This article is intended for those of you who are at the beginning of your investing journey and want a simplistic look at the return on Highlands Pacific Limited (ASX:HIG) stock.
Highlands Pacific Limited (ASX:HIG) outperformed the diversified metals and mining industry on the basis of its ROE – producing a higher 118.67% relative to the peer average of 11.89% over the past 12 months. However, whether this above-industry ROE is actually impressive depends on if it can be maintained. This can be measured by looking at the company’s financial leverage. With more debt, HIG can invest even more and earn more money, thus pushing up its returns. However, ROE only measures returns against equity, not debt. This can be distorted, so let’s take a look at it further. See our latest analysis for Highlands Pacific
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Highlands Pacific’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Investors seeking to maximise their return in the Diversified Metals and Mining industry may want to choose the highest returning stock. However, this can be misleading as each firm has different costs of equity and debt levels i.e. the more debt Highlands Pacific has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Highlands Pacific, which is 15.09%. Since Highlands Pacific’s return covers its cost in excess of 103.58%, its use of equity capital is efficient and likely to be sustainable. Simply put, Highlands Pacific pays less for its capital than what it generates in return. ROE can be dissected into three distinct 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
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 Highlands Pacific 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 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 Highlands Pacific’s debt-to-equity ratio to examine sustainability of its returns. The most recent ratio is greater than 2.5 times which is very high, indicating Highlands Pacific’s above-average ROE is generated by its significant leverage levels and its ability to grow profit hinges on a substantial debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Highlands Pacific’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of Highlands Pacific’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For Highlands Pacific, there are 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.
- Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for Highlands Pacific’s future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Highlands Pacific? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!