PennyMac Mortgage Investment Trust (NYSE:PMT) delivered a less impressive 7.29% ROE over the past year, compared to the 8.92% 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 PMT’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of PMT’s returns. Let me show you what I mean by this. See our latest analysis for PennyMac Mortgage Investment Trust
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of PennyMac Mortgage Investment Trust’s profit relative to its shareholders’ equity. An ROE of 7.29% implies $0.07 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 PennyMac Mortgage Investment Trust, which is 8.49%. Given a discrepancy of -1.20% between return and cost, this indicated that PennyMac Mortgage Investment Trust 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue PennyMac Mortgage Investment Trust 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 inflated by excessive debt, we need to examine PennyMac Mortgage Investment Trust’s debt-to-equity level. Currently the debt-to-equity ratio stands at more than 2.5 times, which means its below-average ROE is already being driven by significant debt levels.
What this means for you:
Are you a shareholder? PMT’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Additionally, with debt capital in excess of equity, the existing ROE is being generated by debt funding, which is something you should be aware of before buying more PMT 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 you are considering investing in PMT, basing your decision on ROE alone is certainly not sufficient. I recommend you do additional fundamental analysis by looking through our most recent infographic report on PennyMac Mortgage Investment Trust 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.