The First Bancorp Inc (NASDAQ:FNLC) outperformed the Regional Banks industry on the basis of its ROE – producing a higher 10.45% relative to the peer average of 8.92% over the past 12 months. Superficially, this looks great since we know that FNLC has generated big profits with little equity capital; however, ROE doesn’t tell us how much FNLC has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether FNLC’s ROE is actually sustainable. View our latest analysis for First Bancorp
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs FNLC’s profit against the level of its shareholders’ equity. For example, if FNLC invests $1 in the form of equity, it will generate $0.1 in earnings from this. 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. FNLC’s cost of equity is 11.27%. This means FNLC’s returns actually do not cover its own cost of equity, with a discrepancy of -0.82%. 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 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 FNLC can generate with its current 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 FNLC’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a high 159.00%, meaning the above-average ratio is a result of a large amount of debt.
What this means for you:
Are you a shareholder? FNLC’s above-industry ROE is noteworthy, but it was not high enough to cover its own cost of equity. Additionally, with debt capital in excess of equity, ROE might be inflated by the use of debt funding, which is something you should be aware of before buying more FNLC shares. 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 FNLC has been on your watch list for a while, making an investment decision based on ROE alone is unwise. I recommend you do additional fundamental analysis by looking through our most recent infographic report on First 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.