First Commonwealth Financial Corporation’s (NYSE:FCF) most recent return on equity was a substandard 8.40% relative to its industry performance of 8.91% over the past year. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into FCF’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of FCF’s returns. See our latest analysis for First Commonwealth Financial

Peeling the layers of ROE – trisecting a company’s profitability

Return on Equity (ROE) weighs First Commonwealth Financial’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.08 in earnings from this. 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. First Commonwealth Financial’s cost of equity is 9.76%. This means First Commonwealth Financial’s returns actually do not cover its own cost of equity, with a discrepancy of -1.36%. 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 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. Asset turnover reveals how much revenue can be generated from First Commonwealth Financial’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine First Commonwealth Financial’s debt-to-equity level. Currently the debt-to-equity ratio stands at a balanced 100.51%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.

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. First Commonwealth Financial’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.