Bank of Baroda (NSEI:BANKBARODA) generated a below-average return on equity of 3.32% in the past 12 months, while its industry returned 8.57%. Though BANKBARODA’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 BANKBARODA’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of BANKBARODA’s returns. Let me show you what I mean by this. Check out our latest analysis for Bank of Baroda
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Bank of Baroda’s profit relative to its shareholders’ equity. For example, if the company invests ₹1 in the form of equity, it will generate ₹0.03 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
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Bank of Baroda, which is 14.12%. Given a discrepancy of -10.80% between return and cost, this indicated that Bank of Baroda may be paying more for its capital than what it’s generating in return. ROE can be split up into three useful 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 the business is with its cost management. Asset turnover reveals how much revenue can be generated from Bank of Baroda’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt Bank of Baroda currently has. The debt-to-equity ratio currently stands at a sensible 74.00%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.
What this means for you:
Are you a shareholder? BANKBARODA’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as BANKBARODA still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. 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%.