Healthscope Limited’s (ASX:HSO) most recent return on equity was a substandard 6.86% relative to its industry performance of 11.86% 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 HSO’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of HSO’s returns. Check out our latest analysis for Healthscope
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of HSO’s profit relative to its shareholders’ equity. For example, if HSO invests A$1 in the form of equity, it will generate A$0.07 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
Returns are usually compared to costs to measure the efficiency of capital. HSO’s cost of equity is 8.55%. Since HSO’s return does not cover its cost, with a difference of -1.69%, this means its current use of equity is not efficient and not sustainable. Very simply, HSO pays more for its capital than what it generates 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 HSO 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 HSO’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check HSO’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a sensible 77.74%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.
What this means for you:
Are you a shareholder? HSO’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as HSO still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.