Should You Expect German American Bancorp Inc (GABC) To Continue Delivering An ROE Of 11.15%?
German American Bancorp Inc (NASDAQ:GABC) outperformed the Regional Banks industry on the basis of its ROE – producing a higher 11.15% relative to the peer average of 8.92% over the past 12 months. While the impressive ratio tells us that GABC has made significant profits from little equity capital, ROE doesn’t tell us if GABC has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether GABC’s ROE is actually sustainable. View our latest analysis for German American Bancorp
Breaking down Return on Equity
Return on Equity (ROE) is a measure of GABC’s profit relative to its shareholders’ equity. It essentially shows how much GABC 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
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 GABC, which is 11.27%. Given a discrepancy of -0.12% between return and cost, this indicated that GABC may be paying more for its capital than what it’s generating in return. ROE can be dissected into three distinct ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient GABC is with its cost management. Asset turnover reveals how much revenue can be generated from GABC’s 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 GABC’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a sensible 72.64%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
What this means for you:
Are you a shareholder? GABC’s ROE is impressive relative to the industry average, though its returns were not strong enough to cover its own cost of equity. Since its high ROE is not fuelled by unsustainable debt, investors shouldn’t give up as GABC 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 GABC, 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 German American 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.
