Wellesley Bancorp Inc’s (NASDAQ:WEBK) most recent return on equity was a substandard 6.22% relative to its industry performance of 8.48% 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 WEBK’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of WEBK’s returns. Check out our latest analysis for Wellesley Bancorp
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Wellesley Bancorp’s profit against the level of 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
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 Wellesley Bancorp, which is 9.90%. This means Wellesley Bancorp’s returns actually do not cover its own cost of equity, with a discrepancy of -3.68%. 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 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
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 Wellesley Bancorp’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 Wellesley Bancorp’s debt-to-equity level. At 191.87%, Wellesley Bancorp’s debt-to-equity ratio appears relatively high and indicates the below-average ROE is already being generated by significant leverage levels.
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. Wellesley Bancorp’s below-industry ROE is disappointing, furthermore, its returns were not even high 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.