Hammond Power Solutions Inc (TSX:HPS.A), with a ROE of 1.4% over the past twelve months, appeared relatively inefficient compared to the broader industry, which averaged 32.52% ROE. Often, we are quick to attribute a sub-par ROE to inneficient company performance. But to make an opinion on the quality of a company’s returns, an investor must look at the factors behind such performance. View our latest analysis for Hammond Power Solutions
Breaking down ROE — the mother of all ratios
ROE is one of the most popular ratios to calculate the profitability of a company. The ratio is arrived by putting net earnings in the numerator and shareholders’ equity in the denominator.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 HPS.A’s cost of equity at 12.26%, compared to its ROE of 1.4%.
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
Among the ratios affecting ROE, the profit margin is the most important as it highlights the operational efficiency of a company. To a potential investor, the ideal scenario would be profit increasing at a higher rate than the revenue.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. Hammond Power Solutions’s ROA stood at 3.6% in the past year, compared to the industry’s 6.76%.
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. HPS.A’s debt to equity ratio currently stands at 0.3. Investors should be cautious about any sharp change in this ratio, more so if it’s due to increasing debt.
ROE – More than just a profitability ratio
ROE is called the mother of all ratios for a reason. It helps gauge a company’s efficiency both through the income statement and the balance sheet, along with telling you how just changing the capital structure of the company can impact perceived return. What are the analysts thinking about Hammond Power Solutions’s ROE in three years? I recommend you see our latest FREE analysis report to find out!
If you are not interested in HPS.A anymore, you can use our free platform to see my list of stocks with Return on Equity over 20%.