Hornbach Baumarkt AG’s (DB:HBM) most recent return on equity was a substandard 6.29% relative to its industry performance of 12.19% over the past year. HBM’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on HBM’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of HBM’s returns. Let me show you what I mean by this. See our latest analysis for Hornbach Baumarkt

Breaking down Return on Equity

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 6.29% implies €0.06 returned on every €1 invested. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.

Return on Equity = Net Profit ÷ Shareholders Equity

ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Hornbach Baumarkt, which is 10.37%. Given a discrepancy of -4.07% between return and cost, this indicated that Hornbach Baumarkt may be paying more for its capital than what it’s generating in return. ROE can be split up into three useful ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:

Dupont Formula

ROE = profit margin × asset turnover × financial leverage

ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)

ROE = annual net profit ÷ shareholders’ equity

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue Hornbach Baumarkt can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check Hornbach Baumarkt’s historic debt-to-equity ratio. At 39.82%, Hornbach Baumarkt’s debt-to-equity ratio appears low and indicates that Hornbach Baumarkt still has room to increase leverage and grow its profits.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Hornbach Baumarkt’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Hornbach Baumarkt’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.