Hanwha Q CELLS Co Ltd. (NASDAQ:HQCL) generated a below-average return on equity of 4.55% in the past 12 months, while its industry returned 12.18%. HQCL’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on HQCL’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of HQCL’s returns. See our latest analysis for Hanwha Q CELLS
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 4.55% implies $0.05 returned on every $1 invested, so the higher the return, the better. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Semiconductors sector by choosing 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 Hanwha Q CELLS 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 Hanwha Q CELLS, which is 17.53%. This means Hanwha Q CELLS’s returns actually do not cover its own cost of equity, with a discrepancy of -12.98%. This isn’t sustainable as it implies, very simply, that the company pays more 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
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 Hanwha Q CELLS’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can determine if Hanwha Q CELLS’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at Hanwha Q CELLS’s debt-to-equity ratio. Currently the ratio stands at 215.74%, which is relatively high. This means Hanwha Q CELLS’s below-average ROE is already being driven by its high leverage and its ability to grow profit hinges on a large debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Hanwha Q CELLS’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Hanwha Q CELLS’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Hanwha Q CELLS, there are three key factors you should further examine:
- 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 Hanwha Q CELLS 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 Hanwha Q CELLS is currently mispriced by the market.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Hanwha Q CELLS? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!