MainSource Financial Group Inc (NASDAQ:MSFG) delivered an ROE of 9.07% over the past 12 months, which is an impressive feat relative to its industry average of 8.93% during the same period. Superficially, this looks great since we know that MSFG has generated big profits with little equity capital; however, ROE doesn’t tell us how much MSFG has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of MSFG’s ROE. Check out our latest analysis for MainSource Financial Group
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs MainSource Financial Group’s profit against the level of its shareholders’ equity. An ROE of 9.07% implies $0.09 returned on every $1 invested. 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. MainSource Financial Group’s cost of equity is 9.87%. Given a discrepancy of -0.81% between return and cost, this indicated that MainSource Financial Group may be paying more for its capital than what it’s generating 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
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 MainSource Financial Group 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 ROE can be inflated by excessive debt, we need to examine MainSource Financial Group’s debt-to-equity level. At 121.03%, MainSource Financial Group’s debt-to-equity ratio appears balanced and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
What this means for you:
Are you a shareholder? MSFG exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. Since its high ROE is not fuelled by unsustainable debt, investors shouldn’t give up as MSFG 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 MSFG 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 MainSource Financial Group 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.