Community Trust Bancorp Inc (NASDAQ:CTBI) outperformed the Regional Banks industry on the basis of its ROE – producing a higher 9.32% relative to the peer average of 8.92% over the past 12 months. On the surface, this looks fantastic since we know that CTBI has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether CTBI’s ROE is actually sustainable. View our latest analysis for Community Trust Bancorp
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs CTBI’s profit against the level of its shareholders’ equity. For example, if CTBI invests $1 in the form of equity, it will generate $0.09 in earnings from this. 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 CTBI’s equity capital deployed. Its cost of equity is 11.27%. Since CTBI’s return does not cover its cost, with a difference of -1.95%, this means its current use of equity is not efficient and not sustainable. Very simply, CTBI 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 CTBI is with its cost management. The other component, asset turnover, illustrates how much revenue CTBI can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine CTBI’s debt-to-equity level. The debt-to-equity ratio currently stands at a sensible 82.47%, 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? CTBI exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means CTBI still has room to improve shareholder returns by raising debt to fund new investments. 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 CTBI, 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 Community Trust Bancorp 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.