Hudson Pacific Properties Inc (NYSE:HPP) generated a below-average return on equity of 1.94% in the past 12 months, while its industry returned 7.96%. 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 HPP’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of HPP’s returns. See our latest analysis for Hudson Pacific Properties
What you must know about ROE
Return on Equity (ROE) is a measure of Hudson Pacific Properties’s profit relative to its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.02 in earnings from this. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Hudson Pacific Properties’s equity capital deployed. Its cost of equity is 8.49%. Given a discrepancy of -6.55% between return and cost, this indicated that Hudson Pacific Properties 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Hudson Pacific Properties’s asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Hudson Pacific Properties currently has. The debt-to-equity ratio currently stands at a sensible 61.02%, 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? HPP’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means HPP still has room to improve shareholder returns by raising debt to fund new investments. 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%.