Husky Energy Inc (TSX:HSE) outperformed the Integrated Oil and Gas industry on the basis of its ROE – producing a higher 9.33% relative to the peer average of 7.14% 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, HSE 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 HSE
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of HSE’s profit relative to its shareholders’ equity.It essentially shows how much HSE can generate in earnings given the amount of equity it has raised.If investors diversify their portfolio by industry, they may want to maximise their return in the Integrated Oil and Gas sector by investing in the highest returning stock.But this can be misleading as each company has different costs of equity and also varying debt levels, which could artificially push up ROE whilst accumulating high interest expense.
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 HSE, which is 9.71%. This means HSE’s returns actually do not cover its own cost of equity, with a discrepancy of -0.39%. 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 HSE is with its cost management.Asset turnover reveals how much revenue can be generated from HSE’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 HSE’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 HSE’s debt-to-equity ratio to examine sustainability of its returns. Currently the ratio stands at 36.57%, which is very low. This means HSE has not taken on leverage, and its above-average ROE is driven by its ability to grow its profit without a huge debt burden.
ROE – It’s not just another ratio
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. HSE’s ROE is impressive relative to the industry average, though its returns were not strong enough to cover its own cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. However, there are other crucial measures we need to account for before determining whether or not its returns are sustainable. I recommend you see our latest FREE analysis report to find out more about other measures!
If you are not interested in HSE anymore, you can use our free platform to see my list of stocks with Return on Equity over 20%.
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