Bank of the James Financial Group Inc (NASDAQ:BOTJ) delivered a less impressive 5.70% 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 BOTJ’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of BOTJ’s returns. Check out our latest analysis for Bank of the James Financial Group
What you must know about ROE
Return on Equity (ROE) is a measure of BOTJ’s profit relative to its shareholders’ equity. It essentially shows how much BOTJ 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
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 BOTJ, which is 11.27%. Since BOTJ’s return does not cover its cost, with a difference of -5.57%, this means its current use of equity is not efficient and not sustainable. Very simply, BOTJ pays more for its capital than what it generates 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from BOTJ’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check BOTJ’s historic debt-to-equity ratio. At 19.59%, BOTJ’s debt-to-equity ratio appears low and indicates that BOTJ still has room to increase leverage and grow its profits.
What this means for you:
Are you a shareholder? BOTJ’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means BOTJ still has room to improve shareholder returns by raising debt to fund new investments. 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 BOTJ, 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 Bank of the James Financial Group 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.