The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to begin learning the link between company’s fundamentals and stock market performance.
PCSB Financial Corporation (NASDAQ:PCSB) delivered a less impressive 2.30% ROE over the past year, compared to the 6.65% 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 PCSB’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of PCSB’s returns.
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 the company 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 measured against cost of equity in order to determine the efficiency of PCSB Financial’s equity capital deployed. Its cost of equity is 9.80%. Given a discrepancy of -7.50% between return and cost, this indicated that PCSB Financial 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 reveals how much revenue can be generated from PCSB Financial’s 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 the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt PCSB Financial currently has. At 6.55%, PCSB Financial’s debt-to-equity ratio appears low and indicates that PCSB Financial still has room to increase leverage and grow its profits.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. PCSB Financial’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, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For PCSB Financial, there are three essential factors you should further examine:
- Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for PCSB Financial’s future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of PCSB Financial? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
To help readers see past 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. For errors that warrant correction please contact the editor at email@example.com.