This article is intended for those of you who are at the beginning of your investing journey and want to begin learning the link between company’s fundamentals and stock market performance.
Wellesley Bancorp Inc’s ( NASDAQ:WEBK ) most recent return on equity was a substandard 6.9% relative to its industry performance of 8.2% over the past year. Though WEBK’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on WEBK’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of WEBK’s returns.
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Wellesley Bancorp’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.069 in earnings from this. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Wellesley Bancorp’s equity capital deployed. Its cost of equity is 10.9%. Given a discrepancy of -4.1% between return and cost, this indicated that Wellesley Bancorp 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue Wellesley Bancorp can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Wellesley Bancorp’s debt-to-equity level. The debt-to-equity ratio currently stands at a high 199%, meaning the below-average ratio is already being driven by a large amount of debt.
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Wellesley Bancorp’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Also, with debt capital in excess of equity, ROE may already be inflated by the use of debt funding, raising questions over the possibility of further decline in the company’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Wellesley Bancorp, I’ve put together three relevant factors 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 Wellesley Bancorp 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 Wellesley Bancorp is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Wellesley Bancorp? 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 .