With an ROE of 57.64%, HEG Limited (NSEI:HEG) outpaced its own industry which delivered a less exciting 10.79% over the past year. Superficially, this looks great since we know that HEG has generated big profits with little equity capital; however, ROE doesn’t tell us how much HEG has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether HEG’s ROE is actually sustainable. Check out our latest analysis for HEG
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of HEG’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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
ROE is measured against cost of equity in order to determine the efficiency of HEG’s equity capital deployed. Its cost of equity is 15.20%. This means HEG returns enough to cover its own cost of equity, with a buffer of 42.44%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be dissected into three distinct 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from HEG’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine HEG’s debt-to-equity level. At 15.59%, HEG’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
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. HEG’s ROE is impressive relative to the industry average and also covers its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. Although ROE can be a useful metric, it is only a small part of diligent research.