NIBC Holding NV. (ENXTAM:NIBC) outperformed the Diversified Banks industry on the basis of its ROE – producing a higher 10.18% relative to the peer average of 8.46% over the past 12 months. Superficially, this looks great since we know that NIBC has generated big profits with little equity capital; however, ROE doesn’t tell us how much NIBC has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether NIBC’s ROE is actually sustainable. Check out our latest analysis for NIBC Holding
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. It essentially shows how much the company 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 measured against cost of equity in order to determine the efficiency of NIBC Holding’s equity capital deployed. Its cost of equity is 10.03%. Given a positive discrepancy of 0.15% between return and cost, this indicates that NIBC Holding 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. The other component, asset turnover, illustrates how much revenue NIBC Holding can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt NIBC Holding currently has. At over 2.5 times, NIBC Holding’s debt-to-equity ratio is very high and indicates the above-average ROE is generated by significant leverage levels.
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. NIBC Holding exhibits a strong ROE against its peers, as well as sufficient returns to cover 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 NIBC Holding’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.