central Pacific Financial’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Central Pacific Financial exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of industry-beating returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For Central Pacific Financial, I’ve compiled three fundamental factors you should further research:
- 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 Central Pacific Financial 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 Central Pacific Financial is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Central Pacific Financial? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
To help readers see past 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. For errors that warrant correction please contact the editor at firstname.lastname@example.org.