This article is intended for those of you who are at the beginning of your investing journey and want to learn about Return on Equity using a real-life example.
Holly Energy Partners LP (NYSE:HEP) delivered an ROE of 36.7% over the past 12 months, which is an impressive feat relative to its industry average of 13.1% during the same period. On the surface, this looks fantastic since we know that HEP has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable HEP’s ROE is.
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 36.7% implies $0.37 returned on every $1 invested. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Holly Energy Partners’s equity capital deployed. Its cost of equity is 11.5%. This means Holly Energy Partners returns enough to cover its own cost of equity, with a buffer of 25.2%. This sustainable practice implies that the company pays less for its capital than what it generates in return. 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
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Holly Energy Partners’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. Since ROE can be artificially increased through excessive borrowing, we should check Holly Energy Partners’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a high 231%, which means its above-average ROE is driven by significant debt levels.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Holly Energy Partners’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 Holly Energy Partners’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Holly Energy Partners, there are three fundamental aspects 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 Holly Energy Partners 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 Holly Energy Partners is currently mispriced by the market.
- Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Holly Energy Partners? 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 firstname.lastname@example.org.