Meridian Bancorp Inc (NASDAQ:EBSB) outperformed the Thrifts and Mortgage Finance industry on the basis of its ROE – producing a higher 6.64% relative to the peer average of 4.99% over the past 12 months. On the surface, this looks fantastic since we know that EBSB has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable EBSB’s ROE is. See our latest analysis for Meridian Bancorp

What you must know about ROE

Return on Equity (ROE) is a measure of Meridian Bancorp’s profit relative to its shareholders’ equity. An ROE of 6.64% implies $0.07 returned on every $1 invested. 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

Returns are usually compared to costs to measure the efficiency of capital. Meridian Bancorp’s cost of equity is 9.83%. This means Meridian Bancorp’s returns actually do not cover its own cost of equity, with a discrepancy of -3.18%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates in return. ROE can be dissected into three distinct 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

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 Meridian Bancorp can generate with its current 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 Meridian Bancorp’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a sensible 79.43%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Meridian Bancorp’s above-industry ROE is noteworthy, but it was not high enough to cover its own cost of equity. 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.