With an ROE of 9.02%, The Community Financial Corporation (NASDAQ:TCFC) outpaced its own industry which delivered a less exciting 8.85% over the past year. On the surface, this looks fantastic since we know that TCFC has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of TCFC’s ROE. Check out our latest analysis for Community Financial
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Community Financial’s profit relative to its 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. Community Financial’s cost of equity is 9.75%. Given a discrepancy of -0.0074% between return and cost, this indicated that Community Financial 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue Community Financial 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 financial leverage can artificially inflate ROE, we need to look at how much debt Community Financial currently has. The debt-to-equity ratio currently stands at a high 164.15%, meaning the above-average ratio is a result of a large amount of debt.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Community Financial’s above-industry ROE is noteworthy, but it was not high enough to cover its own cost of equity. With debt capital in excess of equity, ROE may be inflated by the use of debt funding, raising questions over the sustainability of the company’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.