With an ROE of 2.27%, Baker Hughes a GE company (NYSE:BHGE) outpaced its own industry which delivered a less exciting 1.92% over the past year. While the impressive ratio tells us that BHGE has made significant profits from little equity capital, ROE doesn’t tell us if BHGE has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable BHGE’s ROE is. View our latest analysis for Baker Hughes a GE
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs BHGE’s profit against the level of its shareholders’ equity. An ROE of 2.27% implies $0.02 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 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 BHGE, which is 10.01%. Since BHGE’s return does not cover its cost, with a difference of -7.74%, this means its current use of equity is not efficient and not sustainable. Very simply, BHGE 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 BHGE is with its cost management. The other component, asset turnover, illustrates how much revenue BHGE can make from its asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable BHGE’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check BHGE’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 12.22%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
What this means for you:
Are you a shareholder? BHGE exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. Since its high ROE is not fuelled by unsustainable debt, investors shouldn’t give up as BHGE still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.
Are you a potential investor? If you are considering investing in BHGE, basing your decision on ROE alone is certainly not sufficient. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Baker Hughes a GE to help you make a more informed investment decision.
To help readers see pass 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.