Westpac Banking Corporation (ASX:WBCPC) delivered an ROE of 13.04% over the past 12 months, which is an impressive feat relative to its industry average of 10.87% during the same period. On the surface, this looks fantastic since we know that WBCPC has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether WBCPC’s ROE is actually sustainable. Check out our latest analysis for Westpac Banking

Breaking down Return on Equity

Return on Equity (ROE) weighs Westpac Banking’s profit against the level of its shareholders’ equity. It essentially shows how much the company 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 Westpac Banking’s equity capital deployed. Its cost of equity is 8.55%. Given a positive discrepancy of 4.49% between return and cost, this indicates that Westpac Banking pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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

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 Westpac Banking can make from its 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 Westpac Banking’s historic debt-to-equity ratio. 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.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Westpac Banking exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. With debt capital in excess of equity, ROE may be inflated by the use of debt funding, raising questions over the sustainability of the company’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.

For Westpac Banking, there are three pertinent factors you should further research:

• 1. Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.

• 2. Valuation: What is Westpac Banking worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Westpac Banking is currently mispriced by the market.

• 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Westpac Banking? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.