Investar Holding Corporation (NASDAQ:ISTR) delivered a less impressive 5.83% ROE over the past year, compared to the 8.94% return generated by its industry. ISTR’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on ISTR’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of ISTR’s returns. Check out our latest analysis for Investar Holding
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Investar Holding’s profit relative to its shareholders’ equity. An ROE of 5.83% implies $0.06 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 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 Investar Holding, which is 9.81%. This means Investar Holding’s returns actually do not cover its own cost of equity, with a discrepancy of -3.98%. 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
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 Investar Holding can generate with its current asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine Investar Holding’s debt-to-equity level. The debt-to-equity ratio currently stands at a balanced 136.95%, 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? ISTR’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 ISTR 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%.