Himax Technologies Inc’s (NASDAQ:HIMX) most recent return on equity was a substandard 1.43% relative to its industry performance of 8.36% over the past year. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into HIMX’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of HIMX’s returns. See our latest analysis for Himax Technologies

What you must know about ROE

Return on Equity (ROE) weighs Himax Technologies’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.01 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

ROE is measured against cost of equity in order to determine the efficiency of Himax Technologies’s equity capital deployed. Its cost of equity is 9.87%. Since Himax Technologies’s return does not cover its cost, with a difference of -8.44%, this means its current use of equity is not efficient and not sustainable. Very simply, Himax Technologies pays more 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. The other component, asset turnover, illustrates how much revenue Himax Technologies can make from its 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 the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check Himax Technologies’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 33.78%, meaning Himax Technologies still has headroom to borrow debt to increase profits.

What this means for you:

Are you a shareholder? HIMX’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as HIMX still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. 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%.

Are you a potential investor? If you are considering investing in HIMX, looking at ROE on its own is not enough to make a well-informed decision. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Himax Technologies to help you make a more informed investment decision.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.