The Traditional ROE Equation
The traditional ROE equation simply divides net income by average equity capital. The stockholder ROE, as a bottom-line measure of profitability, fails to reflect the true nature of asset quality in the ROE equation. Institutions with loan loss reserves in excess of 10% of equity capital overstate profitability using this ROE calculation. In addition, the traditional components of this ROE ratio - net interest margin, net income return on assets (ROA), and resulting stockholder ROE - confuse the source of net income by subtracting cost of funding too early in the analysis. Managers are unable to separately compare operating and financial returns with their peers. Also, use of the loan loss provision, and not adjusting net income for the increase in the loan loss reserve, fails to reflect the true cash flow to earnings.
The NOPAT ROE Equation Equals Return on Operating Assets (ROEA) plus Return on Financial Leverage (ROFL)
Return on Earning Assets (ROEA)
An institution’s return on earning assets (ROEA) measures the results of its operations before funding costs; that is, as if the operations were financed entirely by equity funds. The revenue sources are defined as investments including realized gains or losses, loans, and noninterest income sources. The pre-tax return on earning assets is derived by subtracting the loan loss provision and noninterest expenses from revenues.
The after-tax ROEA equals the pretax ROEA less the estimated tax plus the increase in the loan loss reserve. An increase in the loan loss reserve occurs when the loan loss provision is greater than the net of loan charge-offs plus recoveries.
Return on Financial Leverage (ROFL)
An institution’s return on financial leverage (ROFL) measures the efficiency with which the institution uses deposits, borrowings, and other forms of debt to leverage its equity capital and reserves. ROFL equals the product of the institution’s “leverage spread” times “leverage multiplier.”
The leverage spread is the difference between the after-tax ROEA and the after-tax cost of funding adjusted debt. The leverage multiplier is the ratio of adjusted debt (equal to earning assets before the loan loss reserve less equity capital and the loan loss reserve) to the sum of equity capital and the loan loss reserve. The amount of earning assets funded by deposits and total borrowings equals adjusted debt.
Conclusion – See NOPAT ROE and its components on-line as part of IDC’s CAMEL analysis for over 13,000 financial institutions.
The NOPAT ROE equation helps profitability-oriented management understand more clearly the interrelationships between ROE, operating strategy (ROEA), and financial strategy (ROFL). ROEA and ROFL for an individual institution are best analyzed by comparing the institution’s ratios to those of its peers. In striving to generate an ROE above cost of equity capital, the NOPAT ROE equation provides management the best mix of operating returns and financial leverage, with its relative cost, that will generate a value-adding ROE.
This NOPAT ROE ratio analysis is a combination of IDC Financial Publishing’s experience and research, diagnostic equations developed by Dr. William Alberts of Marakon Associates, accounting data treatment as noted by G.Bennett Stewart III of Stern, Stewart & Co., and ROE versus cost of equity (COE) relationships from various sources.
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