House of Friends AB (publ) (OM:HOFF) delivered a less impressive 4.07% ROE over the past year, compared to the 8.12% return generated by its industry. 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 HOFF’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of HOFF’s returns. Let me show you what I mean by this. Check out our latest analysis for House of Friends
What you must know about ROE
Return on Equity (ROE) is a measure of House of Friends’s profit relative to its shareholders’ equity. For example, if the company invests SEK1 in the form of equity, it will generate SEK0.04 in earnings from this. 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 House of Friends’s equity capital deployed. Its cost of equity is 10.50%. This means House of Friends’s returns actually do not cover its own cost of equity, with a discrepancy of -6.43%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates in return. 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. The other component, asset turnover, illustrates how much revenue House of Friends can make from its 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 House of Friends’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 29.83%, which means House of Friends still has headroom to take on more leverage in order to increase profits.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. House of Friends exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of House of Friends’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.