Punjab National Bank (NSEI:PNB) generated a below-average return on equity of 2.87% in the past 12 months, while its industry returned 8.57%. 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 PNB’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of PNB’s returns. View our latest analysis for Punjab National Bank
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Punjab National Bank’s cost of equity is 14.13%. Since Punjab National Bank’s return does not cover its cost, with a difference of -11.27%, this means its current use of equity is not efficient and not sustainable. Very simply, Punjab National Bank 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 shows how much revenue Punjab National Bank 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 the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Punjab National Bank currently has. Currently the debt-to-equity ratio stands at a balanced 98.61%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.
What this means for you:
Are you a shareholder? PNB’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 PNB 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%.