Glen Burnie Bancorp (NASDAQ:GLBZ) generated a below-average return on equity of 3.33% in the past 12 months, while its industry returned 8.95%. 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 GLBZ's past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of GLBZ's returns. Check out our latest analysis for Glen Burnie Bancorp
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if GLBZ invests $1 in the form of equity, it will generate $0.03 in earnings from this. 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. GLBZ’s cost of equity is 11.03%. Given a discrepancy of -7.70% between return and cost, this indicated that GLBZ may be paying more for its capital than what it’s generating in return. ROE can be dissected into three distinct 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. Asset turnover shows how much revenue GLBZ can generate with its current 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 GLBZ’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt GLBZ currently has. Currently the debt-to-equity ratio stands at a reasonable 72.39%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.
What this means for you:
Are you a shareholder? GLBZ exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as GLBZ still has capacity to improve shareholder returns by borrowing to invest in new projects in the future.
Are you a potential investor? If GLBZ 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 Glen Burnie Bancorp to help you make a more informed investment decision. If you are not interested in GLBZ 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.