IF Bancorp Inc (NASDAQ:IROQ) generated a below-average return on equity of 4.26% in the past 12 months, while its industry returned 5.78%. IROQ’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on IROQ’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of IROQ’s returns. View our latest analysis for IF Bancorp
Breaking down Return on Equity
Return on Equity (ROE) is a measure of IF Bancorp’s profit relative to its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.04 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 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 IF Bancorp, which is 9.08%. This means IF Bancorp’s returns actually do not cover its own cost of equity, with a discrepancy of -4.82%. 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 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 IF Bancorp’s 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 IF Bancorp’s debt-to-equity level. The debt-to-equity ratio currently stands at a sensible 80.07%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.
What this means for you:
Are you a shareholder? IROQ’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means IROQ still has room to improve shareholder returns by raising debt to fund new investments. 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%.