In This Article:
Hexagon Composites ASA’s (OB:HEX) most recent return on equity was a substandard 4.92% relative to its industry performance of 10.92% 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 HEX’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of HEX’s returns. View our latest analysis for Hexagon Composites
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests NOK1 in the form of equity, it will generate NOK0.05 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 assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Hexagon Composites, which is 8.40%. Given a discrepancy of -3.48% between return and cost, this indicated that Hexagon Composites may be paying more for its capital than what it’s generating 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from Hexagon Composites’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check Hexagon Composites’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 27.39%, meaning Hexagon Composites still has headroom to borrow debt to increase profits.