With an ROE of 31.31%, Hudson Investment Group Limited (ASX:HGL) outpaced its own industry which delivered a less exciting 11.22% over the past year. On the surface, this looks fantastic since we know that HGL has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of HGL’s ROE. See our latest analysis for Hudson Investment Group
What you must know about ROE
Return on Equity (ROE) weighs Hudson Investment Group’s profit against the level of its shareholders’ equity. An ROE of 31.31% implies A$0.31 returned on every A$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. Hudson Investment Group’s cost of equity is 9.74%. This means Hudson Investment Group returns enough to cover its own cost of equity, with a buffer of 21.58%. This sustainable practice implies that the company pays less 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue Hudson Investment Group 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 Hudson Investment Group’s debt-to-equity level. The debt-to-equity ratio currently stands at a sensible 83.14%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Hudson Investment Group exhibits a strong ROE against its peers, as well as sufficient returns to cover 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. Although ROE can be a useful metric, it is only a small part of diligent research.