1 Simple Number To Help Investors Understand 3 Important Aspects of Oversea-Chinese Banking Corp Limited’s Business

Source: Fool Editorial

Oversea-Chinese Banking Corp Limited (SGX: O39) is one of the largest banks in the Southeast Asia region with its total assets of S$394.2 billion. It is also an important component of Singapore’s stock market barometer, the Straits Times Index (SGX: ^STI); the bank has an 11.9% weighting in the index.

In this article I want to dig deep into the bank’s return on equity, or ROE.

The choice of ROE

Why the ROE some of you might be asking? That’s because the financial metric gives investors important insight on a company’s ability to generate a profit using the shareholders’ capital it has.

A ROE of 20% means that a company generates $0.20 in profit for every dollar of shareholders’ capital invested. In general, the higher the ROE, the more profitable a company is.

That being said, it’s worth noting that the use of high leverage – which increases the financial risk faced by a company – can also increase a company’s ROE. So, that’s something to observe.

Calculating the ROE

The ROE can be calculated using the following formula, which is the way many investors do it:

ROE = Net Profit / Shareholder’s Equity

But, the ROE can also be calculated using a different approach shown below:

ROE = Asset Turnover x Net Profit Margin x Leverage Ratio

Doing so will reveal three important aspects about a company: How well it is managing its assets, how efficient it is at turning revenue into profit, and how much financial risk it could be taking on. For more information about this formula for the ROE, you can check out here.

With that, let’s turn our attention back to the ROE of OCBC.

The actual numbers

The asset turnover measures the efficiency of a company in using its assets to generate revenue. It is calculated by dividing a company’s total revenue by its assets. For OCBC, its asset turnover for 2015 was 0.0224 (the bank reported total revenue of S$8.722 billion and total assets of S$390.19 billion in 2015).

The net profit margin measures the percentage of revenue that is left as a profit after deduction of all expenses. OCBC recorded a profit of S$4.108 billion in 2015; we already know its revenue number. This gives a net profit margin of 47% for the bank.

Lastly, we have the leverage ratio, which shows the relationship of a company’s total assets to its shareholders’ equity. It is calculated by dividing total assets by shareholders’ equity. A higher ratio means that a company is funding its assets with more liabilities, hence resulting in higher risk. In 2015, OCBC had a leverage ratio of 10.51 (the bank had total shareholders’ equity of S$37.11 billion; we already know the total assets number).

When we put all the three numbers together for OCBC, we arrive at a ROE of 11.1%. This is slightly higher than the ROE of 10.7% that Singapore’s largest bank, DBS Group Holdings Ltd (SGX: D05), in 2015.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Lawrence Nga doesn’t own shares in any companies mentioned.