Assessing Operating and Financial Strategies
The Common Stockholder's Net Operating Profit After-tax Return on Tangible Common Equity Capital (NOPAT ROE) ratio and the Operating Profit Margin are two unique ratios that are of particular importance in IDC Financial Publishing’s (IDCFP) risk assessment process. Below is a summary description of the NOPAT ROE equation and why it provides a better measure of each bank’s performance when compared with the traditional stockholder ROE.
IDC Financial Publishing (IDCFP) identifies each bank’s strengths and weaknesses by type of financial ratio and combines the overall view into a summary rank. In addition to performing a CAMEL ratio analysis, IDCFP calculates the Common Stockholder's NOPAT ROE along with its components.
The Traditional ROE Equation
The traditional ROE equation simply divides net income by the average of common stockholder's tangible equity capital. The stockholder ROE, as a bottom-line measure of profitability, fails to reflect the true nature of asset quality. 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 so 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 = ROEA + ROFL
In contrast, the NOPAT ROE equation expresses ROE as a sum of two components. The first is the return on earning assets (ROEA), which equals the return that the bank earns before interest expense on the debt funds, but after tax, that is invested in loans, securities, cash equivalents, and other earning assets. In order to capture cash flow, any increase in the loan loss reserve is added to ROEA. ROEA focuses on operating strategy, which identifies returns from investments, loans, and noninterest income sources. The second component is the bank’s return on financial leverage (ROFL). This reflects both the degree to which the bank uses debt funds to finance its operating strategy and the cost of these debt funds.
Return on Earning Assets (ROEA)
A bank’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 common shareholder's tangible equity funds and the loan loss reserve. The revenue sources are defined as investments including realized gains or losses, loans, income and noninterest income sources. Each is separately analyzed to determine the contribution to overall profit. The after-tax ROEA is equal to the pretax ROEA times the tax multiplier* plus the increase in the loan loss reserve.
*The tax multiplier is defined as the difference between unity and the rate at which the bank’s operating income would be taxed if its interest expense was not deductible, given that the taxable revenues are calculated to reflect the grossing-up of tax-exempt income to a tax-equivalent basis. The amount this adjusted tax rate diverges from the marginal federal tax rate depends primarily on 1) the state and local taxes to which the bank is subject and 2) the size and productivity of the bank’s tax-exempt security and loan portfolios as adjusted for nondeductible interest.
Return on Financial Leverage (ROFL) = Leverage Spread x Leverage Multiplier
A bank’s return on financial leverage (ROFL) measures the efficiency with which the bank uses deposits, borrowings, and other forms of debt to leverage its tangible common equity capital and reserves. ROFL is the product of the bank’s “leverage spread ”and “leverage multiplier.”
The leverage spread is the difference between the after-tax ROEA and the after-tax cost of funding. The after-tax cost of funding equals interest expense times the tax multiplier divided by adjusted debt. Adjusted debt (equal to total earning assets less tangible common equity capital and the loan loss reserve) is the amount of earning assets funded by deposits, borrowings, or other debt. The leverage multiplier is the ratio of adjusted debt divided by the sum of tangible common equity capital and the loan loss reserve.
The NOPAT ROE equation is a tool that helps profitability-oriented management understand more clearly the relationships between ROE, operating strategy (ROEA), and financial strategy (ROFL). ROEA and ROFL for an individual bank are best analyzed by comparing the bank's ratios to those of its peers.
In striving to generate an ROE above cost of equity capital, the NOPAT ROE equation provides bank management with the "big picture." Management is able to determine the best mix of operating effectiveness and financial leverage and its cost that will generate a value-adding ROE
In today’s higher cost of debt environment, controlling cost of debt relative to the ROEA is imperative to maintain the leverage spread. Limiting the amount of debt in the leverage multiplier controls risk and avoids over leveraging debt to tangible common equity capital.
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.
John E Rickmeier, CFA