Sierra Bancorp (NASDAQ:BSRR) delivered an ROE of 9.83% over the past 12 months, which is an impressive feat relative to its industry average of 8.87% during the same period. While the impressive ratio tells us that BSRR has made significant profits from little equity capital, ROE doesn’t tell us if BSRR has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of BSRR’s ROE. Check out our latest analysis for Sierra 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. It essentially shows how much BSRR can generate in earnings given the amount of equity it has raised. 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 BSRR, which is 9.86%. Since BSRR’s return does not cover its cost, with a difference of -0.03%, this means its current use of equity is not efficient and not sustainable. Very simply, BSRR pays more for its capital than what it generates 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 BSRR 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 BSRR’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine BSRR’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 25.25%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
What this means for you:
Are you a shareholder? BSRR 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 BSRR 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 you are considering investing in BSRR, looking at ROE on its own is not enough to make a well-informed decision. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Sierra Bancorp 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.