Farmers National Banc Corp (NASDAQ:FMNB) outperformed the Regional Banks industry on the basis of its ROE – producing a higher 10.12% relative to the peer average of 8.95% over the past 12 months. On the surface, this looks fantastic since we know that FMNB has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of FMNB’s ROE. View our latest analysis for Farmers National Banc
Peeling the layers of ROE – trisecting a company’s profitability
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 FMNB 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 FMNB’s equity capital deployed. Its cost of equity is 11.02%. This means FMNB’s returns actually do not cover its own cost of equity, with a discrepancy of -0.90%. 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 split up into three useful 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. The other component, asset turnover, illustrates how much revenue FMNB 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 FMNB’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check FMNB’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a balanced 132.08%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
What this means for you:
Are you a shareholder? FMNB’s ROE is impressive relative to the industry average, though its returns were not strong enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means FMNB still has room to improve shareholder returns by raising debt to fund new investments.
Are you a potential investor? If you are considering investing in FMNB, 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 Farmers National Banc to help you make a more informed investment decision. If you are not interested in FMNB anymore, you can use our free platform to see our list of stocks with Return on Equity over 20%.
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.