Commonwealth Bank of Australia (ASX:CBA) delivered an ROE of 16.02% over the past 12 months, which is an impressive feat relative to its industry average of 10.98% during the same period. On the surface, this looks fantastic since we know that CBA has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of CBA’s ROE. See our latest analysis for CBA
Breaking down Return on Equity
Return on Equity (ROE) weighs CBA’s profit against the level of its shareholders’ equity. It essentially shows how much CBA can generate in earnings given the amount of equity it has raised. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
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 CBA, which is 8.55%. Given a positive discrepancy of 7.46% between return and cost, this indicates that CBA 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
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 CBA can make from its 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 CBA’s debt-to-equity level. Currently the debt-to-equity ratio stands at more than 2.5 times, which means its above-average ROE is driven by significant debt levels.
What this means for you:
Are you a shareholder? CBA’s ROE is impressive relative to the industry average and also covers its cost of equity. However, with debt capital in excess of equity, ROE might be inflated by the use of debt funding, which is something you should be aware of before buying more CBA shares. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.