Wellesley Bancorp Inc’s (NASDAQ:WEBK) most recent return on equity was a substandard 5.87% relative to its industry performance of 8.95% over the past year. Though WEBK's recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on WEBK's below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of WEBK's returns. View our latest analysis for Wellesley Bancorp
Peeling the layers of ROE – trisecting a company’s profitability
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 WEBK can generate in earnings given the amount of equity it has raised. 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 measured against cost of equity in order to determine the efficiency of WEBK’s equity capital deployed. Its cost of equity is 11.02%. Since WEBK’s return does not cover its cost, with a difference of -5.16%, this means its current use of equity is not efficient and not sustainable. Very simply, WEBK pays more for its capital than what it generates in return. ROE can be broken down into three different 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 WEBK is with its cost management. Asset turnover shows how much revenue WEBK can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check WEBK’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a high 233.91%, which means its below-average ROE is already being driven by significant debt levels.
What this means for you:
Are you a shareholder? WEBK’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Additionally, its high debt level appears to be a key driver of its ROE and is something you should be mindful of before adding more of WEBK to your portfolio.