Preferred Bank (NASDAQ:PFBC) delivered an ROE of 15.04% over the past 12 months, which is an impressive feat relative to its industry average of 8.95% during the same period. On the surface, this looks fantastic since we know that PFBC 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 PFBC’s ROE. See our latest analysis for PFBC
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs PFBC’s profit against the level of its shareholders’ equity. An ROE of 15.04% implies $0.15 returned on every $1 invested. 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
Returns are usually compared to costs to measure the efficiency of capital. PFBC’s cost of equity is 11.27%. This means PFBC returns enough to cover its own cost of equity, with a buffer of 3.77%. 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue PFBC 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 PFBC’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine PFBC’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 33.23%, 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? PFBC exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of PFBC 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 PFBC, looking at ROE on its own is not enough to make a well-informed decision. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Preferred Bank 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.