This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.
Midland States Bancorp Inc (NASDAQ:MSBI) generated a below-average return on equity of 3.1% in the past 12 months, while its industry returned 8.2%. 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 MSBI’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of MSBI’s returns.
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Midland States Bancorp’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Midland States Bancorp’s cost of equity is 10.9%. Since Midland States Bancorp’s return does not cover its cost, with a difference of -7.8%, this means its current use of equity is not efficient and not sustainable. Very simply, Midland States Bancorp 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from Midland States Bancorp’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 the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Midland States Bancorp currently has. Currently the debt-to-equity ratio stands at a high 158%, which means its below-average ROE is already being driven by significant debt levels.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Midland States Bancorp’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Also, with debt capital in excess of equity, ROE may already be inflated by the use of debt funding, raising questions over the possibility of further decline in the company’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For Midland States Bancorp, there are three essential aspects you should further research:
- Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Valuation: What is Midland States Bancorp worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Midland States Bancorp is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Midland States Bancorp? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
To help readers see past 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. For errors that warrant correction please contact the editor at firstname.lastname@example.org.