Hugoton Royalty Trust (NYSE:HGT) delivered an ROE of 26.01% over the past 12 months, which is an impressive feat relative to its industry average of 10.63% during the same period. On the surface, this looks fantastic since we know that HGT has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of HGT’s ROE. View our latest analysis for Hugoton Royalty Trust

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) is a measure of Hugoton Royalty Trust’s profit relative to its shareholders’ equity. An ROE of 26.01% implies $0.26 returned on every $1 invested. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.

Return on Equity = Net Profit ÷ Shareholders Equity

Returns are usually compared to costs to measure the efficiency of capital. Hugoton Royalty Trust’s cost of equity is 10.28%. Given a positive discrepancy of 15.73% between return and cost, this indicates that Hugoton Royalty Trust pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be broken down into three different 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

Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from Hugoton Royalty Trust’s 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 financial leverage can artificially inflate ROE, we need to look at how much debt Hugoton Royalty Trust currently has. Currently, Hugoton Royalty Trust has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.

Next Steps:

While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Hugoton Royalty Trust’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.