The Goldman Sachs Group Inc (NYSE:GS) delivered a less impressive 9.79% ROE over the past year, compared to the 11.19% return generated by its industry. 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 GS's past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of GS's returns. Let me show you what I mean by this. View our latest analysis for Goldman Sachs Group
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 9.79% implies $0.1 returned on every $1 invested. 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 GS’s equity capital deployed. Its cost of equity is 13.42%. This means GS’s returns actually do not cover its own cost of equity, with a discrepancy of -3.63%. 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 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 GS can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable GS’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine GS’s debt-to-equity level. At over 2.5 times, GS’s debt-to-equity ratio is very high and indicates the below-average ROE is already being generated by significant leverage levels.
What this means for you:
Are you a shareholder? GS’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 GS to your portfolio. 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%.