Yahoo Finance Should You Expect Lloyds Banking Group plc (LON:LLOY) To Continue Delivering An ROE Of 8.45%?
I am writing today to help inform people who are new to the stock market and want to begin learning the link between Lloyds Banking Group plc (LON:LLOY)’s return fundamentals and stock market performance.
Lloyds Banking Group plc (LON:LLOY) outperformed the Diversified Banks industry on the basis of its ROE – producing a higher 8.45% relative to the peer average of 7.99% over the past 12 months. Superficially, this looks great since we know that LLOY has generated big profits with little equity capital; however, ROE doesn’t tell us how much LLOY has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether LLOY’s ROE is actually sustainable. View out our latest analysis for Lloyds Banking Group
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. For example, if the company invests £1 in the form of equity, it will generate £0.085 in earnings from this. 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 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 Lloyds Banking Group, which is 8.67%. Since Lloyds Banking Group’s return does not cover its cost, with a difference of -0.22%, this means its current use of equity is not efficient and not sustainable. Very simply, Lloyds Banking Group 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. The other component, asset turnover, illustrates how much revenue Lloyds Banking Group can make from its 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 Lloyds Banking Group’s debt-to-equity level. Currently the debt-to-equity ratio stands at more than 2.5 times, which means its above-average ROE is driven by significant debt levels.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Lloyds Banking Group’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 Lloyds Banking Group’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Lloyds Banking Group, I’ve put together three important aspects you should look at:
Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
Valuation: What is Lloyds Banking Group worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Lloyds Banking Group is currently mispriced by the market.
Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Lloyds Banking Group? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.
