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Huntsman Corporation (NYSE:HUN) outperformed the Diversified Chemicals industry on the basis of its ROE – producing a higher 19.10% relative to the peer average of 13.89% over the past 12 months. While the impressive ratio tells us that HUN has made significant profits from little equity capital, ROE doesn’t tell us if HUN has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of HUN’s ROE. Check out our latest analysis for Huntsman
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Huntsman’s profit relative to its shareholders’ equity. An ROE of 19.10% implies $0.19 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. Huntsman’s cost of equity is 10.22%. This means Huntsman returns enough to cover its own cost of equity, with a buffer of 8.88%. 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. The other component, asset turnover, illustrates how much revenue Huntsman 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 Huntsman’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a sensible 61.95%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge 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. Huntsman’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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.