A bank’s return on equity (ROE) is a key metric used to determine how efficient it is in using its shareholders’ equity to generate a profit. The higher the ROE is, the more efficient the bank is. At the same time, the return on equity must also be sustainable, and must not come at the expense of a weak balance sheet. With this in mind, I wanted to assess whether DBS Group Holdings Ltd (SGX: D05) could achieve its aggressive 13% ROE target for 2018. A sky-high goal This is an exceptionally ambitious goal. For perspective, DBS’s ROE in 2017…
A bank’s return on equity (ROE) is a key metric used to determine how efficient it is in using its shareholders’ equity to generate a profit. The higher the ROE is, the more efficient the bank is. At the same time, the return on equity must also be sustainable, and must not come at the expense of a weak balance sheet.
With this in mind, I wanted to assess whether DBS Group Holdings Ltd (SGX: D05) could achieve its aggressive 13% ROE target for 2018.
A sky-high goal
This is an exceptionally ambitious goal. For perspective, DBS’s ROE in 2017 was just 9.31%. Furthermore, over the past five years, the highest ROE that DBS achieved was 11.05% in 2015. The other two major banks in Singapore, United Overseas Bank Ltd (SGX: U11) and Oversea-Chinese Banking Corp Limited (SGX: O39), achieved ROEs of 9.72% and 10.84%, respectively, in 2017.
Despite this, DBS’s CEO, Piyush Gupta, said in the bank’s latest annual report that the 13% ROE goal for 2018 is “readily achievable.” Here are the three reasons Gupta stated for his confidence in DBS being able to meet its ROE target.
Higher proportion of low-capital, high-return business
Over the past seven years, the bank’s wealth management income has quadrupled to S$2.11 billion, while cash management income for 2017 rose to more than S$1 billion. Both these segments are comparatively low low-capital and high-return businesses. Combined, they now make up close to 30% of DBS’s overall income.
At the same time, the bank’s capital-intensive trading income has fallen to just 10% of total income, from 20%.
If this trend of DBS growing its low-capital, high-return businesses was to continue, the bank can grow its overall profit margins, and ultimately its ROE.
Net interest margin to widen
Interest rates have been low since the Great Financial Crisis started in 2008. However, the general view is that interest rates will start to rise this year and next. The Federal Reserve in the United States has already said that it’s likely to implement two to three more rate hikes this year.
Gupta said that a rise in interest rates will improve DBS’s net interest margin, and consequently the bank’s profitability. Given DBS’s current balance sheet structure, he estimated that a one percentage point increase in domestic interest rates will expand the bank’s ROE by one percentage point.
Furthermore, by paying out a higher ordinary dividend plus a special dividend in 2017, the bank has less unused capital on its balance sheet, which provides a further boost to its ROE in the future.
Technological enhancement is the third driver of DBS’s ROE-growth. Digitalisation has lowered customer-acquisition costs in DBS’s developed markets such as Singapore and Hong Kong, thereby increasing wallet-share at lower marginal costs. The bank’s digital initiatives have also permitted it to scale its business in developing countries such as India and Indonesia at much lower marginal costs.
For instance, DBS’s digibank business in India does not require an expensive network of bank branches, since it is a mobile-only bank. Yet digibank has already grown its customer count to more than 1 million in India. Gupta believes that with the cost efficiencies of digital platforms and services, DBS can lower its cost-income ratio, thereby improving its ROE.
The Foolish bottom line
Based on historical and industry-wide averages, a 13% ROE target for 2018 may seem overly ambitious for DBS. However, to get a better picture, we need to take a look at the bank’s overall business trends and the seeds it has planted for the future. When we see how DBS’s low-capital businesses have grown, how digitalization will reduce its cost-income ratio, and how a rising interest rate environment can benefit its business, a 13% ROE certainly does not seem so implausible.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. The Motley Fool Singapore has a recommendation on DBS Group Holdings and United Overseas Bank Limited. Motley Fool Singapore contributor Jeremy Chia owns shares in DBS Group Holdings.