United Bancorp Inc (NASDAQ:UBCP) generated a below-average return on equity of 8.44% in the past 12 months, while its industry returned 8.95%. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into UBCP’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of UBCP’s returns. Check out our latest analysis for United Bancorp
Breaking down Return on Equity
Return on Equity (ROE) weighs UBCP’s profit against the level of its shareholders’ equity. It essentially shows how much UBCP can generate in earnings given the amount of equity it has raised. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. UBCP’s cost of equity is 11.27%. Since UBCP’s return does not cover its cost, with a difference of -2.83%, this means its current use of equity is not efficient and not sustainable. Very simply, UBCP 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
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 UBCP’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 UBCP’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check UBCP’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 48.61%, meaning UBCP still has headroom to borrow debt to increase profits.
What this means for you:
Are you a shareholder? UBCP’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as UBCP still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. 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 UBCP, 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 United 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.