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Commonwealth Bank of Australia (ASX:CBA) delivered an ROE of 15.15% over the past 12 months, which is an impressive feat relative to its industry average of 11.83% during the same period. While the impressive ratio tells us that CBA has made significant profits from little equity capital, ROE doesn’t tell us if CBA has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether CBA’s ROE is actually sustainable. View our latest analysis for Commonwealth Bank of Australia
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. For example, if the company invests A$1 in the form of equity, it will generate A$0.15 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
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 Commonwealth Bank of Australia, which is 8.55%. Given a positive discrepancy of 6.59% between return and cost, this indicates that Commonwealth Bank of Australia pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be split up into three useful ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from Commonwealth Bank of Australia’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 ROE can be artificially increased through excessive borrowing, we should check Commonwealth Bank of Australia’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at over 2.5 times, meaning the above-average ratio is a result of a large amount of debt.
Next Steps:
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. Commonwealth Bank of Australia’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 Commonwealth Bank of Australia’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.