The Howard Hughes Corporation’s (NYSE:HHC) most recent return on equity was a substandard 2.08% relative to its industry performance of 9.50% over the past year. Though HHC’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on HHC’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of HHC’s returns. View our latest analysis for Howard Hughes
Breaking down Return on Equity
Return on Equity (ROE) weighs Howard Hughes’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.02 in earnings from this. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Howard Hughes’s equity capital deployed. Its cost of equity is 9.95%. Given a discrepancy of -7.87% between return and cost, this indicated that Howard Hughes may be paying more for its capital than what it’s generating in return. ROE can be split up into three useful 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 shows how much revenue Howard Hughes can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine Howard Hughes’s debt-to-equity level. The debt-to-equity ratio currently stands at a balanced 99.04%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Howard Hughes’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Howard Hughes’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.