Malvern Bancorp Inc (NASDAQ:MLVF) delivered an ROE of 5.90% over the past 12 months, which is an impressive feat relative to its industry average of 5.78% during the same period. While the impressive ratio tells us that MLVF has made significant profits from little equity capital, ROE doesn’t tell us if MLVF has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether MLVF’s ROE is actually sustainable. Check out our latest analysis for Malvern Bancorp
What you must know about ROE
Return on Equity (ROE) weighs Malvern Bancorp’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.06 in earnings from this. 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 Malvern Bancorp, which is 9.08%. Given a discrepancy of -3.18% between return and cost, this indicated that Malvern Bancorp may be paying more for its capital than what it’s generating 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue Malvern Bancorp can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Malvern Bancorp currently has. Currently the debt-to-equity ratio stands at a balanced 143.68%, 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? MLVF’s above-industry ROE is noteworthy, but it was not high enough to cover its own cost of equity. Since its high ROE is not fuelled by unsustainable debt, investors shouldn’t give up as MLVF 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 MLVF, 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 Malvern 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.