There's a Problem With This Bank's 15% Return on Equity

By Markets Fool.com

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The Toronto-Dominion Bank flies under the radars of many bank investors. The low profile could be a result of the bank being based and primarily operated in Canada. Or it could be that the bank largely avoids the negative press that haunts its U.S. counterparts.

Despite its low profile, the bank has done pretty well over the past 10 years on U.S. markets, beating the S&P 500 by about 35% and the KBW Bank Index by about 135%. The bank also trades on the Toronto Stock Exchange.

That performance is driven by some impressive profits, especially in terms of return on equity. But it's not all good news. There's a problem with the bank's returns that investors need to understand.

A nice long-term trend
On the surface, the bank's profits look pretty solid. TD Bank operates on a fiscal year that ends in October, so we already have full-year 2014 results.

The bank produced $7.8 billion in profits for the 2014 fiscal year, a strong improvement from 2013's$6.5 billion. That trend of profits moving from the lower left to the upper right is nothing new for TD. The bank has been doing a fantastic job for over 20 years growing net income.

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In terms of return on equity, the bank is doing an even better job. While the industry is struggling to produce ROE yields of even 10%, TD bank has already return to pre-crisis levels of the ratio

For the 2014 fiscal year, TD returned 14.7% on equity. The bank has produced at least a 13.3% annualized return on equity since 2011. According the most current Quarterly Banking Profile from the FDIC, the industry averaged a paltry 9% ROE for the 2014 third quarter. In fact, the industry hasn't averaged above 10% since the second quarter of 2007!

Pulling the wrong lever
Don't get too excited, though -- there's a problem we need to discuss. Return on equity relates the bank's profits with its equity. That's an important relationship, but its also one that can be manipulated by one specific, and dangerous, mechanism: leverage.

Currently, TD Bank has an assets to equity ratio of 16.8 times. That's roughly 50% higher than the rest of the industry. It is by no means as reckless as the 25 or 30 times that were common ratiosin the mid-2000s, but it is an outlier in the industry.

That leverage successfully boosts the bank's ROE, but it hides an unimpressive efficiency ratio and return on assets figure. A bank's efficiency ratio compares non-interest expenses to the institution's net revenue. A lower ratio is considered more efficient. Return on assets uses the assets side of the bank's balance sheet to measure relative profitability, meaning that it effectively ignores leverage. Using the efficiency ratio and return on assets in tandem gives a very clear picture of the real profitability of the operations, without accounting trickery.

TD Bank, unfortunately, fails to impress with either metric. The bank's ROA was just 0.9% in the fourth quarter, trailing the industry average of 1.02%. The bank's efficiency ratio was reported at 58.1% for the fourth quarter, which is slightly better than the industry average: 60.8% per the FDIC.

What to think of TD Bank's profitability?
There is nothing inherently wrong with using leverage to boost return on equity. In the perfect bank stock, strong returns would come from an efficient operation. Both ROE and ROA would be strong. But in today's highly regulated world, that's not always possible.

The question boils down to risk. Operating with a more leveraged balance sheet gives TD Bank an industry leading ROE, but the trade off is a higher-risk profile. In my opinion, that trade-off is a recipe for disaster. There are other bank stocks with more efficient operations that can yield similar ROEs without the risks that come with extra leverage on the balance sheet.

The article There's a Problem With This Bank's 15% Return on Equity originally appeared on Fool.com.

Jay Jenkins has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.