About the Talk
July 5, 2017 12:00 PM
Sydney, AustraliaSydney, Australia
Over the past 12 months, Cathay General Bancorp (NASDAQ:CATY) generated an ROE of 9.8%, implying the company created 9.8 cents on every dollar of shareholders’ invested capital. While Cathay General Bancorp turned out to be more efficient than its industry, which delivered a Return on Equity of 9.3%, there are other factors to consider before we call it superior.
Peeling the layers of ROE – trisecting a company’s profitability
ROE ratio basically calculates the net income as a percentage of total capital committed by shareholders, namely shareholders’ equity. Generally, an ROE of 20% or more is considered highly attractive for any investment consideration. Although, it’s more of an industry-specific ratio as the constituents share similar risk profile.
Return on Equity = Net Profit ÷ Shareholders Equity
For a company to create value for its shareholders, it must generate an ROE higher than the cost of equity. Unlike debt-holders, there is no predefined return for equity investors. However, an expected return to account for market risk can be arrived at using the Capital Asset Pricing Model. For CATY, it stands at 8.75% versus its ROE of 9.8%.
ROE can be broken down into three ratios using the Dupont formula. The profit margin is the income as a percentage of sales, while asset turnover highlights how efficiently Cathay Dupont Award a company is using the resources at its disposal. Increased leverage, primarily through raising debt, is good for a profitable company, but only to the extent it doesn’t make the firm insolvent in a time of crisis.
ROE = annual net profit ÷ shareholders’ equity ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity) ROE = profit margin × asset turnover × financial leverage
A trend of profit growing faster than revenue is indicative of improvement in ROE. While investors should assess the past correlation between them, an assessment of the analysts’ profit and revenue forecast points to the most likely scenario going forward. The asset turnover for a capital intensive industry such as bricks-and-mortar retail would be substantially lower than the e-commerce retail industry. A comparison with the industry can be drawn through ROA, which represents earnings as a percentage of assets. Cathay General Bancorp’s ROA stood at 1.3% in the past year, compared to the industry’s 0.98%.
The impact of leverage on ROE is reflected in a company’s debt-equity profile. Rapidly rising debt compared to equity, while profit margin and asset turnover underperform, raises a red flag on the ROE. It’s important as a company can inflate its ROE by consistently increasing debt despite weak operating performance. CATY’s debt to equity ratio currently stands at 0.46. Investors should be cautious about any sharp change in this ratio, more so if it’s due to increasing debt.
ROE – More than just a profitability ratio
While ROE can be calculated through a very simple calculation, investors should look at various ratios by breaking it down and how each of them affects the return to understand the strengths and weakness of a company. It’s one of the few ratios which stitches together performance metrics from the income statement and the balance sheet. What are the analysts’ projection of Cathay General Bancorp’s ROE in three years? I recommend you see our latest FREE analysis report to find out!
If you are not interested in CATY anymore, you can use our free platform to see my list of stocks with Return on Equity over 20%.