This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about Return on Equity using a real-life example.
With an ROE of 27.1%, Hugo Boss AG (FRA:BOSS) outpaced its own industry which delivered a less exciting 7.9% over the past year. Though, the impressiveness of BOSS’s ROE is contingent on whether this industry-beating level can be sustained. Sustainability can be gauged by a company’s financial leverage – the more debt it has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden. Let me show you what I mean by this.
Breaking down Return on Equity
Return on Equity (ROE) weighs Hugo Boss’s profit against the level of its shareholders’ equity. An ROE of 27.1% implies €0.27 returned on every €1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Apparel, Accessories and Luxury Goods industry may want to choose the highest returning stock. However, this can be deceiving as each company has varying costs of equity and debt levels, which could exaggeratedly push up ROE at the same time as accumulating high interest expense.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Hugo Boss’s cost of equity is 8.1%. Given a positive discrepancy of 19.0% between return and cost, this indicates that Hugo Boss pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be split up into three useful ratios: net profit margin, asset turnover, and financial leverage. This is called the 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 Hugo Boss’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. ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at Hugo Boss’s debt-to-equity ratio to examine sustainability of its returns. The ratio currently stands at a sensible 31.6%, meaning Hugo Boss has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden.
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Hugo Boss’s ROE is impressive relative to the industry average and also covers its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For Hugo Boss, I’ve compiled three key factors you should further research:
- Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Valuation: What is Hugo Boss worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Hugo Boss is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Hugo Boss? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.