Tompkins Financial Corporation (AMEX:TMP) outperformed the Regional Banks industry on the basis of its ROE – producing a higher 11.34% relative to the peer average of 8.93% over the past 12 months. On the surface, this looks fantastic since we know that TMP has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether TMP’s ROE is actually sustainable. View our latest analysis for Tompkins Financial
What you must know about ROE
Return on Equity (ROE) is a measure of Tompkins Financial’s profit relative to its shareholders’ equity. An ROE of 11.34% implies $0.11 returned on every $1 invested. 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. Tompkins Financial’s cost of equity is 9.76%. This means Tompkins Financial returns enough to cover its own cost of equity, with a buffer of 1.59%. This sustainable practice implies that the company pays less 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Tompkins Financial 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 financial leverage can artificially inflate ROE, we need to look at how much debt Tompkins Financial currently has. At 156.83%, Tompkins Financial’s debt-to-equity ratio appears relatively high and indicates the above-average ROE is generated by significant leverage levels.
What this means for you:
Are you a shareholder? TMP’s above-industry ROE is encouraging, and is also in excess of its cost of equity. However, its high debt level appears to be the driver of a strong ROE and is something you should be mindful of before adding more of TMP to your portfolio. 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 TMP 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 Tompkins Financial 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.