With an ROE of 75.46%, Hargreaves Lansdown plc (LSE:HL.) outpaced its own industry which delivered a less exciting 13.55% over the past year. Superficially, this looks great since we know that HL. has generated big profits with little equity capital; however, ROE doesn’t tell us how much HL. has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of HL.’s ROE. View our latest analysis for Hargreaves Lansdown
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs HL.’s profit against the level of its shareholders’ equity. For example, if HL. invests £1 in the form of equity, it will generate £0.75 in earnings from this. 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
Returns are usually compared to costs to measure the efficiency of capital. HL.’s cost of equity is 9.21%. Given a positive discrepancy of 66.25% between return and cost, this indicates that HL. pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be broken down into three different 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue HL. can generate with its current 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 HL.’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt HL. currently has. Currently, HL. has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
What this means for you:
Are you a shareholder? HL.’s ROE is impressive relative to the industry average and also covers its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. 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 HL., 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 Hargreaves Lansdown 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.