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With an ROE of 9.56%, JPMorgan Chase & Co (NYSE:JPM) outpaced its own industry which delivered a less exciting 8.20% over the past year. While the impressive ratio tells us that JPM has made significant profits from little equity capital, ROE doesn’t tell us if JPM has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether JPM’s ROE is actually sustainable. View our latest analysis for JPMorgan Chase
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 9.56% implies $0.1 returned on every $1 invested. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of JPMorgan Chase’s equity capital deployed. Its cost of equity is 9.86%. This means JPMorgan Chase’s returns actually do not cover its own cost of equity, with a discrepancy of -0.30%. 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
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 shows how much revenue JPMorgan Chase can generate with its current 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 JPMorgan Chase currently has. At 218.49%, JPMorgan Chase’s debt-to-equity ratio appears relatively high and indicates the above-average ROE is generated by significant leverage levels.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. JPMorgan Chase’s ROE is impressive relative to the industry average, though its returns were not strong enough to cover its own cost of equity. Its debt level is above equity which means its above-industry ROE may be driven by debt funding which raises concerns over the sustainability of JPMorgan Chase’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.