SmartFinancial Inc (NASDAQ:SMBK) delivered a less impressive 5.48% ROE over the past year, compared to the 8.93% return generated by its industry. Though SMBK’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 SMBK’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of SMBK’s returns. Check out our latest analysis for SmartFinancial
What you must know about ROE
Return on Equity (ROE) is a measure of SmartFinancial’s profit relative to 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
Returns are usually compared to costs to measure the efficiency of capital. SmartFinancial’s cost of equity is 9.77%. Since SmartFinancial’s return does not cover its cost, with a difference of -4.29%, this means its current use of equity is not efficient and not sustainable. Very simply, SmartFinancial 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue SmartFinancial 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 inflated by excessive debt, we need to examine SmartFinancial’s debt-to-equity level. At 23.82%, SmartFinancial’s debt-to-equity ratio appears low and indicates that SmartFinancial still has room to increase leverage and grow its profits.
What this means for you:
Are you a shareholder? SMBK’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 SMBK 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%.