I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.
Dime Community Bancshares Inc (NASDAQ:DCOM) outperformed the Thrifts and Mortgage Finance industry on the basis of its ROE – producing a higher 9.07% relative to the peer average of 6.60% over the past 12 months. While the impressive ratio tells us that DCOM has made significant profits from little equity capital, ROE doesn’t tell us if DCOM has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable DCOM’s ROE is.
What you must know about ROE
Return on Equity (ROE) is a measure of Dime Community Bancshares’s profit relative to its shareholders’ equity. An ROE of 9.07% implies $0.091 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
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 Dime Community Bancshares, which is 9.78%. This means Dime Community Bancshares’s returns actually do not cover its own cost of equity, with a discrepancy of -0.72%. 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 Dime Community Bancshares can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check Dime Community Bancshares’s historic debt-to-equity ratio. At 188.02%, Dime Community Bancshares’s debt-to-equity ratio appears relatively high and indicates the above-average ROE is generated by significant leverage levels.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Dime Community Bancshares’s ROE is impressive relative to the industry average, though its returns were not strong enough to cover its own cost of equity. Its debt level is above equity which means its above-industry ROE may be driven by debt funding which raises concerns over the sustainability of Dime Community Bancshares’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Dime Community Bancshares, there are three important 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 Dime Community Bancshares 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 Dime Community Bancshares is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Dime Community Bancshares? 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 past 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. For errors that warrant correction please contact the editor at firstname.lastname@example.org.