This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
Citizens Financial Group Inc (NYSE:CFG) delivered an ROE of 8.9% over the past 12 months, which is an impressive feat relative to its industry average of 8.2% during the same period. While the impressive ratio tells us that CFG has made significant profits from little equity capital, ROE doesn’t tell us if CFG has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable CFG’s ROE is.
What you must know about ROE
Return on Equity (ROE) is a measure of Citizens Financial Group’s profit relative to its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.089 in earnings from this. 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. Citizens Financial Group’s cost of equity is 10.9%. Given a discrepancy of -1.9% between return and cost, this indicated that Citizens Financial Group may be paying more for its capital than what it’s generating 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 Citizens Financial Group 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 ROE can be inflated by excessive debt, we need to examine Citizens Financial Group’s debt-to-equity level. The debt-to-equity ratio currently stands at a sensible 77.6%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Citizens Financial Group exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.
For Citizens Financial Group, I’ve put together three relevant aspects you should look at:
- 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 Citizens Financial 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 Citizens Financial Group is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Citizens Financial 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 firstname.lastname@example.org.