Ames National Corporation (NASDAQ:ATLO) delivered a less impressive 8.73% ROE over the past year, compared to the 8.95% return generated by its industry. 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 ATLO's past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of ATLO's returns. See our latest analysis for ATLO
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of ATLO’s profit relative to its shareholders’ equity. An ROE of 8.73% implies $0.09 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 ATLO, which is 11.02%. Since ATLO’s return does not cover its cost, with a difference of -2.30%, this means its current use of equity is not efficient and not sustainable. Very simply, ATLO 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. Asset turnover reveals how much revenue can be generated from ATLO’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 ATLO’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt ATLO currently has. At 37.98%, ATLO’s debt-to-equity ratio appears low and indicates that ATLO still has room to increase leverage and grow its profits.
What this means for you:
Are you a shareholder? ATLO’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means ATLO still has room to improve shareholder returns by raising debt to fund new investments.
Are you a potential investor? If ATLO 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 Ames National to help you make a more informed investment decision. If you are not interested in ATLO anymore, you can use our free platform to see our list of stocks with Return on Equity over 20%.
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.