With an ROE of 8.37%, Enterprise Bancorp Inc (NASDAQ:EBTC) outpaced its own industry which delivered a less exciting 8.17% over the past year. While the impressive ratio tells us that EBTC has made significant profits from little equity capital, ROE doesn’t tell us if EBTC has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether EBTC’s ROE is actually sustainable. View our latest analysis for Enterprise Bancorp
Breaking down Return on Equity
Return on Equity (ROE) weighs Enterprise Bancorp’s profit against the level of its shareholders’ equity. It essentially shows how much the company 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 assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Enterprise Bancorp, which is 9.90%. This means Enterprise Bancorp’s returns actually do not cover its own cost of equity, with a discrepancy of -1.53%. This isn’t sustainable as it implies, very simply, that the company pays more 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 shows how much revenue Enterprise Bancorp can generate with its current 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 artificially increased through excessive borrowing, we should check Enterprise Bancorp’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 45.04%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Enterprise Bancorp’s ROE is impressive relative to the industry average, though its returns were not strong enough to cover its own cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of industry-beating returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Enterprise Bancorp, I’ve put together three pertinent 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 Enterprise Bancorp 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 Enterprise Bancorp is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Enterprise Bancorp? 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 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.