DNB Financial Corporation (NASDAQ:DNBF) outperformed the Regional Banks industry on the basis of its ROE – producing a higher 11.73% relative to the peer average of 8.94% over the past 12 months. Superficially, this looks great since we know that DNBF has generated big profits with little equity capital; however, ROE doesn’t tell us how much DNBF has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of DNBF’s ROE. Check out our latest analysis for DNB Financial
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of DNB Financial’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 DNB Financial’s equity capital deployed. Its cost of equity is 9.75%. This means DNB Financial returns enough to cover its own cost of equity, with a buffer of 1.98%. This sustainable practice implies that the company pays less for its capital than what it generates in return. 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from DNB Financial’s 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 DNB Financial’s debt-to-equity level. The debt-to-equity ratio currently stands at a sensible 84.25%, 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? DNBF’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of DNBF to your portfolio if your personal research is confirming what the ROE is telling you. 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 DNBF, 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 DNB 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.