I am writing today to help inform people who are new to the stock market and want to learn about Return on Equity using a real-life example.
With an ROE of 12.45%, Australia and New Zealand Banking Group Limited (ASX:ANZ) outpaced its own industry which delivered a less exciting 11.83% over the past year. While the impressive ratio tells us that ANZ has made significant profits from little equity capital, ROE doesn’t tell us if ANZ has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable ANZ’s ROE is.
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 12.45% implies A$0.12 returned on every A$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
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 Australia and New Zealand Banking Group, which is 8.55%. Since Australia and New Zealand Banking Group’s return covers its cost in excess of 3.90%, its use of equity capital is efficient and likely to be sustainable. Simply put, Australia and New Zealand Banking Group 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue Australia and New Zealand Banking Group can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt Australia and New Zealand Banking Group currently has. At over 2.5 times, Australia and New Zealand Banking Group’s debt-to-equity ratio is very high and indicates the above-average ROE is generated by significant leverage levels.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Australia and New Zealand Banking Group’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of Australia and New Zealand Banking Group’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Australia and New Zealand Banking Group, I’ve put together three key factors you should further research:
- 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.
- Valuation: What is Australia and New Zealand Banking Group worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Australia and New Zealand Banking Group is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Australia and New Zealand Banking Group? 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.