Humana Inc (NYSE:HUM) outperformed the Managed Healthcare industry on the basis of its ROE – producing a higher 16.62% relative to the peer average of 13.29% over the past 12 months. Superficially, this looks great since we know that HUM has generated big profits with little equity capital; however, ROE doesn’t tell us how much HUM has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable HUM’s ROE is. Check out our latest analysis for Humana
What you must know about ROE
Return on Equity (ROE) is a measure of HUM’s profit relative to its shareholders’ equity. For example, if HUM invests $1 in the form of equity, it will generate $0.17 in earnings from this. 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
Returns are usually compared to costs to measure the efficiency of capital. HUM’s cost of equity is 8.49%. Since HUM’s return covers its cost in excess of 8.13%, its use of equity capital is efficient and likely to be sustainable. Simply put, HUM 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient HUM is with its cost management. Asset turnover shows how much revenue HUM can generate with its current asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable HUM’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check HUM’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 46.53%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
What this means for you:
Are you a shareholder? HUM’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.