Red Hat Inc (NYSE:RHT), with a ROE of 16.4% over the past twelve months, appeared relatively inefficient compared to the broader industry, which averaged 22.72% ROE. But to make an opinion on the quality of the returns, an investor must look at the factors behind such performance. View our latest analysis for Red Hat
Breaking down Return on Equity
ROE is simply the percentage of past year earnings against the book value of shareholders’ equity, which is the sum of retained earnings and capital raised through equity offerings. Any ROE north of 20%, implying 20 cents return on every dollar invested, is favourable for any investor. But investors seek multiple assets to diversify risk and an industry-specific comparison makes more sense to achieve the goal of choosing the best among a given lot.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE above the cost of equity estimate indicates value creation, which apparently is the only reason shares rally. The cost of equity can be estimated through a popular and Nobel-prize winning method called Capital Asset Pricing Model (CAPM). With a few sets of assumptions, the CAPM pegs RHT’s cost of equity at 11.62%, compared to its ROE of 16.4%. When we break down ROE using a very popular method called Dupont Formula, it unfolds into three key ratios which are responsible for a company’s profitability: net profit margin, asset turnover, and financial leverage. While higher margin and asset turnover indicate improved efficiency, investors should be cautious about the impact of increased leverage.
ROE = annual net profit ÷ shareholders’ equity
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = profit margin × asset turnover × financial leverage
A reflection of how net profit margin has affected ROE in the past can be seen in the trend of income and revenue. An investor can gauge a fair estimate of how it’s going to play out in the future by looking at the analysts’ forecasts in the years ahead. The asset turnover for a capital intensive industry such as bricks-and-mortar retail would be substantially lower than the e-commerce retail industry. A comparison with the industry can be drawn through ROA, which represents earnings as a percentage of assets. Red Hat’s ROA stood at 4.8% in the past year, compared to the industry’s 8.94%.
The impact of leverage on ROE is reflected in a company’s debt-equity profile. Rapidly rising debt compared to equity, while profit margin and asset turnover underperform, raises a red flag on the ROE. It’s important as a company can inflate its ROE by consistently increasing debt despite weak operating performance. RHT’s debt to equity ratio currently stands at 0.56. Investors should be cautious about any sharp change in this ratio, more so if it’s due to increasing debt.
Why is ROE called the mother of all ratios
On the surface, ROE appears to be a simple profitability ratio indicating the return an investor should expect. However, for a sound investment consideration, it should still appear good when a company’s debt profile, profit-revenue trend, and leverage are considered. What do the analysts think about Red Hat’s ROE three-years ahead? I recommend you see our latest FREE analysis report to find out!
If you are not interested in RHT anymore, you can use our free platform to see my list of stocks with Return on Equity over 20%.