Can Harley-Davidson Inc's (NYSE:HOG) ROE Continue To Surpass The Industry Average?

Harley-Davidson Inc (NYSE:HOG) outperformed the motorcycle manufacturers industry on the basis of its ROE – producing a higher 28.29% relative to the peer average of 14.50% over the past 12 months. Though, the impressiveness of HOG’s ROE is contingent on whether this industry-beating level can be sustained. This can be measured by looking at the company’s financial leverage. With more debt, HOG 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. View our latest analysis for Harley-Davidson

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) is a measure of Harley-Davidson’s profit relative to its shareholders’ equity. An ROE of 28.29% implies $0.28 returned on every $1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Motorcycle Manufacturers 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 Harley-Davidson has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.

Returns are usually compared to costs to measure the efficiency of capital. Harley-Davidson’s cost of equity is 9.90%. Since Harley-Davidson’s return covers its cost in excess of 18.39%, its use of equity capital is efficient and likely to be sustainable. Simply put, Harley-Davidson pays less for its capital than what it generates in return. ROE can be broken down into three different ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:

The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue Harley-Davidson can make from its 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 Harley-Davidson’s debt-to-equity ratio to examine sustainability of its returns. The ratio currently stands is significantly high, above 2.5 times, meaning Harley-Davidson has taken on a disproportionately large level of debt which is driving the high return. The company’s ability to produce profit growth hinges on its large debt burden.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Harley-Davidson’s above-industry ROE is encouraging, and is also in excess of 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 Harley-Davidson’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.

For Harley-Davidson, I've put together three fundamental aspects you should further research:

• 1. 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.
• 2. Valuation: What is Harley-Davidson 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 Harley-Davidson is currently mispriced by the market.
• 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Harley-Davidson? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!